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7. Determining Economic Values
Once financial prices or costs and benefits have been determined and entered in the project accounts, the analyst estimates the economic value of a proposed project to the nation as a whole. The financial prices are the starting point for the economic analysis; they are adjusted as needed to reflect the value to the society as a whole of both the inputs and outputs of the project.
When the market price of any good or service is changed to make it more closely represent the opportunity cost (the value of a good or service in its next best alternative use) to the society, the new value assigned becomes the "shadow price" (sometimes referred to as an "accounting price"). In the strictest sense, a shadow price is any price that is not a market price, but the term usually also carries the connotation that it is an estimate of the economic value of the good or service in question, perhaps weighted to reflect income distribution and savings objectives.
In chapter 2, for purposes of project analysis, we took the objective of a farm to be to maximize the farm family's incremental net benefit, the objective of the firm to maximize its incremental net income, and the objective of the society to maximize the contribution a project makes to the national income-the value of all final goods and services produced in the country during a particular period. These objectives, and the analysis to test their realization, were seen in financial terms for farms and firms. But economic analysis of a project moves beyond financial accounting. Strictly speaking, we may say that in financial analysis our numeraire-the common yardstick of account-is the real income change of the entity being analyzed valued in domestic market prices and in general expressed in domestic currency. But in economic analysis, since market prices do not always reflect scarcity values, our numeraire becomes the real, net national income change valued in opportunity cost. As we will note below, one methodology expresses these economic values in domestic currency and uses a shadow price of foreign exchange; the shadow price increases the value of traded goods to allow for the premium on foreign exchange arising from distortions caused by trade policies. Another method in use expresses the opportunity cost value of real national income change in domestic currency converted from foreign exchange at the official exchange rate and applies a conversion factor to the opportunity cost or value in use of nontraded goods expressed in domestic currency; the conversion factor reduces the value of nontraded goods relative to traded goods to allow for the foreign exchange premium.
Before a detailed discussion of adjusting financial accounts to reflect economic values commences, an important practical consideration must be emphasized. Many of the adjustments to the financial accounts can become quite complex. Not every point made in this chapter will apply to every agricultural project, nor will all points have the same importance in those projects where they do apply. The complexity of some calculations and the relative importance of some adjustments recall the reason for undertaking an economic analysis of a project: to improve the investment decision. Some adjustments will make a considerable difference to the economic attractiveness of a proposed project; others will be of minor importance, and no reasonable adjustment would change the investment decision. What we need to do here is to adopt an accounting practice-the doctrine of materiality. The analyst must focus his attention on those adjustments to the financial accounts that are likely to make a difference in the project investment decision. He should use rough approximations or ignore trivial adjustments that will not make any difference in the decision. There is an important balance to be struck between analytical elegance and getting on with the job.
In this chapter we will adjust the financial prices of tangible items to reflect economic values in three successive steps: (1) adjustment for direct transfer payments, (2) adjustment for price distortions in traded items, and (3) adjustment for price distortions in nontraded items. Before embarking on this series of adjustments, we will examine the problem of determining the appropriate premium for foreign exchange. After completing the adjustments, we will summarize the main points in a "decision tree" for determining economic values.
The series of successive adjustments to the financial accounts will lead to a set of economic accounts in which all values are stated in "efficiency prices," that is, in prices that reflect real resource use or consumption satisfaction and that are adjusted to eliminate direct and indirect transfers. These values will be market prices when market prices are good estimates of economic value or they will be shadow prices when market prices have had to be adjusted for distortions. When we adjust financial prices to reflect economic values better, in the vast majority of cases we will use the opportunity cost of the good or service as the criterion. We will use opportunity costs to value all inputs and outputs that are intermediate products used in the production of some other good or service. For some final goods and services, however, the concept of opportunity cost is not applicable because it is consumption value that sets the economic value, not value in some alternative use. In these instances, we will adopt the criterion of "willingness to pay" (also called "value in use"). We need to do this, however, only when the good or service in question is nontraded (perhaps as a result of government regulation) during some part of the life of the project-a point to which we will return later in our discussion. Because the ultimate objective of all economic activity is to satisfy consumption wants, all opportunity costs are derived from consumption values, and thus from willingness to pay.
An example may clarify our use of willingness to pay and opportunity cost. Suppose a country that is a rather inefficient producer of sugar has a policy to forbid sugar imports to protect its local industry. The price of sugar may then rise well above what it would be if sugar were imported. Even at these higher prices, most consumers will still buy some sugar for direct consumption-say, in coffee or tea-even though they may use less sugar than if the price were lower. The domestic price of sugar will be above the world market price and will represent the value of the sugar by the criterion of willingness to pay. If we were now to consider the economic value of sugar from the standpoint of its use in making fruit preserves, its value would become the opportunity cost of diverting the sugar from direct consumption, where willingness to pay is the criterion and has set the economic value.
Economic analysis, then, will state the cost and benefit to the society of the proposed project investment either in opportunity cost or in values determined by the willingness to pay. The costs or values will be determined in part by both the resource constraints and the policy constraints faced by the project. The difference between the benefit and the cost-the incremental net benefit stream-will be an accurate reflection of the project's income-generating capacity-that is, its net contribution to real national income.
The system outlined here will make no adjustment for the income distribution effects of a proposed project nor for its effect on the amount of the benefit generated that will be invested to accelerate future growth. Rather, the economic project analysis, stated in efficiency prices, will judge the capacity of the project to generate national income. The analyst can then choose from those alternative projects (or alternative formulations of roughly the same project) the high-yielding alternative that in his subjective judgment also makes the most effective contribution to objectives other than maximizing national income-objectives
such as income distribution, savings generated, number of jobs produced, regional development, national security, or whatever. The choice about the kind of project will of course be made rather early in the project cycle. Thus, it may be determined early on that for reasons of social policy a project will be preferred that encourages smallholder agriculture rather than plantations. Then, the choices will likely be several projects or variants of projects that encourage smallholders; the analytical technique presented here can determine from among the projects that will further the desired social objective the ones that are more economically efficient.
Although the system outlined here makes no adjustment for income distribution effects or for saving versus consumption, it is compatible with other analytical systems that do. In particular, Squire and van der Tak (1975) recommend evaluating proposed projects first by using essentially the same efficiency prices that will be estimated here and then by further adjusting these prices to weight them for income distribution effects and for potential effects on further investment of the benefits generated. The systems in Little and Mirrlees (1974) and the uxmo Guidelines for Project Evaluation (I 972a), with minor departures, also propose evaluating the project by first establishing its economic accounts in efficiency prices and then by adjusting these accounts to weight them for income distribution and savings effects. Making allowances for income distribution and savings effects involves somewhat more complex adjustments than those necessary to estimate efficiency prices; it also unavoidably incorporates some element of subjective judgment. Although these systems have attracted widespread interest among economists, their application has been only partial or on a limited scale. The system of economic analysis using efficiency prices that is outlined here is essentially the one currently used for all but a few World Bank projects and also the one used for most analyses of projects funded by other international organizations.
The economic analysis follows on the financial analysis presented in the preceding chapters; it will be based on projected farm budgets similar to those in chapter 4, on projected accounts for commercial firms such as those in chapter 5, and on projected government cash flows such as those in chapter 6. Since these accounts are projected for the life of the project, there will be no separate allowance for depreciation. Instead, as noted earlier, the costs will have been entered in the years they are incurred and the returns in the year they are realized.
In the economic analysis, we will want to work with accounts cast on a constant basis; thus we will want to be sure that any inflation contingency allowances have been taken out. As noted in chapter 2, however, physical contingency allowances and contingency allowances intended to allow for relative price changes are properly incorporated in the economic accounts, even when the accounts are in constant prices. Of course, any of the items included among the contingencies may be revalued, if necessary, to adjust them from their market prices to economic values. The projected financial accounts will usually not have any entry for cash. Instead, they will show separately the cash position of the farmer or note a cumulative cash surplus or deficit. It is possible, however, that some accounts may have a cash balance included in an entry for working capital or the like. If such an entry exists, it must be removed from the economic analysis; since we will be working on a real basis in the economic accounts, we will show real costs when they occur and real benefits when they are realized.
