Economic Analysis

Chapter six

Economic Analysis

6.1 Introduction

    Economic analysis is one step forward in the project planning effort. Because as compared to financial analysis, which should assess the impact of a project on the income of its owners, economic analysis is a form of more general tool of cost benefit analysis. The use of the word "economic" implies the analysis is undertaken is from the point of view of the nation or the economy as a whole. It can be seen as a cost benefit analysis from the social and national perspective. It ascertains the overall country impact of a project. In other words, it is the measure of the costs and benefits of a project to the society. The exercise of project appraisal is not accomplished till the proposed project is also viewed from the economic viewpoint. Therefore, this unit focuses on economic analysis and items included in it.


   6.2 Objectives (reasons) for economic analysis


In project planning there are two main objectives to economic analysis. These are:

  1. to provide information for making decisions on the acceptability of projects from the national point of view, and
  2. to provide information of value for project design and planning, macro economic planning and economic research.


Economic analysis broadens the analysis from confining attention to the project itself to investigating the impact of the project on the national economy.


Economic analysis is the core of project analysis and evaluation. It is made to ascertain the overall country impact of a project. It is a measure of the costs and benefits of a project to the society. The exercise of project appraisal is not accomplished till the proposed project is also viewed from the economy viewpoint.


Economic analysis substitutes shadow price (economic prices) for market prices because market prices do not reflect their true or scarcity prices. Regardless of their difference, financial analysis is the base for economic analysis. It provides the necessary information to be used for economic analysis.


In addition to the above two major reasons , Economic analysis is done because of the following reasons.

  1. Inflation: is a general price increase of commodities (Inputs and outputs). When high degree of inflation prevails in any economy, the project's inputs and outputs do not reflect their real value. Therefore, the price of these inputs and outputs should be adjusted using the world price by conducting economic analysis.
  2. Currency over valuation: when the foreign currency is over valued (eg., dollar), most developing countries are exercising devaluation of their currency in order to reflect the world price. For example, our birr is depreciated from time to time whenever the value of dollar is appreciating. ($1 = Br. 8.00, $1 = Br. 8.65 etc.)
  3. Existence of under employment: in developed countries like Ethiopia, the domestic prices are distorted and do not reflect the real value of inputs and outputs. In other words, the market prices and economic prices are not the same. One of the highly distorted market is the labor market. Unskilled and semi-skilled labor market is highly affected because workers are paid less and the payment is employees not the same for all doing the same job. Therefore, for economic analysis purpose this distortion should be adjusted.
  4. Existence of income/wealth inequality: due to this inequality price may not reflect the social equalities. As a result project analysts shift to apply social pricing techniques (that is shadow pricing techniques).
  5. Externalities: are costs and benefits to the economy as a whole and that are attributed to the project but are not taken in to account in estimating quantities and values for the project inputs and outputs. Since they are not paid for by a particular firm, financial analysts ignore them. But someone has covered their cost (government), thus their value should be included in the economic pricing technique. 
  6. Existence of tariffs, customs and duties: existence of these restrictions and impositions by the government may increase the price of commodities. This cost needs to be excluded in the economic analysis because it does not reflect the commitment of real resources.


The existence of the above mentioned factors demands economic analysis so that the value of inputs and outputs of a project can reflect its real value. Markets like commodity market, labor market, foreign exchange and capital markets are highly distorted in developing countries. Therefore, adjustment of price to reflect the real cost of resources should be made using shadow prices, which is a set of prices that better reflect the opportunity costs of goods and services in their best use. The objective of economic analysis is utilization or best use of the scarce resources of a nation.


Economic analysis, to achieve its intended purposes, should follow the following steps. These are:

Step 1: Identify and eliminate transfer payments. As it is explained above, transfer payments like duties, taxes etc should be eliminated. Turning the economic analysis.

Step 2: Identify linkages and externalities

Step 3: Identify the effect on the use or creation of traded goods

Step 4: Identify the effect of the project on the employment of labor.

   6.3 Shadow prices

Shadow prices are a set of prices that are believed to better reflect the opportunity cost of resources in their best use. They are employed instead of domestic market prices in guiding the allocation of resources since the later is distorted and using them would lead to resource misallocation.


   Shadow prices for economic analysis are based on the opportunity costs. If costs can be broken down into basic resource categories on an opportunity cost basis, all that remains to be done is to value the basic categories according to their opportunity cost.


    6.3.1 Opportunity Cost

Before we proceed to the discussion of shadow price and its calculation, let us first outline the opportunity costs of resources because opportunity cost is the most important concept underlying economic analysis. It is defined as the next best alternative foregone in undertaking a course of action. Whenever, there is an opportunity cost, there is an argument for using shadow prices. Opportunity cost can best be explained by reference to examples commonly used in the economic analysis of projects: land, labor and capital.


