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	Table of Contents
p. 44 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 2: Project Economic Rationale : Market and Nonmarket Failures

I. Establishing the Economic Rationale of a Project

1. The main rationale for Bank operations lies in the inadequacies of markets to produce what society wants. However, this rationale provides only a necessary, not a sufficient justification for project investments. Sufficiency requires that specifically identified market failures be compared with potential nonmarket failures associated with project implementation and operation. Such an assessment is needed to arrive at a balanced appraisal of whether and what kind of Bank operation will come closer to a socially preferred outcome.

II. Market Failure

2. In a relatively undistorted environment, the economic internal rate of return (EIRR) and financial internal rate of return (FIRR) of a project tend to converge. The exception is projects producing pure public goods, such as rural roads and primary education. Public goods create positive external benefits that do not enter into financial production decisions. Markets therefore underproduce goods and services whose provision entails positive externalities, and overproduce goods and services whose provision entails negative externalities. Projects should aim at producing public goods or at reducing negative public goods, such as negative environmental impacts and poverty, while assisting the production of some private goods through private production and regulation.

3. Eligibility for Bank assistance will vary by project or subsector, depending on how much the output of each subsector approximates a public good. Criteria for distinguishing between public and private goods are excludability and subtractability:

• Excludability is the degree to which a potential user of a good or service can be excluded if the user does not meet conditions set by the supplier. Users cannot be excluded from using public goods.
• Subtractability refers to how much one users consumption of a service subtracts from the ability of others to consume without raising production costs. Subtractability is a matter of degree: virtually all public goods experience crowding out at sufficiently high levels of use, thus increasing marginal costs of supply.

4. These two characteristics enable a fourfold classification of the publicness of projects:

• public goods, for example, urban and rural roads, wastewater treatment, and unpiped water, have low subtractability and low excludability.
• private goods, such as rail, urban, and road transport services, have high subtractability and high excludability.
• toll goods, such as highways, telecommunications, piped water, and power transmission and distribution, have low subtractability and high excludability.
• common property goods, for example, power generation, and irrigation systems, have high subtractability and low excludability.

Public goods should be produced by the public sector and private goods by the private sector. The practical issue is how far toll and common property goods can, through technological and institutional development, approach the conditions of private goods and be operated under competition.

5. Publicness varies with government policy. For a project producing toll goods or services in a relatively undistorted economic environment, public provision should be compared with the alternative of private provision. The economic and financial rates of return may not differ very much. On the other hand, if the policy environment was not conducive to private sector investment, the acceptability of the projects EIRR and unacceptability of the projects FIRR provides a case for policy reform rather than for Bank-assisted investment. However, policy reform takes time. The large size and long maturity of many projects bring high risks. In such cases, the Bank could make greater use of guarantees, taking on those political risks that participants in private markets are unwilling to shoulder.

6. Publicness also varies with affordability. In a distorted environment, if a project producing private goods yields an acceptable EIRR but unacceptable FIRR solely because the project benefits the poor, there is a case for Bank assistance. If the project yields an unacceptable FIRR as a result of both the inability of the poor to pay and nonmarket distortions, then policy reform would be a necessary precondition for the project to be viable, even with concessional credit.

III. Nonmarket Failure

7. Nonmarket failure helps to explain why projects often yield higher costs and lower benefits, as well as different consequences, from those forecast at appraisal. Nonmarket failure results in projects underperforming for four main reasons:

• the private goals of nonmarket organizations are not congruent with the public objectives set for them,
• implementation and operation is inefficient,
• externalities are derived, and
• there is distributional inequity.

These reasons can apply just as well to the private as well as to the public sector, but the extent to which they do is limited by competition.

8. The sources of nonmarket failures generally lie in the monopolistic structure of supply. Government interventions to correct market failure can generate unanticipated side effects, often as a result of premature action or inefficient regulation. Unless located in areas in which poor people live, projects typically benefit the nonpoor more than the poor. Bank projects and operations can reduce nonmarket failure by strengthening organizational capacity and improving institutional efficiency. With both being related, Getting the institutions right is as important as getting the prices right. Fostering competition between state enterprises, and promoting financial autonomy and accountability, reforms both prices and institutions.

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