Determining the Premium on Foreign Exchange
Adjusting the financial accounts of a project to reflect economic values involves determining the proper premium to attach to foreign exchange. That determination quickly involves issues of obtaining proper values and of economic theory. Fortunately for most agricultural project analysts, the answer to the question about how to determine the foreign exchange premium is simple (and simplistic): ask the central planning agency. The point is that if various alternative investment opportunities open to a nation are to be compared, the same foreign exchange premium must be used in the economic analysis of each alternative. Otherwise we will be mixing apples and oranges and cannot use our analysis reliably to choose among alternatives. Sometimes, however, the analyst will be forced to make his own estimate of the foreign exchange premium. A practical approach, along with some of the theoretical and applied problems of the computation, is given by Ward (1976). Little and Mirrlees (1974), Squire and van der Tak (1975), and the UNIDO Guidelines (1972a) also outline in considerable detail how to make the conversion between foreign exchange and domestic currency when their analytical systems are used.
The need to determine the foreign exchange premium arises because in many countries, as a result of national trade policies (including tariffs on imported goods and subsidies on exports), people pay a premium on traded goods over what they pay for nontraded goods. This premium is not adequately reflected when the prices of traded goods are converted to the domestic currency equivalent at the official exchange rate. The premium represents the additional amount that users of traded goods, on an average and throughout the economy, are willing to pay to obtain one more unit of traded goods. Since all costs and benefits in economic analysis are valued on the basis of opportunity cost or willingness to pay, it is the relation between willingness to pay for traded as opposed to nontraded goods that establishes their relative value.
The premium people are willing to pay for traded goods, then, represents the amount that, on the average, traded goods are mispriced in relation to nontraded items when the official exchange rate is used to convert foreign exchange prices into domestic values. By applying the premium to traded goods, we are able to compare the values of traded and nontraded goods by the criterion of opportunity cost or willingness to pay. Although this premium is commonly referred to as the foreign exchange premium, it should be recognized that the premium is actually a premium for traded goods; foreign exchange itself has no intrinsic value. The premium for traded goods is a premium on the particular "basket" of traded goods that the present and projected trade pattern implies. Of course, future patterns of trade could change the exact composition of the basket, and thus the premium would change; to estimate these changes involves a knowledge of elasticities-the way demand and supply of goods and services vary when prices change-that is generally not available. Where such elasticities are known, it is possible for a well-trained economist to provide the project analyst with a more accurate estimate of the expected premium on foreign exchange.
If traded items were to be taken into the project analysis at an economic value obtained by simply multiplying the border price by the official exchange rate without adjusting for the foreign exchange premium, imported items would appear too cheap and domestic items too dear. This would encourage overinvestment in projects that use imports. For example, if combine harvesters look cheap because no allowance is made for the premium on traded goods, then imported combines might displace local harvest labor, even though the local labor might have no other opportunities for employment.
There are two equivalent ways of incorporating the premium on foreign exchange in our economic analysis. The first is to multiply the official exchange rate by the foreign exchange premium, which yields a shadow foreign exchange rate. [Note that this derivation of the shadow exchange rate is appropriate for efficiency analysis of projects and thus has a discrete definition. Other definitions of the shadow exchange rate are appropriate depending on the uses to which the rate will be put. Bacha and Taylor (1972) discuss some of these alternatives.] The shadow exchange rate is then used to convert the foreign exchange price of traded items into domestic currency. The effect of using the shadow exchange rate is to make traded items relatively more expensive in domestic currency by the amount of the foreign exchange premium. (An alternative arithmetic formulation is to convert the foreign exchange price into domestic currency at the official exchange rate and then multiply by 1 plus the foreign exchange premium stated in decimal terms.) The shadow exchange rate approach has been used in the past in most World Bank projects when adjustments have been made to allow for the foreign exchange premium on traded goods, and it is also used in the UNIDO Guidelines (1972a).
An alternative way to allow for the foreign exchange premium on traded items that is increasingly coming into use is to reduce the domestic currency values for nontraded items by an amount sufficient to reflect the premium. This is sometimes called the "conversion factor" approach. In its simplest form, based on straightforward efficiency prices, a single conversion factor-the "standard conversion factor" of Squire and van der Tak-is derived by taking the ratio of the value of all exports and imports at border prices to their value at domestic prices (Squire and van der Tak 1975, p. 93). In this form, the standard conversion factor bears a close relation to our shadow exchange rate; indeed, the standard conversion factor may be determined by dividing the official exchange rate by the shadow exchange rate or by taking the reciprocal of 1 plus the foreign exchange premium stated in decimal terms. Market prices or shadow prices of nontraded items are then multiplied by this standard conversion factor, and this reduces them to their appropriate economic value. Little and Mirrlees and Squire and van der Tak both adopt the conversion factor approach. In addition, both pairs of authors recommend deriving specific conversion factors for particular groups of products that will allow for any difference between market prices and opportunity costs and for the foreign exchange premium on traded items. As a result, their specific conversion factors may always be applied directly to domestic market prices. These authors also recommend that their conversion factors be calculated in social prices by including distribution weights.
In the valuation system followed here, all items are valued at efficiency prices without allowance for distribution weights (the issue of selecting projects to achieve distributional objectives is treated as a subsequent decision). This being the case, consideration of the distribution-weighted conversion factors proposed by Little and Mirrlees and Squire and van der Tak may be left aside, and we may focus our discussion on the Squire and van der Tak standard conversion factor as it relates to efficiency prices.
The relation between the official exchange rate (in the equations below, OER), the foreign exchange premium (Fx premium), the shadow exchange rate (SER), and the standard conversion factor (SCF) is perhaps easier to understand in equation form:
so that, as Squire and van der Tak note (1975, p. 93),
We may illustrate these relations by an example taken from the Agricultural Minimum Package Project in Ethiopia. At the time the project was appraised, the analyst knew that the official exchange rate of Eth$2.07 = US$1 failed to account for a foreign exchange premium of at least 10 percent. (The symbol for the Ethiopian dollar is Eth$; since this project was appraised the name of the currency unit has been changed to birr.) Thus, the analyst multiplied the official exchange rate by 1 plus a 10 percent foreign exchange premium to obtain a shadow exchange rate of Eth$2.28 = US$1 (2.07 x 1.1 = 2.28) that he rounded up to Eth$2.30 = US$ 1. The shadow exchange rate was then applied to all'traded items in the financial accounts, thereby increasing their relative value.
If the domestic currency is worth more per unit than the foreign exchange, the arithmetic is somewhat different. At the time the Nucleus Estate/Smallholder Oil Palm Project in Rivers State, Nigeria, was appraised, the official exchange rate was N 1 = US$1.54. (The symbol for Nigerian naira is N.) The project analysts were given a shadow exchange rate of N1 = US$1.27 to use in their economic evaluation. If, however, they had simply been informed that the foreign exchange premium was 21 percent, they could have determined the shadow exchange rate by dividing the dollar value by 1 plus the premium stated in decimal terms (1.54 - 1.21 = 1.27).
Of course, the effect of applying the shadow exchange rate to the traded items in the Ethiopian project was to make all nontraded items 10 percent less expensive in relation to the traded items in the economic accounts as opposed to the financial accounts. Now, instead of increasing the relative value of traded items, we could reduce the value of all nontraded items appearing in the financial accounts so that in the economic account they are relatively 10 percent less expensive. To do this we calculate the standard conversion factor, which is 1 divided by 1 plus the amount of the foreign exchange premium stated in decimal terms. In this case, the result is a factor of 0.909 (1 - 1.1 = 0.909). To obtain the economic values, we would then multiply all financial prices for non-traded items by this factor if these market prices have been judged good estimates of opportunity cost or good estimates of economic value on grounds of willingness to pay. For nontraded items such as wage rates for unskilled labor for which it is felt that the market price has overstated the economic values, we would first determine a good estimate of the economic value in domestic currency and then multiply that by the standard conversion factor. Financial prices for traded items, whether imports or exports, would be left unchanged in the economic accounts except that any transfer payment included in these prices would be taken out. To get all values into the same currency, we would convert all foreign currency prices to domestic currency values using the official exchange rate.