  1. Opportunity Cost of Land

In economic analysis land is not usually treated as a capital value. The opportunity cost of land is defined by its next best alternative use. Urban land can be used for houses, offices, shops and factories. Rural land is normally used for crops, pasture, forestry or sometimes conservation.


The opportunity cost of rural land is likely to be very important in the assessment of any agricultural or agro industrial project. When agricultural land is being used, the opportunity cost is the value of the alternative crop produced less the other costs involved in producing the crop. For urban land the opportunity cost is usually defined by rental values.


  1. Opportunity Cost of Labor

Opportunity cost of labor is the value of the worker's output in the next best alternative. It usually varies significantly between occupational groups and often between regions. In determining the opportunity cost of labor it is important to identify the potential source of labor (urban or rural). Project appraisal also distinguish between skilled and unskilled labor. The most common assumption is that skilled labor is in scarce supply and has an opportunity cost equal or greater than its market price, while unskilled labor is in excess supply and has an opportunity cost below its market price.


The first assumption implies that skilled workers are able to obtain the same salary whether they work on the project in question or on another project. This assumption is reasonable for most countries including Ethiopia. For our country, on the other hand, the labor category assumed to be in excess supply are formal sectoral rural and urban unskilled labor. The largest potential source of unskilled labor is the agricultural sector. 


Skilled labor was assumed to be relatively scarce and so the opportunity cost of skilled manpower was assumed to be the same as the market price. The opportunity cost is assumed to consist of outputs of the various sectors in proportion to the estimated employment of skilled labor in each sector.


c) Opportunity Cost of Capital

In principle the opportunity cost of capital (investment funds) for an individual, a company or an economy is the rate of return available on the next best alternative project. For an individual or company the bank interest rate may give a reasonable guide. Because the alternative to investing in a project is to lend to a bank that pays a periodic interest. However, it is not easy to directly estimate the opportunity cost of capital for an economy at large because economic analysis using shadow prices is not applied consistently to all projects.


d) Opportunity Cost and Traded Goods

Traded goods are those items, which can be imported or exported. The opportunity cost of traded goods to an economy is defined by their border prices (CIF for imports and FOB for exports). This can be understood using the following example.

Assume that the country produces sugar to satisfy the local market. The alternative to production of the sugar is to import the sugar. The value of the sugar produced is then the CIF (Cost Insurance and Freight) price, which has been saved. Similarly, if a textile factory use locally produced cotton as a raw materials the alternative is to export the raw material (cotton). The opportunity cost of using the cotton for the textile project is the export price (FOB) foregone.


There are four main types of traded goods. The basic for their valuation can be summarized as:

  1. Imported input (opportunity cost: foreign exchange foregone i.e., the input price plus the cost of transport and handling to the project)
  2. Locally produced import substitute (opportunity cost: foreign exchange saved (the import price) plus transport and handling costs from boarder to the point of sale minus transport from the project to the point of sale.
  3. Exported output (value foreign exchange earned (the export price) minus transport and handling from the project to the boarder.
  4. Diverted export as an input.


e) Opportunity Cost and Non-Traded Goods

Most projects, in addition to imported inputs and exported outputs, use inputs and produce outputs that are not traded internationally. Goods and services produced and sold in a country only are defined as non-traded. They do not enter world trade either because of their nature, eg. Electricity, unskilled labor, inland transport etc or due to trade barriers and other special reasons such as high transport cost, government policy etc.


The value of non-traded items is estimated by decomposing them in to traded and non traded elements. The former is valued at boarder price directly and the later at specially estimated shadow prices or at domestic prices multiplied by conversion factor. (Conversion factors are covered in the following section of this material).


6.3.2 Conversion and Adjustment Factors

Shadow prices are often applied using either conversion factors (CF's) or adjustment factors (AF's). Ideally, all project inputs and outputs should be valued directly at accounting price/shadow price or boarder prices. However, this is not always possible because some of the goods and services are not traded and for them you know only the domestic price. This price most of the times is distorted due to several reasons. Therefore, it should be translated into shadow prices using conversion factors.


Conversion factor (CF) is the factor by which we multiply the actual price(s) in the domestic market of an input or output to arrive at its economic price, when the later cannot be observed or estimated directly.


To conclude, these are the major national economic parameters used to make economic analysis. All parameters (shadow prices) reflect opportunity cost. They are very important for project planners because they show the alternative side of the project, what it will contribute to the economy and to the society.


Once the financial and economic analysis are done and if the project is worthwhile to take, it should be put into action, that is, it should be implemented. The next unit is devoted to the discussion of project implementation.



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