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	Table of Contents
p. 69 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 27 : Difference Between Economic and Financial Prices

1. Financial returns are based on financial prices. Economic returns are based on economic prices. If the financial and economic boundaries of a project are the same, as in public utility projects for example, differences between financial and economic returns come down to differences between financial and economic prices.¹

I. Indirect Taxes and Subsidies

2. Both financial and economic prices are related to market prices. If governments impose indirect taxes to raise revenues, prices paid by buyers will diverge from prices received by sellers, as taxes drive a wedge between demand and supply prices. For any good the demand price is the price at which buyers are willing to buy, that is, the market price plus consumption taxes and less consumption subsidies, and the supply price is the price at which suppliers are willing to sell, that is the market price less production taxes and plus production subsidies.

3. Indirect taxes and subsidies, therefore, are important to understanding the difference between economic and financial prices. For project output, the economic price exceeds the financial price by at least the amount of the indirect tax, whereas for project input, the financial price exceeds the economic price by at least the amount of the indirect tax. This result applies whether project output or input is tradable or nontradable.

II. The Economic Price of Foreign Exchange

4. Indirect taxes and subsidies are not the only reason economic and financial prices diverge. Market structures, with monopolized supplies or monopolized stocks, also tend to maintain national price levels at higher levels than world prices. The extent to which the exchange rate is overvalued is proportional to the sum of government and market effects on domestic price levels relative to the level of world prices. To account for these effects on the price for foreign exchange, the economic or shadow exchange rate (SER) is estimated (see Appendix 16).

5. The SER is the weighted average of the demand price of foreign exchange paid for by importers and the supply price of foreign exchange received by exporters. Import tariffs and subsidies have the same effect on the foreign exchange rate as would consumption taxes and subsidies on the price of a nontradable. Similarly, export taxes and subsidies have the same effect as production taxes and subsidies. A further major difference between the economic and financial prices therefore stems from the foreign exchange premium. This premium is given by the percentage difference between the SER and the official exchange rate. The foreign exchange premium is in effect a tax paid by exporters to importers.

III. Producer and Consumer Surplus

6. Economic and financial values can also differ as a result of producer and consumer surpluses. Such surpluses stem from the market impact of projects. For example, if a project is large enough to cause the price of output to fall, the producer surplus of existing producers is reduced and the consumer surplus of both existing and new consumers is increased. Though both producer and consumer surpluses are difficult to quantify, rough estimates can be made, particularly for key project beneficiaries. For example, the difference between the financial price of labor and its economic price is a major source of producer surplus and benefit to the poor.

IV. Externalities

7. External effects can also cause differences between economic and financial prices. Externalities are imposed by a project on parties outside the project. Positive externalities are known as external benefits and negative externalities as external costs. In cases in which the government imposes a tax to correct for a negative externality, such a tax is incorporated in both financial and economic prices.

V. Differences Between Economic and Financial Values

8. In sum, the main differences between the economic and financial values of project costs and benefits are made up of government taxes and subsidies, excess operating surpluses from monopolized markets, foreign exchange premia, producer and consumer surplus, and positive and negative externalities. Economic values exceed financial values as a result of output taxes, input subsidies, foreign exchange premia, consumer surplus, and positive externalities. Financial values exceed economic values as a result of output subsidies, input taxes, foreign exchange discounts, producer surplus, and negative externalities.

9. The difference between economic and financial values is subject, in part, to policy changes. Changes in the level of taxes and subsidy may affect the difference substantially. The difference will also depend on other forms of policy: the extent to which governments ensure external costs are internalized in financial costs, the extent to which governments regulate prices in monopolized markets or open them up for competition, the level of charges for services that will capture some of the consumer surplus. All these forms of government action can be applied at the project level, in the design of projects that are economically viable, that meet all their financial costs and at the same time provide sufficient incentives for project participants.

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¹ Depending upon project type and sector, analytical boundaries for financial and economic analyses may not be congruent. Financial analysis may focus on the project's impact on commercial entities whereas economic analysis encompasses the project's impact on the economy. To better understand the impact of government policy on project performance, there are advantages to undertaking analyses at financial and economic prices at both the entity and project level.

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