When we turn to determining measures of project worth in chapter 9, we will find that the absolute value of the net present worth differs depending on which approach we use, shadow exchange rate or conversion factor, but that the relative net present worths of different projects analyzed by the same approach will not change. Whichever approach is used, the internal rate of return, the benefit-cost ratio, and the net benefit-investment ratio do not change. (Using a number of disaggregated conversion factors, rather than a standard conversion factor, can give different values for the measures of project worth. Hence, for projects at the margin of acceptability, using specific conversion factors rather than a standard conversion factor or a shadow exchange rate may result in a different decision on whether to accept or reject, but such cases are infrequent.)
Adjusting Financial Prices to Economic Values
Let us now proceed with the adjustments necessary to convert financial prices to economic values. We will divide these into three steps: (1)
adjustment for direct transfer payments, (2) adjustment for price distortions in traded items, and (3) adjustment for price distortions in non-traded items. We will then note that, for what are termed "indirectly traded" items (locally produced items that use a high proportion of traded inputs, such as locally assembled tractors, or construction that uses imported materials), steps 2 and 3 must be done at the same time.
Step 1. Adjustment for direct transfer payments
The first step in adjusting financial prices to economic values is to eliminate direct transfer payments.
Direct transfer payments (see chapter 2) are payments that represent not the use of real resources but only the transfer of claims to real resources from one person in the society to another. In agricultural projects, the most common transfer payments are taxes, direct subsidies, and credit transactions that include loans, receipts, repayment of principal, and interest payments. Two credit transactions that might escape notice are accounts payable and accounts receivable. All these entries should be taken out before the financial accounts are adjusted to reflect economic values.
Many important subsidies in agriculture operate not by means of direct payments but through mechanisms that change market prices. These subsidies are not direct subsidies treated as direct transfer payments but rather are indirect subsidies. The financial price of an item for which the price has been changed because of an indirect subsidy is converted to an economic value according to the procedures outlined below for traded items in step 2 and, as appropriate, for nontraded items in step 3.
Step 2. Adjustment for price distortions in traded items
The second step in adjusting financial prices to economic values is the adjustment for distortions in market prices of traded items.
Traded items are those for which, if exports,f.o.b. price > domestic cost of production, or the items may be exported through government intervention by use of export subsidies and the like, and, if imports,domestic cost of production > c.i.f. price.
Conceptually-and usually in practice, too-prices for traded items in project analysis are more easily dealt with than those for nontraded items. We begin the valuation by determining the "border price." For imports, this normally will be the c.i.f. price and, for exports, normally the f.o.b. price. The border price is then adjusted to allow for domestic transport and marketing costs between the point of import or export and the project site; the result is the efficiency price to be used in the project account (see the subsection on "Economic export and import parity values," below).
If the proposed project produces something that can be used in place of imported goods-that is, if it produces an "import substitute"-the value to the society is the foreign exchange saved by using the domestic product valued at the border price, in this case the c.i.f. price. But if the project uses items that might otherwise have been exported-that is, if it uses "diverted exports"-then the opportunity cost to the society of these items is the foreign exchange lost on the exports forgone valued at the border price, this time the f.o.b. price.
If we are using conversion factors to allow for the foreign exchange premium, the economic value of a traded item would be obtained by converting the foreign exchange price to its domestic currency equivalent using the official exchange rate.
If we are using the shadow exchange rate to allow for the foreign exchange premium, the economic value of a traded item would be obtained by converting the foreign exchange price to its domestic currency equivalent using the shadow exchange rate.
To illustrate how these computations are made, we may take as an example an imported item such as a combine harvester for which the c.i.f. price is US$45,000. In the financial accounts, we will convert this price to domestic currency using the official exchange rate of, say, Rs10 = US$1, obtaining a c.i.f. price in domestic currency of Rs450,000 (45,000 x 10 = 450,000). To this would be added any import duty, say 10 percent, or Rs45,000 (450,000 x 0.10 = 45,000); the price of the combine in our financial accounts would therefore be Rs495,000 (450,000 + 45,000 = 495,000). (The costs of moving the harvester to the project site would also be added; see the subsection on "Economic export and import parity values," below.) If we are using the conversion factor approach to allow for the foreign exchange premium in our economic accounts, we would enter the combine in the accounts at the c.i.f. price expressed in domestic currency converted at the official exchange rate, or Rs450,000 (45,000 x 10 = 450,000). There would be no allowance for the duty because that is a transfer payment. If we are using the shadow exchange rate approach to allow for the foreign exchange premium, however, we would increase the price of the imported items to reflect the premium. Suppose we assume the foreign exchange premium to be 20 percent; our shadow exchange rate thus becomes Rs12 = US$1 (10 x 1.2 = 12). Now the Rs495,000 item in our financial accounts becomes Rs540,000 in our economic account (45,000 x 12 = 540,000). We could have accomplished the same thing, of course, by multiplying our domestic financial price (net of transfer payments) by 1 plus the foreign exchange premium (450,000 x 1.2 = 540,000). The effect of our computation, obviously, is to make imported items more expensive in our economic analysis.
The same logic works in reverse for exports. The ton of wheat that is worth $176 a ton f.o.b. at the port of export will be entered in the financial accounts by converting the foreign exchange price to its domestic currency equivalent using the official exchange rate. This gives a value of Rsl,760 (176 x 10 = 1,760), assuming that there is no export subsidy. The same rupee value would be entered in the economic accounts if we are using the conversion factor approach to allow for the foreign exchange premium. If we are using the shadow exchange rate approach to allow for the foreign exchange premium, we multiply the foreign exchange border price of the wheat by the shadow exchange rate instead of the official exchange rate to calculate the economic value expressed in domestic currency. This increases the relative value of the wheat, which now will be valued at Rs2,112 (176 x 12 = 2,112). We could have accomplished the same thing, of course, by multiplying our financial domestic price by 1 plus the foreign exchange premium stated in decimal terms (1,760 x 1.2 = 2,112). Now the ton of wheat, like other exported goods, is valued at its opportunity cost and is seen to be relatively much more valuable.
Diverted exports and import substitutes are valued by the same line of reasoning, except that for a diverted export we would take the f.o.b. price as the basis for valuation and for import substitutes we would take the c.i.f. price. In the examples of the previous paragraphs, if the country exported combines but diverted them to a domestic project, the opportunity cost would be based on the f.o.b. price instead of the c.i.f. price we assumed for imported combines. Similarly, if the wheat produced were to substitute for imports, we would base its value on the c.i.f. price of wheat rather than on the f.o.b. price we assumed for the case of exports.
In practice, values for most traded items are determined by taking the border price as we have been using it and then either subtracting or adding the domestic handling costs to obtain an economic value at the farm gate or project boundary-the economic export or import parity value (see the subsection on "Economic export and import parity values," below). Also, many items that are locally produced incorporate a significant proportion of imported components and may be considered indirectly imported items (see the section on "Indirectly Traded Items," below). To determine either parity values or values for indirectly traded items involves valuing separately not only the traded component but the nontraded component as well, so we will defer detailed discussion of these values until we have discussed valuing nontraded items.
Step 3. Adjustment for price distortions in nontraded items
The third step in adjusting financial prices to economic values is the adjustment for distortions in market prices of nontraded items. Nontraded items are those for which c.i.f. price > domestic cost of production > f.o.b. price, or the items are nontraded because of government intervention by means of import bans, quotas, and the like.
Often, nontraded items will be bulky goods such as straw or bricks, which by their very nature tend to be cheaper to produce domestically than to import but for which the export price is lower than the domestic cost of production. In other instances, nontraded items are highly perishable goods such as fresh vegetables or fluid milk for direct consumption.
In general, these are produced under relatively competitive conditions-they are produced either by many small farmers or by a few industrial producers for whom entry into the market is relatively easy; thus prices cannot rise too far out of line before new competition appears.
If we are using the shadow exchange rate approach to allow for the foreign exchange premium, and if the market price of a nontraded item is a good estimate of the opportunity cost, or willingness to pay is the criterion, we will accept the market price directly as our economic value. Otherwise, we will adjust the market price to eliminate distortions by the methods outlined in this section and then use the estimate of the opportunity cost we obtain as the shadow price to be entered in the economic accounts.
