Abstract
This chapter summarizes the economic principles that would help evaluate individual investment projects, general expenditure programs, government policies, and the regulation of economic activities. The objective of the project and program evaluation is to measure the net benefit of a project or program to those individuals in the society who are affected by such public initiatives. The chapter begins with theoretical perspectives on cost-benefit analysis and then proceeds to discuss the difficulties of implementing such an analysis and provides guidance on practical ways of dealing with those problems. The chapter recognizes project evaluation as “an art, though one with scientific underpinnings.” The chapter concludes with a plea for incorporating new insights into project evaluation from recent advances in economic theory and development economics, such as imperfect information, implications of unfettered markets, and the underground economy.
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Notes
- 1.
The term ‘welfarism’ is due to Sen (1970), who used it to describe the property of a social welfare function which orders alternative resource allocations according to the levels of utility achieved by members of the society. Sen has been critical of the principle of welfarism, arguing that other characteristics of social well-being, such as freedom, justice, non-discrimination, equality of opportunity, and so on, should also count. Project evaluators sidestep this issue by arguing either that the projects under consideration have no particular effect on these virtues or that if they do it is impossible to measure them so they ought to be weighted according to the values of those ultimately responsible for decision-making.
- 2.
Technically speaking, it is the area beneath the compensated demand curve associated with the pre-change utility level. This area will differ from the area beneath the uncompensated demand curve because of income effects. For typical project evaluations, the difference will not be important, given the limitations of data.
- 3.
For example, in the case of a single price change, each welfare change measure will correspond to a consumer surplus area beneath a demand curve, but the actual demand curve that is appropriate will vary according to the measure used. For the CV, the compensated demand curve corresponding to the utility level of the final situation will be appropriate, while for the EV, that corresponding to the initial utility level is used. The two will differ only because of income effects. See Boadway and Bruce (1984) for a more complete discussion.
- 4.
A comprehensive summary of the arguments against using this procedure may be found in Blackorby and Donaldson (1990).
- 5.
A simple example will illustrate. Consider two projects, A and B. Project A has a present value of benefits and costs of PVB = 2,000,000 rupees and PVC = 1,000,000 rupees, giving a benefit-cost ratio of 2 and an NPV of 1,000,000 rupees. Project B has PVB = 1,200,000 rupees and PVC = 400,000 rupees, for a benefit-cost ratio of 3 and a NPV of 800,000 rupees. While project B has a higher net present value, it yields a lower NPV.
- 6.
To see this, note that the relation between real and nominal prices is given by pt = (1 + π)tp0, where pt is the nominal price level in period t, while p0 is the real price using a base year of zero. The NPV using nominal prices can be written:
$$ \mathrm{NPV}=\sum {\mathrm{p}}_{\mathrm{t}}{\mathrm{X}}_{\mathrm{t}}/{\left[\left(1+\mathrm{r}\right)\left(1+\pi \right)\right]}^t=\sum {\mathrm{p}}_0{\mathrm{X}}_{\mathrm{t}}/{\left(1+\mathrm{r}\right)}^t $$where Xt is the vector of net benefits in year t. Note that (1 + π)t is the price index for period t.
- 7.
These weighted-average shadow prices might be augmented by distributive weights if desired. We discuss the use of distributive weights later.
- 8.
Moreover, if equity is a concern, distributional weights need not be attached to traded inputs and outputs of items of importance to, say, low-income groups since they do not directly affect the domestic consumption of those goods. In the Little-Mirrlees approach, which uses foreign exchange as the numeraire, this makes the valuing of traded commodities particularly easy: world prices in rupees.
- 9.
Evaluating reductions in the risk of death by ex ante willingness-to-pay, that is, without knowing precisely who will be saved, is not without controversy. Some would argue that as a society, loss of life should be evaluated from an ex post point of view since some persons will be saved for certain. This would give much larger values to each life saved. There will also typically be other benefits and costs associated with project that reduce the risk of death or injury, such as loss of output, and psychic costs to friends and relatives. They are valued in the usual way.
- 10.
Formally, let the representative consumers’ utility be given by U(X1,...,Xn). The change in utility from a change in demands is given by dU = Σ(∂U/∂Xi)dXi. Consumers will set relative prices equal to their marginal rates of substitution so qi = (∂U∕∂Xi)∕(∂U∕∂Xn), assuming good n is the numeraire. Then, we can write dW = ΣqidXi, where dW is the change in utility measured in terms of the numeraire (dW = dU ∕ (∂U ∕ ∂Xn)). Now, suppose public project demands are Gi and market supplies are Yi; then dW = Σqi(dYi + dGi). Since Σpi(dYi) = 0 by the economy’s production possibilities frontier, we have dW = ΣtidXi + ΣpidGi, where ti (= qi − pi) is the tax, or other, distortion. Finally, consider the change in a commodity used by or produced by a project, say, dGk. The welfare change measure becomes dW = Σi ≠ ktidXi + tkdXk + pkdGk. The latter two terms can be shown to correspond with the value or cost of the public commodity dGk evaluated at the weighted average shadow price as above. The first term is what we are calling the indirect effect, following Harberger (1971a). Further details on this are provided in Boadway and Bruce (1984). See also Drèze and Stern (1987).
- 11.
Even if the funds are not obtained from current taxes, there will be a deadweight loss involved. Funds raised through borrowing will induce a deadweight loss. Since borrowing is simply postponed taxes, the deadweight loss will be incurred later on when the loan is eventually repaid. As well, borrowing through printing money will create a deadweight loss as a result of inflation. Of course, if there are unemployed resources, this deadweight loss may be mitigated.
- 12.
This example draws on Feldstein (1972a), which in turn draws on a seminal paper by Marglin (1963).
- 13.
To see this, we can use a Taylor series approximation to obtain u(yi) = u(\( \hat{y} \)) + u′(\( \hat{y} \))(yi − \( \hat{y} \)) + ½u″(\( \hat{y} \))(yi − \( \hat{y} \))2 + R, where R is the sum of the higher-order terms. Similarly, given that k is relatively small, a first-order approximation of u(\( \hat{y} \) − k) can be obtained as u(\( \hat{y} \) − k) ≅ u(\( \hat{y} \)) − ku(\( \hat{y} \) − k). Combining these in the above definition of k yields:
$$ u\left(\hat{y}\right)- ku\left(\hat{y}-k\right)\tilde{=}\Sigma {p}_i\left[u\left(\hat{y}\right)+{u}^{\prime}\left(\hat{y}\right)\left({y}_i-\hat{y}\right)+\raisebox{1ex}{$1$}\!\left/ \!\raisebox{-1ex}{$2$}\right.u"\left(\hat{y}\right){\left({y}_i-\hat{y}\right)}^2\right] $$which can be rearranged to obtain the expression for k in the text.
- 14.
As in the case of capital market distortions, some persons advocate taking account of risk by incorporating it into the discount rate. There may be special cases in which the use of a risk-adjusted discount rate to discount expected benefits and costs is equivalent to treating the cost of risk as a cost and discounting at a risk-free discount rate that represents how consumers actually discount future versus present consumption. But, in general, the two procedures will not be equivalent.
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Boadway, R. (2020). Economic Evaluation of Projects. In: Shah, A. (eds) Policy, Program and Project Evaluation. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-48567-2_3
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