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	Table of Contents
p. 54 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices Appendix 1: Key Questions For The Economic Analysis of Projects Appendix 2: Project Economic Rationale: Market and Nonmarket Failures Appendix 3: The Project Framework Appendix 4: Identification and Measurement of Consumer Surplus Appendix 5: Treatment of Working Capital Appendix 6: Depletion Premium Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects Appendix 8: General Methodology For Building Up Project Statements Appendix 9: Economic Evaluation of Project Output and Input Appendix 10: Economic Price of Traded Goods and Services Appendix 11: Valuation of Nontraded Outputs and Inputs Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor Appendix 13: The Economic Price of Land Appendix 14: Treatment of Resettlement Components of Projects Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example Appendix 19: Least-Cost Analysis and Choosing Between Alternatives Appendix 20: Estimating The Economic Opportunity Cost of Capital Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water Appendix 23: Financial Returns To Project Participants: An Illustration Appendix 24: Economic Evaluation of Environmental Impacts Appendix 25: Distribution of Project Effects Appendix 26: Impact On Poverty Reduction Appendix 27: Difference Between Economic and Financial Prices Appendix 28: Use of Economic Prices In Measuring Effective Protection Appendix 29: Exchange Rate Issues In Project Analysis XVII. Others

Guidelines for the Economic Analysis of Projects : XVI. Appendices

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Appendix 12 : Shadow Wage Rate and the Shadow Wage Rate Factor

1. In the financial analysis of a project, money wages (and other benefits) paid to employees are treated as the financial price of labor. The shadow wage rate (SWR) is an estimate of the economic price of labor.

I. General Principles for Calculating the Shadow Wage Rate

2. The economic price of labor is measured through its supply price. At very low wages, people may prefer leisure to work. The supply price of labor depends upon several factors, such as the value placed on leisure and other nonwage activities, family income, the cost of migration, and the nature of employment and other benefits accruing from that employment. The reservation wage, below which people in an area will not offer their labor, varies across classes of labor and geographic locations.

3. There are large variations in the types of labor, depending on skills, regions within countries, and even individual jobs. It is thus often necessary to use a set of shadow wage rates, one for each skill, location, economic sector, and even season, rather than a single rate for the whole country. A simplified approach based on the prevailing wage rates for the various types of skills and locations, and the degree of unemployment relating to those skills can be used to estimate the SWR. For purposes of analysis, workers may be divided into three categories: skilled, semiskilled, and unskilled, corresponding to different degrees of scarcity.

4. Since skilled workers are generally in short supply in DMCs, prevailing market wages in the project area may be taken as corresponding to their supply price. Other benefits, such as housing and provident fund contributions, also should be included in the supply price estimates.

5. For semi-skilled workers, wages in the informal or unprotected sector, beyond the effective control of wage regulations and labor unions, adjusted for the degree of unemployment in the project area, can be used in estimating the SWR. In the formal or protected sector, wages can be held above the market-clearing level by minimum wage laws, collective bargaining agreements, or by the hiring policies of companies. Thus, the supply price of semiskilled labor can be estimated as a weighted average of the informal and formal wage sectors, with the weight given by the proportion of labor drawn from each.

6. For unskilled workers, the SWR should be estimated on the basis of the unprotected wage rate for the number of days and gainful employment during the year. Most DMCs report a high degree of unemployment and underemployment in both rural and urban areas, with most of the unemployed being unskilled. In determining the SWR for such workers, it should be borne in mind that unskilled workers in urban areas engage in many informal activities. In rural areas, the unemployed may provide help in family farms, do seasonal work in nearby industries or work on construction projects. These alternative activities should also be included when estimating the SWR.

7. In estimating the SWR, the degree and nature of unemployment and underemployment in the project area and its environs should be carefully assessed. It is preferable that independent surveys made in the project or surrounding areas be used to confirm the estimates obtained from official sources.

8. Estimation of the SWR is particularly important in projects where the wage component in the total cost or benefit stream is significant, and where technological options exist in formulating projects. For these projects, expected changes in the SWR over the project cycle should be assessed, on the basis of forecasts about the supply and demand for labor. Other projects may involve only a few workers. For projects that have a very small wage component, and that are not sensitive to the valuation of labor, it will not be necessary to estimate a project specific SWR.

9. If the market works fairly well, minimum wage legislation is absent, and unemployment is low, but there is an income tax imposed on wages, the SWR would be the average of the market wage which represents the value to the employer of the foregone labor, and the net-of-tax wage received by labor. On the other hand, new vacancies created by the project will reduce unemployment compensation payments and this will result in savings of public funds.

10. It should be noted that the procedure outlined thus far establishes the SWR in terms of the value of output foregone at domestic market prices. In economic analysis, the SWR has to be defined in border price equivalents. This can be done by applying appropriate conversion factors.

II. Illustrative Example: Calculating the Shadow Wage Rate for Unskilled Labor in a Government Rural Project

11. Consider the case of a government corporation that is undertaking a labor-intensive sugar project in a rural area. The project requires unskilled workers on a temporary basis and pays a gross-of-tax wage that varies by the month. This amount will be subject to a 5 percent income tax. The following schedule shows in column (3), the after tax monthly wage rate for landless labor working in several alternative formal sector activities in the area, and, in column (4), the projects monthly requirements for person-months.

12. To estimate the economic cost of the unskilled labor to the project, we first need to calculate the monthly share of the annual person-months required by the project. This is obtained in column (5), above, by dividing the number of person-months for a particular month by the total yearly person-months.

13. The weighted average monthly wage for casual labor is then calculated as

120 * 0.2 + 100 * 0.2 + . . . + 150 * 0.1 + 180 * 0.1
Average monthly wage after tax = 141 rupees per month, and
Average monthly wage before tax = 148 rupees per month
Shadow wage rate = (141 + 148) / 2 = 144.5

III. The Shadow Wage Rate Factor

14. The shadow wage rate factor (SWRF) for a certain type of labor is the ratio between its shadow wage rate and its price. If project labor is paid a wage of 200 rupees per month, then the SWRF is calculated as: 144.5/200 = 0.723 in domestic prices. Where the world price numeraire is being used, this SWRF has to be revalued again using a standard conversion factor or a specific conversion factor for the output of this type of casual labor.

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