If we are using the conversion factor approach to allow for the foreign exchange premium, an additional step is necessary. All prices for non-traded items are reduced by multiplying them by the appropriate conversion factor. When willingness to pay is the criterion or when the market price is considered to be a good estimate of opportunity cost, the market price is accepted as the basis for valuation and then reduced by multiplying it by the conversion factor to obtain the economic value. But if we are using the standard conversion factor and the market price must be adjusted to obtain a better estimate of the opportunity cost, then the opportunity cost must, in turn, be multiplied by the standard conversion factor. (If specific conversion factors have been developed, as Little and Mirrlees and Squire and van der Tak suggest in their systems, then these factors incorporate the adjustments for nontraded goods distortions, opportunity costs, and distribution weights; the market price need only be multiplied by the specific conversion factor to reach the economic value.) Whether we use a shadow exchange rate or a standard conversion factor to allow for the foreign exchange premium, the adjustments we make to allow for distortions in market prices of nontraded items are essentially the same; only the step of multiplying the market price or the opportunity cost by the standard conversion factor differs.
As we said earlier in the chapter, prices for traded items are more easily adjusted to economic values than are prices for nontraded items. The following subsections treat some of the difficulties encountered in determining economic values for various nontraded items.
Market prices as estimates of economic value.. In a perfectly competitive market, the opportunity cost of an item would be its price, and this price would also be equal to the marginal value product of the item (see chapter 3). If a nontraded item is bought and sold in a relatively competitive market, the market price is the measure of the willingness to pay and is generally the best estimate of an opportunity cost. Most agricultural projects are expected to meet a growing demand for food or fiber and are small relative to the total agricultural production of the nation. If that is the case, in general we can accept the market price directly as our estimate of the economic value of a nontraded item. Also, if we are valuing a domestically produced project input that is produced by a supply industry operating near full capacity, we can generally accept the market price of the input as its economic value.
In some instances more common in industrial and transport projects than in agricultural, the output of the project is large relative to the market. The output from the project may therefore cause the price to fall. But the economic value of the new production, despite the fall in price, is not lower to the old users of the product; to them, it is still worth what the price was without the project. Yet to new users, the project output is not worth what the old price was; otherwise, the price would not have fallen. Under these circumstances, the economic value of the new output is neither the old price nor the new; rather, it is estimated by some weighted average of the old and new values. In technical economic terms, the total value of the new output is measured by the additional area under the demand curve as project output is increased, and the marginal value in use for each new buyer is measured by the demand curve at the point the buyer enters the market. The problem is that the precise shape of the demand curve is rarely known. As a result most project economists, when dealing with a project whose output is large relative to the market, adopt a simplifying rule of thumb-they assume that the demand curve is linear and downward sloping at 45 degrees. They then take the new estimate of the average value in use or opportunity cost-hence, of economic value-to be the average of the price without the project and the lower price with the project.
Sometimes a project will be proposed that does not meet new demand but replaces other goods or services in the market. Again, this is more common in industrial and transport projects than it is in agricultural. In such situations, if the project accounts are cast on a with-and-without basis, the economic value of the incremental net benefit stream would reflect only the saving from the new project compared with the old. This is because one of the costs of the new project would be the benefit forgone from the old production no longer realized and because one of the benefits would be the cost avoided for the old production. Such a case might arise, for instance, if an inefficient food processing plant were to be replaced by a more modern and efficient one, or if a high-cost railway branch line were to be replaced by bus and truck transport along an existing highway. Occasionally, however, a project will be proposed for a new plant that will replace existing output, and the analyst fails to recognize the with-and-without situation. Instead, he values the output from the new plant as if it were meeting new demand and forgets to charge as a cost to the project the benefit forgone from the production of the old plant that is to be displaced. If the project is not to be cast on a with-and-without basis, then the analyst must take as his gross benefit only the economic value of the resources saved by replacing the old plant, not the economic value of the output from the new plant.
Note that some nontraded items may involve using significant amounts of imported raw materials. These will be considered below, in the discussion of indirectly traded items. Such items might include machinery assembled domestically from imported components or electricity that is generally nontraded but that may require imported generating equipment and traded fuels for production.
One nontraded item that can sometimes lead to confusion is insurance. At first glance, insurance might look like a transfer payment and thus would not be included in the economic accounts of the project. We may, however, look upon insurance as a kind of sharing of the risk of real economic loss. This would be the case for fire insurance if project buildings were to be pooled with many other buildings in the society. In the event of a fire, there is a real economic cost. The resources used to replace a burned building, or the output forgone because a building no longer is available, reduce the amount of final goods and services available to the society and thus create a real reduction of the national income. Therefore, to the extent an insurance cost represents sharing of risk, it represents a proportionate sharing of real economic cost and should be included in the economic accounts. The insurance rate is usually based on the probability of a real loss and the value of the item insured.
Although the market price can frequently be accepted as a good estimate of the economic value of a nontraded item, for institutional reasons of one kind or another the market price can vary significantly from the opportunity cost of the item to the society. Two such nontraded items are important in most agricultural projects: land and labor.
Valuing Land. The opportunity cost of land is the net value of production forgone when the use of the land is changed from its without-project use to its with-project use.
The simplest case to value is one in which land changes use but not management control, either because an owner-operator is farming the land or because the same tenant continues to farm it. This is a common case in agricultural projects in which farmers are simply encouraged to adopt a more productive technology. If the analyst has laid out the financial accounts to show the situations with and without the project for farm budgets as suggested in chapter 4, then the incremental net benefit (that is, the incremental cash flow) of the project, when financial prices have been converted to economic values and the accounts aggregated as suggested in chapter 8, will include an allowance for the net value of production forgone by changing the land use. Take, for example, the Kemubu Irrigation Project in Malaysia in which new irrigation water permitted changing the land use in the dry season from rather unproductive pasture to second-crop paddy rice production. The contribution of the land to the value of the pasture-hence, its opportunity cost-would be properly accounted for when the value of the weight gain of the livestock pastured on the land without the project is subtracted from the value of the paddy rice produced on the land with the project. Converting project financial prices to economic values-say, changing the market price of the weight gain of the animals on the pasture and the market price of paddy rice to their economic equivalents if these are seen to be different from the market prices-automatically revalues the opportunity cost of the change in land use from financial to economic terms.
In other instances, however, the financial accounts must show a cost for purchasing land or the right to use it. Here problems arise because in many countries agricultural land is hardly sold at all, and, when it is, considerations of investment security and prestige may push its price well above what the land could reasonably be expected to contribute to agricultural production. In these instances, we will not want to accept the market purchase price as a good estimate of the economic opportunity cost of the land and must search for an alternative. Many times that alternative will be to take the rental value of the land. In a number of countries, although land is infrequently sold, there is a fairly widespread and competitive rental market. This may be true if there is considerable tenancy in the country, of course, but it may also hold true if the dominant form of land tenure is the owner-occupied farm. Older farmers may not wish to cultivate all of their holdings themselves and will be willing to rent a field to a younger neighboring farmer; widows may not wish to operate their holdings themselves; or a farmer suffering from an illness may wish to rent part of his farm for a season while he recovers. When such a rental market exists, it probably provides a fairly good indication of the net value of production of the land and, hence, of the opportunity cost if the land use is changed. A renter is not likely to pay any premium for prestige or investment security and thus will not pay a rent higher than the contribution the land can make to the crop he proposes to grow. That rental value may then be entered in the project's financial account year by year as a cost. Alternatively, it may be capitalized by dividing the rent by an appropriate rate of interest stated in decimal terms; the capitalized value is then entered in the first year of the project's financial accounts. The appropriate rate of interest actually would be the economic rate of return (see chapter 9), but this may well involve repetitive computations. Some analysts prefer to use the opportunity cost of capital (also discussed in chapter 9). If this rate were, say, 12 percent and the going rental rate were Rs525 a hectare, then the capital value of a hectare would be Rs4,375 (525 - 0.12 = 4,375). If we were using the conversion factor approach to allow for the foreign exchange premium, this capitalized value would be, in turn, multiplied by a conversion factor. If the standard conversion factor were 0.909, for instance, the land would then have an economic value of Rs3,977 (4,375 x 0.909 = 3,977). At the end of the project, the same value of the land could be credited to the project as a residual value.
