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p. 51 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 9 : Economic Valuation of Project Output and Input

1. The economic valuation of project output and input is undertaken within a common conceptual framework. This framework distinguishes incremental output from nonincremental output, and incremental input demand from nonincremental input demand. This appendix outlines the conceptual framework and Appendixes 10 and 11 apply the framework to tradable and nontradable goods, respectively.

I. Project Output

2. The economic price (EP) of project output is the gross economic benefit per unit of output. The EP is equal to the gross economic benefit (GEB) of the project divided by project output (Q_P ).

3. The competitive market model provides a framework for valuing project output (see Figure 1). A project is represented by a rightward shift in the supply curve, with output being produced at a lower cost. The market price of project output falls from P_WO to P_W and the quantity sold increases from Q_WO to Q_W. The project displaces a part of supply that was provided at a higher price. The incremental output of the project is (Q_W- Q_WO) and nonincremental output is QP less incremental output. The gross economic benefit of the project is therefore made up of two parts: gross benefit from incremental output and gross benefit from nonincremental output.

4. The GEB from incremental output is represented by the light-shaded area under the demand curve, defined by P_WO, P_W, Q_W, Q_WO. It comprises incremental revenues (area below the price line) and consumer surplus (area above the price line).

5. The GEB from nonincremental output is represented by the dark shaded area under the without project supply curve, defined by P_WO, Q_WO, Q_E, P_W, where Q_E is the supply of output from other sources with the project. It is the cost to the economy of producing nonincremental output without the project.

6. The GEB of the project is equal to the average market price with and without the project, multiplied by project output, and the EP of project output is equal to the GEB divided by the project output.

7. In this illustration, it is assumed there are no distortions in any product or factor markets. However, with government intervention, the market price, demand price, and supply price may differ. Figure 2 shows the result of an ad valorem consumption tax and production subsidy. The consumption tax shifts the demand curve leftward by the amount of the tax, while the production subsidy shifts the supply curve rightward by the amount of the subsidy.

8. Gross benefit from incremental output (QD) is shown by the area under the before-tax demand curve, which is equal to the product of the average demand price (DP) with and without the project, and QD. Gross benefit from nonincremental output (QS) is shown by the area under the before-subsidy supply curve, which is equal to the product of the average supply price (SP) with and without the project, and QS.

GEB = (DP x Q_D) + (SP x Q_S)

where¹ DP = 0.5 (DP_WO + DP_W)

SP = 0.5 (SP_WO + SP_W)

EP = GEB/Q_P

II. Demand and Supply Elasticities

EP = DP.dw + SP.sw

where dw is demand weight, and sw is the supply weight.

dw = (-D_E.Q_D /Q_S) / [S_E - D_E(Q_D /Q_S )]

sw = S_E / [S_E - D_E(Q_D / Q_S)]

sw = 1 - dw

where D_E is the price elasticity of demand, and S_E is the price elasticity of supply.

Where distortions appear in other commodity or factor markets, the demand price and supply price have to be adjusted for these.

III. Project Input

10. The EP of a project input is the economic cost per unit of input. The EP is equal to the economic cost (EC) of the project input divided by the quantity demanded (Q_P).

11. The competitive market model again provides a conceptual framework for valuing a project input (see Figure 3). The input demand by the project is represented by a rightward shift in the total demand curve for the input. The market price of the project input rises from PWO to PW and the total quantity demanded increases from Q_WO to Q_W. At the higher price, the new project bids some supply away from existing projects. The incremental quantity demanded is (Q_W-Q_WO ) and the nonincremental quantity demanded is [Q_P - (Q_W-Q_WO )]. The economic cost of the project input is therefore made up of two parts: the economic cost of the incremental quantity demanded and the economic cost of the nonincremental quantity demanded.

12. Without any distortions in commodity or factor markets, the EC of the incremental quantity demanded by the project is represented by the light-shaded area under the supply curve, defined by P_WO, P_W, Q_W, and Q_WO. It comprises the incremental cost of increasing supply to meet project demand.

13. The EC of the nonincremental quantity demanded by the project is represented by the dark-shaded area under the without project demand curve, defined by P_WO, Q_WO, Q_E, and P_W. It comprises the economic benefit foregone by the without project buyers of the project input, as measured by their willingness to pay.

14. The total EC of the project input is equal to the average market price with and without the project multiplied by the quantity of input demanded by the project. The EP is equal to the EC divided by the quantity of input demanded.

15. The input market represented in Figure 3 is perfectly competitive. However, with government intervention, the market price, demand price, and supply price may differ. Figure 4 shows the result of an ad valorem consumption tax and production subsidy. The consumption tax shifts the demand curve leftward by the amount of the tax, while the production subsidy shifts the supply curve rightward by the amount of the subsidy.

16. With no distortions in other markets, the EC of incremental input (Q_S) is shown by the area under the before-subsidy supply curve, which is equal to the product of the average supply price (SP) with and without the project, and Q_S. The EC of nonincremental input (Q_D) is shown by the area under the after-tax demand curve, which is equal to the product of the average demand price (DP) with and without the project, and Q_D.

EC = (DP.QD ) + (SP.QS)

where DP = 0.5 (DPWO + DPW); and

SP = 0.5 (SPWO + SPW)

EP = EC/QP

IV. Demand and Supply Elasticities

17. The EP can also be expressed in terms of the price elasticities of demand and supply for the project output. The EP is based on the weighted average of the demand and supply price of project output, with the weights depending on the price elasticities of demand and supply.

EP = DP.dw + SP.sw

where dw is demand weight, and sw is the supply weight

dw = (-D_E.Q_D / Q_S) / [S_E - DE(Q_D /Q_S )]

sw = S_E / [S_E - D_E(Q_D /Q_S )]

sw = 1 - dw

where D_E is the price elasticity of demand, and

S_E is the price elasticity of supply

Where distortions appear in other commodity or factor markets, the demand price and supply price have to be adjusted for these.

V. Application

18. In principle, the framework provided here can be applied to any project output or input. It is especially relevant on the output side to analyze the effects of a project producing nontraded outputs, where adjustments of both quantities and prices are confined to the domestic economy and are therefore likely to be larger. It can also be applied to all types of project impact, to materials and services, equipment, construction, and labor, as well as to factors of production more broadly defined, such as capital or foreign exchange. In each case, the approach requires the analyst to assess the market structure for a good, and to work out what the incremental and nonincremental project effects will be.

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¹ The formulations in this Appendix are based on linear demand and supply functions. The numerical values for the coefficients can be adjusted for circumstances where the demand and supply functions take a different form.

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