Inevitably, however, there will be instances in which neither the purchase price nor the rental value is a good estimate; we then will have to make a direct estimate of the productive capability of the land. Such a direct estimate is not difficult if idle land is to be used for a settlement project. In the projects financed by the World Bank in the Amazon basin at Alto Bene in Brazil and in the Caqueta region of Colombia, the land without the project would in effect have produced no economically valuable output at all. Hence, the net value of production forgone was clearly zero, and no value for the land was entered in the project economic accounts. If settlers were required to pay the government a purchase price, either all at once or in installments, the farm budgets at market prices in the financial analysis would have to show those payments as a cost. When these financial farm budgets were converted to economic values, however, there would be no cost entered for the land because there was no reduction in national income as a result of shifting its use from jungle to farmland. (Of course, the cost of clearing jungle land should be reflected somewhere in the project costs.)
In other cases it will not be so simple. The analyst will have to make a direct estimate of the net value of production forgone for bringing the land into the project. A straightforward approach is to take the gross value of the land's output at market prices and deduct from that all the costs of production-including allowances for hired and family labor and for the interest on the capital engaged, again all at market prices. The analyst can assign the residual as the contribution of the land to the production of the output and take that as the opportunity cost of the land in financial terms. This set of computations can then be converted to economic terms by using economic values for each of the input and output entries. For those familiar with the technique, estimating a production function would provide a much more accurate estimate of the contribution of the land to the value of the output than the direct method described here and thus is a preferable approach.
Valuing Labor. Wage rates for labor in many developing countries may not accurately reflect the opportunity cost of shifting labor from its without-project occupation to its with-project use.
The price of labor in a perfectly competitive market, like other prices in that impossible place, would be determined by its marginal value product. That is, the wage would be equal to the value of the additional product that one additional laborer could produce. It would pay a farmer to hire an additional laborer-for harvesting, for example-so long as that extra worker increased total output by a value more than the wage the farmer had to pay him.
Even in labor-abundant societies, there are probably peak seasons at planting and harvesting when most rural workers can find employment. At those seasons, the market wage paid rural labor is probably a pretty good estimate of its opportunity cost and its marginal value product; therefore, we could accept the market wage as the economic value of the rural labor.
The problem of course is that, except for the peak seasons, in many crowded countries the addition of one more laborer may add very little to the total production-in an extreme instance, nothing at all. That is, if there is a surplus of agricultural workers, there may be very little or virtually no productive outlet for their energies in the off-season. In technical language, we may say that the marginal value product of such labor-the amount such labor adds to the national income-is very close to zero. Because the marginal value product of labor is also the opportunity cost of labor in the economic accounts, we may make another statement: if we take a laborer away from a farm community where he is
producing very little or nothing and put him to work productively in an agricultural project that produces something of value, we do not have to forgo very much to use this labor to realize new production. This being the case, we can consider the cost of the laborer to be very low-some economists would say even zero. By this line of reasoning, the proper value to enter in the economic (not financial) account as the cost of labor would be very small, perhaps only a fraction of the going market wage. If the opportunity cost of labor in an agricultural project is properly priced at a very small amount, then it is likely that the rate of return on the project will look very favorable in comparison, say, with a capital-intensive alternative project that uses labor-saving tractors or expensive imported harvesting machinery.
Note that the validity of this reasoning is not changed by the fact that agricultural labor is, in fact, paid a wage well above its opportunity cost. A common example of a "wage" paid, even though little productive work is available on the margin, is found in the case of family labor. Older children and the farmer's wife will be entitled to a share of the family income even if the family farm is too small to give them an opportunity to be productive. In this instance, if an older son were to find productive employment elsewhere, the total production on the farm might be reduced by very little or none at all. Yet, because the older son is entitled to a share of the total family income, he would accept new employment far away from his home only if he were offered a wage in excess of his share-and that might be well above what his marginal value product would be and the reduction in farm output that would occur if he were to leave.
Rural wages may be above the marginal value product because of a traditional concept of a "proper" wage or because of social pressure on the more prosperous farmers in a community to share their wealth with their less fortunate neighbors. In parts of Java, for example, social custom prevents even quite small farmers from harvesting their own rice. Instead, they permit landless laborers to do the work, even though the farmer himself may well have the time to do it. This is explicitly seen by the community as a means of providing at least something for the poorest agricultural laborers. Unfortunately, increasing economic pressures on small farmers and continued population growth are leading to a break-down of this system.
Virtually all economists now agree that the marginal value product of agricultural labor on an annual basis worldwide is more than zero, so that in every instance our opportunity cost of labor, at least in some season or another, will be positive-even though it may still be very low. [A more detailed discussion of the marginal value product of agricultural labor can be found in McDiarmid (1977) and in Barnum and Squire (1979).]
To begin our discussion of how actually to determine an economic value for labor, we can take the easiest case. In most instances, skilled labor in developing countries is considered to be in rather short supply and would most likely be fully employed even without the project being considered. Hence, the wages paid workers such as mechanics, foremen, or project managers are in general assumed to represent the true marginal value product of these workers, and the wages are entered at their market values in the economic accounts. The rationale here is that, if those skills are in such scarce supply that they would be worth more than the going wage, then someone in the society would be prepared to pay more, and the skilled worker would then move to where he could earn that higher wage, thus establishing a new equilibrium. This convention of accepting market wages as good estimates of economic value may substantially undervalue skilled labor or the management skills of such top civil servants as extension specialists and project managers-or project analysts!
Note too that, as we consider the opportunity cost of labor and how to estimate it, if we set the financial accounts so they correctly show the situations with and without the project, then the opportunity cost of family labor will be appropriately priced in financial terms. Suppose that, in the dry season without the project, a farmer along the north coast of Java could find essentially no gainful employment. With the advent of the Jatiluhur Irrigation Project he now is able to produce a second crop of rice, and his net benefit rises accordingly. When we subtract his without-project net benefit (which would be essentially only what the family could earn for a rainy-season rice crop) from the with-project net benefit (which will include earnings from two crops), the incremental net benefit will correctly show the labor return the family had to give up during the dry season (essentially nothing) to participate in the project and produce a second crop of rice. Shifting the financial prices in the farm budget to economic values also automatically converts the opportunity cost of family labor to economic values.
To make our farm budgets work this way, we must remember to include any off-farm earnings in the accounts. Suppose we assume that the farmer from the north coast of Java goes to Jakarta and finds employment in the construction industry during the dry season, as many such farmers do. The without-project net benefit will thus be increased by the amount of the farmer's off-farm earnings. If he wishes to use Jatiluhur irrigation water to produce a second crop of rice, he must now give up the construction wages he could otherwise have earned in the dry season. In turn, when we subtract the without-project net benefit from the with-project net benefit, which includes the returns from two crops of rice, the incremental net benefit will be smaller by the amount of the opportunity cost of labor at the market wage, that is, by the amount of construction earnings the farmer must forgo. We may proceed to convert these financial accounts to economic terms by revaluing the appropriate entries at their shadow prices. In doing so, however, we must remember that one shadow price will be the shadow wage rate for the construction earnings the farmer had to forgo. It is to estimating this shadow wage rate that we now may turn.
In most discussions of the marginal value product of labor-hence, of its economic opportunity cost-the standard is the productivity of the marginal agricultural laborer. This is true not only for agricultural projects but also for projects in other sectors, since it is assumed that additional manufacturing employment, for example, will tend to reduce the number of unemployed agricultural laborers. This would be true even if it is urban workers drawn from some other urban occupation who actually take the new factory jobs, since it is assumed the jobs they vacate will, in turn, be filled by workers drawn from agriculture.
Cast in this form, our estimate of the shadow wage rate must now focus on how to estimate the marginal value product of agricultural labor without the project. We can begin by noting that in most agricultural communities there is usually a season when virtually everyone who wants work can find it. Even unemployed urban laborers may return to their home villages in these peak seasons to help their families or to work as hired laborers. This happens at harvest time in Java, and may happen at the peak planting time in other areas where transplanted rice is grown. Thus, we may reasonably assume that this peak season labor market is a relatively competitive one, that labor is in relatively short supply at this period, and that the daily wage at this period is a good indicator of the daily marginal value product of the labor engaged.
With this accepted, a good estimate of the annual shadow wage for agricultural labor is the number of days in the year when most rural labor can expect to find employment, multiplied by the daily wage rate at such times, and reduced by a conversion factor if appropriate. If an agricultural worker's daily wage at harvest were Rs7.50, and during harvest and other peak seasons most people in the rural work force could find employment for 90 days, then his annual shadow wage might be Rs675 if we are using the shadow exchange rate approach to allow for the foreign exchange premium (7.50 x 90 = 675), or Rs614 if we are using the conversion factor approach and the factor is 0.909 (7.50 x 90 x 0.909 = 614). Now if we wanted to hire an agricultural laborer to work in our project for 250 days a year, all the society would give up in production-the opportunity cost-would be Rs675 if we are using the shadow exchange rate approach, or Rs614 if we are using the conversion factor approach. This opportunity cost is the economic value of the annual earnings of the laborer without the project. Note that we surely would have to expect to pay a wage much greater than this amount, and thus our financial accounts at market prices would have quite a different cost for this same agricultural laborer. It is possible, for instance, that the hired laborer would expect a wage of Rs7.50 a day for all 250 days he worked during the year, or an annual wage of Rs1,875 (7.50 x 250 = 1,875). More probably, he would be willing to work for rather less a day outside the harvest season-say, Rs5.00 a day. Thus, his annual wage might be something more on the order of Rs675 for 90 days and Rs5.00 a day for the remaining 160 days, or an annual total wage of Rs 1,475 [(7.50 x 90) + (5.00 x 160) = 1,475]. The project analyst would clearly have to form a judgment of the shadow wage of hired labor on the best basis he could, just as he must for every other price estimate he makes.
Of course, in many agricultural projects labor is not engaged on a year-round basis. Rather, the work is quite seasonal, and we must consider in which particular season hired labor would be engaged. If our new
cropping pattern calls for work to be done during the peak season, then we will have to consider that the peak season market wage is probably a good estimate of the marginal value product, and we could not justify using a lower wage as the basis for our shadow wage rate, even though there might be considerable unemployment in the off-season. In Egypt, for example, a common rotation calls for both rice and cotton to be harvested in October. If we were to propose a project incorporating these crops-or another crop requiring hired labor at this period-then the going wage (in 1975 about E^0.30 a day; the symbol for Egyptian pounds is E^) would be paid. Since even in a country as populous as Egypt most rural labor can find employment at this peak season, the use of a shadow wage rate derived from a basis less than the market wage would be unjustified. But suppose our project called for growing maize, which is planted in May when there is little other agricultural work available and harvested in August before the peak harvest season for rice and cotton. Then we might find that, on the margin, many agricultural laborers were either unemployed or not very productively engaged at that season and that to draw them into maize planting might entail an opportunity cost considerably less than the going wage, although it would perhaps not be zero. Thus, we might estimate that at this season the combination of being able to work only two or three days a week on the average, and then at jobs of rather low productivity, would justify taking a shadow wage rate based on half the going market rate. This would mean the equivalent of E^0.15 in 1975 if we are using the shadow foreign exchange rate approach (0.30 - 2 = 0.15), or E^0.14 if we are using the conversion factor approach and the conversion factor is 0.909 (0.30 - 2 x 0.909 = 0.14), even though our farm budget at market prices would continue to show a wage for hired labor of E^0.30.
All of these considerations will have to be adapted to fit the circumstances of any given project. For example, in India nationwide we might expect a shadow wage rate for agricultural labor rather less than the going wage rate. But using a nationwide shadow wage rate in particular projects might underestimate the true opportunity cost of the labor actually engaged in a project. The peak season in the Punjab, for instance, finds virtually all agricultural labor fully engaged, but in the neighboring state of Haryana the marginal labor in agriculture is not fully engaged. While many laborers from Haryana do migrate in search of peak season employment in the Punjab, not enough do so to meet the demand for labor completely. Using a very low shadow wage rate for a project in the Punjab might be unjustified because at the peak season the project would have to bid labor away from harvesting. Thus, although the shadow wage rate might not be as high as the harvest wage (but it might), neither would it be as low as conditions in neighboring Haryana might otherwise indicate.
This discussion of how to value labor applies whether labor is to be paid a money wage or is to be compensated in kind. The discussion so far has emphasized that it is the opportunity cost that determines the value of labor in the system of economic analysis we have adopted. The value of
the payment actually made to labor-whether in money or in kind-is not the issue. If we shadow-price labor, we already are acknowledging that the wage the labor receives is different from the benefit forgone by using that labor in the project instead of in its next best alternative use without the project. It is the opportunity cost of the labor, not the form of payment, that sets the economic value of labor. Hence, it is irrelevant in a determination of the economic value of labor whether labor is paid a money wage or is compensated in kind-for example, in food grain, even though the food grain may be a tradable commodity and even though the food grain itself might need to be shadow-priced if it is to be valued.
Excess Capacity. In some projects, a domestically produced input may come from a plant that is not operating at its full capacity. If that is the case, then the opportunity cost of using the input in a new project is only the marginal variable cost of producing the input, and no allowance need be made for the fixed capital cost of the plant itself. If the national cement industry is operating at less than its full capacity and it is proposed to line irrigation canals with cement, then the cost of the cement for the canals would be only the marginal variable cost of producing the cement. This would be less than the average cost of cement production, which would include some allowance for fixed costs of production.
Situations such as these are more common in industrial projects than in agricultural projects. When they do occur, however, they may influence the timing of projects. A canal-lining project might be quite attractive if it is begun soon, while there is excess cement-manufacturing capacity, but much less attractive later, when demand has caught up with the cement industry's capacity. To supply cement for canal lining later, after demand has picked up, would entail constructing an additional cement plant. At that time, new fixed as well as variable costs would be incurred, and the analyst would include all costs, both fixed and variable, plus an estimate of the "normal" profit in calculating the cost of cement.
TRADABLE BUT NONTRADED ITEMS. In the system of project analysis presented here, we lay out the economic accounts as best we can to reflect the real resource costs and benefits of the proposed project. The project will be carried out within a framework of economic policies set by the government. The project analyst must make the best judgment about what those policies are and will be, not just what they ought to be, and work the economic analysis accordingly. This can lead to difficult choices when the analyst must evaluate the real effects on resources of a project that involves items that could be traded but probably will not be because of government regulation. These items, which are "tradable but non-traded" across national boundaries, are valued as nontraded.
Such items would usually be imported were it not for an import quota .00 or an outright ban that is enforced against them. Their domestic price may well rise high above the prevailing price on the world market. The import restriction might be enforced to protect domestic industries, even
though the imported item may be preferred by consumers. Import of foreign engines for tubewells, for example, may be forbidden so that domestic manufacture might be encouraged. Yet, the domestic equivalent may not be as efficient or as durable as the imported engine and may cost more to produce. The domestic engine clearly could not compete on the world market, and it would therefore be a nontraded item. For those few imported engines allowed to enter the country, the price may rise quite high. This indicates that to some buyer the imported item is worth more than its domestic equivalent. If our project will use one of these engines, the economic value is not a price based on the world market as if the engines could be relatively freely traded. Rather, it is the higher domestic market price of the imported engine, which indicates its high opportunity cost. Upon reexamination, of course, we might consider changing the project design to use the domestic engine-for example, we might do so if we find the domestic engine to be less costly when valued at shadow prices.
For the domestic equivalent of an imported item, the market price usually will closely approximate the real resource use that went into producing it. But if there is a shortage and the price is bid up, in the absence of additional imports the market price will rise above the cost of production. In this case, the opportunity cost of the item will not be determined by the resources used to produce it but by its marginal value product in its best alternative use. If the price is higher than is justified by the resources used to produce the item, it may well be because to someone that high price for the domestic engine is worth it-for this buyer's purposes, the marginal value product of the scarce engine at least equals the market price. If we wish to bid that engine away for use in our project, we are denying its use to the other potential buyer. If we use the engine in our project, the economy must forgo the productive contribution of the engine in the alternative use the other potential buyer had in mind-our standard concept of opportunity cost. Again, in this instance the opportunity cost is most likely well estimated by the market price; if it were not, other buyers would not have bid the price up so high for the limited number of engines available.
If there is an import ban on an imported final good or service, then we will base the economic valuation on the criterion of willingness to pay and accept the market price as a good indicator of the economic value of the product-provided that we expect the trade ban to remain in force throughout the life of the project. Earlier we cited the example of a ban on sugar imports that would force the domestic price of sugar above its border price. If the ban on imports will continue, then the higher price of sugar indicates a willingness to pay that, in turn, is an indicator of the economic value set on sugar by the consumers. In the project analysis, we would accept this market price as the economic value, not a border price as if the sugar were being traded.
For both kinds of import substitutes we have cited, the analyst may want to prepare an analysis that will indicate the effect on the proposed project of lifting the import ban. We will discuss this topic further below,
and value each separately. Take locally assembled tractors, for example. We may be told that the market price of Rs65,000 includes a 30 percent local component (in other words, 30 percent of the market price represents domestic value added) and that 70 percent of the market price represents the imported component, which includes a 15 percent tariff. Thus, the local component will amount to Rs19,500 (65,000 x 0.3 = 19,500), and the imported component including the tariff will amount to Rs45,500 (65,000 x 0.7 = 45,500). The domestic value added will most likely arise from sources such as wages paid domestic skilled labor and domestically manufactured items that use mainly domestic raw materials. If so, we probably can accept the market price as a good indicator of the opportunity cost to the economy of these items.
To determine the economic value of the imported component of the tractor, the tariff must first be eliminated. This may be done by dividing the value of the imported component including the tariff by 1 plus the percentage of the tariff stated in decimal terms; this calculation gives a value for the imported component without the tariff of Rs39,565 (45,500
1.15 = 39,565). This is, of course, the c.i.f. price converted to its domestic equivalent at the official exchange rate.
Now, if we are using the shadow exchange rate to allow for the foreign exchange premium, we will want to revalue the imported component of the indirect import (after the tariff has been eliminated) to reflect the distortion in the prices of traded goods. To do this, we can take the c.i.f. price converted at the official exchange rate and multiply it by 1 plus the foreign exchange premium stated in decimal terms. If the official exchange rate is Rs10 = US$1 and the foreign exchange premium is 20 percent, then for the imported component of the tractor we derive a value of Rs47,478 (39,565 x 1.2 = 47,478). (We could, of course, have taken the c.i.f. price in foreign exchange and converted it to its domestic equivalent by the shadow exchange rate; this would have given the identical result.) The shadow price of the tractor is now the market price of the domestic component, which we calculated to be Rs19,500, plus the shadow-priced value of the imported component of Rs47,478-or a total economic value of Rs66,978 (19,500 + 47,478 = 66,978).
If we are using the conversion factor to allow for the foreign exchange premium, the economic value of the imported component will be the c.i.f. price converted to the domestic currency equivalent at the official exchange rate after eliminating the tariff, or Rs39,565. To obtain the economic value of the domestic component we will need to multiply it by the conversion factor. For efficiency prices, we would use the standard conversion factor of 1 divided by 1 plus the foreign exchange premium stated in decimal terms. In this instance, the foreign exchange premium is 20 percent, so the standard conversion factor becomes 0.833 (1 - 1.2 = 0.833). Applying this to the domestic component of the tractor, estimated to be Rs19,500 at market prices, gives us an economic value of Rs16,244 (19,500 x 0.833 = 16,244). The shadow price of the tractor now becomes the sum of the imported component valued at c.i.f. converted at the
official exchange rate and the shadow price for the domestic component, or Rs55,809 (39,565 + 16,244) = 55,809).
In some agricultural projects, electricity is an important cost that may raise valuation problems. Electricity is usually thought of as a nontraded commodity. In reality, part of the value of electricity in most developing countries arises from the imported generating and transmission equipment and, perhaps, from imported fuel. Thus, in our system of project analysis, electricity might be an indirectly traded item. The first difficulty is that the price charged for electricity is not competitively set, since there is no competition in electricity. Rather, electricity rates are administered prices, and electricity prices thus may bear little relation to marginal value product or to opportunity cost. No easy means exists to resolve this problem. Some average rate, or perhaps some weighted average rate, will probably have to suffice as an estimate of opportunity cost at market prices. Once a rate is accepted, an estimate will have to be made of the domestic and imported components, and the components revalued using the shadow exchange rate or a conversion factor as appropriate, just as for any other indirectly imported item (and as we illustrated earlier by the example of tractors assembled from imported components). These calculations would usually not be undertaken by agricultural project analysts. The planning office should estimate a shadow price for electricity and other utilities to be used in all project analyses.
For some agricultural projects, new generating facilities will be required. In the simplest case, we might think of a project remote from the electric grid, such as a settlement project, in which a diesel generating unit might be included as a cost of the project. In that instance, there would be no particular problem of valuation. When new generating facilities would be needed to meet the demand on the power grid arising from an irrigation project, however, the problem would not be so simple. Here, the best approach would probably be to ask the electricity authority for an estimate of the additional cost the authority would incur for this particular project, and then to treat that cost-properly shadow-priced to allow for the imported component-as the opportunity cost. The cost of the additional facilities needed for the project will probably have to be reduced to a kilowatt-hour basis (using, perhaps, the capital recovery factor to estimate the annual charge for the new facilities).
We have contrasted use of a shadow exchange rate and a conversion factor to correct for price distortions caused by import and export tariffs and subsidies, and we have noted that the same correction can be realized whichever approach is used. This is illustrated in table 7-1, in which an economic account for a hypothetical project is drawn up using both a shadow exchange rate and a standard conversion factor.
When indirectly traded items will be used repeatedly in projects, it may be convenient to have specific conversion factors that, once they are derived, can be directly applied to the same class of indirectly traded items. This is the approach both Little and Mirrlees (1974) and Squire
Table 7-1. Use of Shadow Exchange Rate and Standard Conversion Factor Compared
Economic value (Rs)b
Rs Indian rupees. US$ U.S. dollars.
a. The official exchange rate is assumed to be Rs10 = US$1. Financial prices are converted by this official exchange rate.
b. The foreign exchange premium is assumed to be 20 percent. As in note a, the official exchange rate is assumed to be Rs10 = US$1.
c. The shadow exchange rate is the official exchange rate of Rs 10 multiplied by 1 plus the percentage of the foreign exchange premium stated in decimal terms, or Rs12 (10 x 1.2 = 12), so that Rs12 = US$ 1. Foreign exchange prices
are converted into domestic currency values by multiplying the foreign currency price by Rs12.
d. The standard conversion factor is the reciprocal of 1 plus the foreign exchange premium stated in decimal terms, or 0.833 (1 - 1.2 = 0.833). Foreign currency prices are converted into decimal currency values at the official exchange rate. Domestic currency prices are multiplied by the standard conversion factor of 0.833.
and van der Tak (1975) suggest, and both sets of authors recommend that some central agency prepare specific conversion factors for project analysts to use. It is possible in a parallel manner to derive "specific shadow exchange rates" that may then be applied repeatedly, although in practice this has rarely been done. Instead, when the shadow exchange rate approach is followed, nontraded items are decomposed into their traded and nontraded elements and each is valued separately. Use of a specific conversion factor can be illustrated by referring to table 7-1. Suppose we planned a number of projects in which tractor services would be important and we wanted a specific conversion factor for tractor services. Once we had the conversion factor in hand, we could multiply the domestic market price of items in each project by the same specific conversion factor to obtain the various economic values. In table 7-1, in the column illustrating use of the standard conversion factor, we have a value for the imported component of the tractor services of Rs90, which was converted at the official exchange rate. The domestic component was multiplied by the standard conversion factor to obtain an economic value of Rs25. If we accept this as a good estimate of the value of the domestic component, then by adding the two we reach an economic value for the tractor services of Rsl 15. If we divide this economic value by the domestic price, we obtain a specific conversion factor of 0.958 (115 - 120 = 0.958). In the future, we can simply multiply the market price of tractor services by the specific conversion factor to obtain the economic value directly.
Economic export and import parity values
The economic value of a traded item-either an export or an import-at the farm gate or project boundary is its export or import parity value. These values are derived by adjusting the c.i.f. (cost, insurance, and freight) or f.o.b. (free-on-board) prices (converted to economic values) by all the relevant charges (again converted to economic values) between the farm gate or project boundary and the point where the c.i.f. or f.o.b. price is quoted. The general method of calculating export and import parity prices was discussed in the last section of chapter 3. When these financial prices are adjusted to derive their economic equivalent, both traded and nontraded elements must be valued simultaneously.
The methods for deriving import and export parity values are parallel. Thus, it is unnecessary to discuss the method for both; instead, we will discuss only derivation of the import parity price as an example because import parity values tend to be a bit more complicated to derive.
We may return to the example of the imported combine harvester used earlier in the chapter to illustrate economic valuation of a traded item. In our financial accounts, the c.i.f. price of US$45,000 was converted to its domestic currency equivalent at the official exchange rate of Rs 10 = US$1, to which we would add, say, a 10 percent duty, Rs 1,500 in domestic handling and marketing charges, and Rs2,250 in internal transport costs to the project site-for an import parity price at the farm
gate of Rs498,750 [(45,000 x 10) + (45,000 x 10 x 0.10) + 1,500 + 2,250 = 498,750].
To obtain the economic import parity value at the farm gate or project boundary when using the shadow exchange rate to allow for the foreign exchange premium, we would make the same computations except that we would use the shadow exchange rate and omit the tariff, which is a transfer payment. In the illustration of valuing traded items, we assumed that the foreign exchange premium on the imported combine was 20 percent, and so we assumed a shadow exchange rate of Rs12 = US$1 (10 x 1.2 = 12). Now, to obtain the import parity value of the harvester, we would convert the c.i.f. price to its domestic equivalent using the shadow exchange rate, omit the tariff, and then add the value of the nontraded domestic items. To simplify matters, we will assume that all costs of moving the combine to the project site reflect only nontraded items-although that might not be acceptable if, say, the transport costs included significant amounts of petroleum fuel. We now reach an economic import parity value of Rs543,750 [(45,000 x 12) + 1,500 + 2,250 = 543,7501.
If we are using the conversion factor to allow for the foreign exchange premium, the foreign exchange would be converted to its domestic currency equivalent in the economic accounts by using the official exchange rate, and every nontraded item would be reduced by the conversion factor. Recalling that the standard conversion factor is 1 divided by 1 plus the foreign exchange premium stated in decimal terms, we obtain a standard conversion factor of 0.833 (1 - 1.2 = 0.833). Now, to obtain the economic import parity value of the harvester at the farm gate or project boundary, we convert all foreign exchange costs to domestic currency at the official exchange rate and reduce all prices of nontraded items by applying the standard conversion factor. Again, we will assume that the transport costs are predominantly made up of nontraded items. As before, we will omit the tariff because it is a transfer payment. The economic import parity price thus becomes Rs453,124 [(45,000 x 10) + (1,500 x 0.833) + (2,250 x 0.833) = 453,124].
In certain instances, the value in local currency of an imported item at the project site will be known, as will the rate of tariff and local transport charges from the point of import to the project site. If this is the case, to determine the economic value it is necessary to determine the c.i.f. price, take out the tariff, and allow for the cost of domestic transport. Using our previous values, we may know, for example, that a combine harvester delivered to the project site costs Rs498,750, that the tariff on imported harvesters is 10 percent, and that local transport and domestic handling from the point of import to the project site costs Rs3,750. We know that the official exchange rate is Rs10 = US$1 and that the foreign exchange premium is 20 percent, so the shadow exchange rate would be Rs12 = US$1 (10 x 1.2 = 12) and the standard conversion factor 0.833 (1 - 1.2 = 0.833). We deduct the cost of local transport to obtain a financial value of Rs495,000 at the point of entry, which includes the c.i.f. price plus the duty (498,750 - 3,750 = 495,000). To take out the duty, we divide by 1 plus the percentage of the duty stated in decimal terms to obtain
Rs450,000 (495,000 - 1.1 = 450,000). This is the c.i.f. value at the official exchange rate. We can then divide by the official exchange rate to obtain the c.i.f. value in foreign exchange of US$45,000 (450,000 - 10 = 45,000). If we are using the shadow exchange rate to allow for the foreign exchange premium, we can obtain our c.i.f. economic value by multiplying by the shadow exchange rate of Rs12 = US$1 to obtain a value of Rs540,000 (45,000 x 12 = 540,000). Then, to obtain the economic value at the project site, we would add the cost of transport from the point of entry to the project site; this yields an economic import parity value for the harvester at the farm gate or project boundary of Rs543,750 (540,000 + 3,750 = 543,750). If we are using the conversion factor to allow for the foreign exchange premium, the economic value of the combine at the port will be the c.i.f. foreign exchange price converted at the official exchange rate, or Rs450,000 (45,000 x 10 = 450,000). To obtain the economic import parity value at the farm gate or project boundary, we would add to this c.i.f. value the cost of domestic transport and domestic handling, reduced by the standard conversion factor, to obtain an economic import parity value of Rs453,124 [450,000 + (3,750 x 0.833) _ 453,124].
It is clear that to derive the import and export parity values in the economic analysis we must omit transfer payments, allow for the foreign exchange premium, and use shadow prices for those domestic goods and services for which prices are inaccurate indicators of opportunity cost. The same examples from the Sudanese and Nigerian projects used to illustrate the discussion of import and export parity prices in chapter 3 (tables 3-3 and 3-4) are used again in tables 7-2 and 7-3 to show economic parity values using both the shadow exchange rate and the conversion factor to allow for the foreign exchange premium.
Trade Policy Signals from Project Analysis
Up to this point, we have been discussing an analytical system that estimates the contribution of a proposed project to national income within a policy framework that the project analyst considers will exist during the life of the project. We have assumed that the project analyst has very little influence on trade policies, for this is true in the agriculture sector in most countries. Questions often arise, however, about the effects on a proposed project if trade policies were to change, and about whether changes in trade policies should be recommended. Unfortunately, when assessing the effects on a project of policies that would lift or impose a ban on trade, the analytical issues become very complex, and the analysis of a single project is of limited usefulness. The limitations of project analysis in influencing policy arise from the partial nature of project analysis and from the assumption that the project investment does not significantly change price relations in the economy as a whole.
Two important cases involving trade policy often arise that cause soul-searching among project analysts. The first is when a quota or prohibitive tariff prevents entry of a crucial input-perhaps fertilizer-
Table 7-2. Economic Export Parity Value of Cotton, Rahad Irrigation Project, Sudan (1980 forecast prices)
Scartoa
(Table continues on the following pages.)
Table 7-2 (continued)
^Sd Sudanese pounds.
Source: Adapted from World Bank, "Appraisal of the Rahad Irrigation Project," PA-139b (Washington, D.C., 1973; restricted circulation), annex 16, table 6. The format of the table is adapted from William A. Ward, "Calculating Import and Export Parity Prices," training material of the Economic Development Institute, CN3 (Washington, D.C.: World Bank, 1977), p. 9.
a. Scarto is a by-product of very short, soiled fibers not suitable for export and is sold locally at a price of ^Sd110.200 per ton.
b. For purposes of illustration, there is assumed to be a foreign exchange
premium of 10 percent. Thus, the dollar value of the Sudanese pound at the official exchange rate of ^Sd1.000 = US$2.872 has been divided by 1.1 to give an assumed shadow exchange rate of ^Sd1.000 = US$2.611 (2.872 - 1.1 = 2.611), whereas the standard conversion factor is divided by 1 plus the foreign exchange premium, or 0.909 (1 - 1.1 = 0.909). In the appraisal report that is the source of this table, no foreign exchange premium was assumed.
c. Seed cotton is converted to lint, seed, and scarto assuming that a ton of seed cotton yields 400 kilograms lint, 590 kilograms seed, and 10 kilograms scarto.
and this forces use of a more costly domestic alternative and thus greatly reduces the contribution of the project to national income. The second is when an import quota imposed on products that compete with the project's output makes the contribution of the project investment to national income high, even though the cost of production per unit of output from the project is higher than the cost of competing imports.
When the domestic cost of an important project input is higher than the world market price because of a quota or prohibitive tariff, the potential contribution of the proposed investment to national income
Table 7-3. Economic Import Parity Value of Early Crop Maize, Central Agricultural Development Projects, Nigeria
(1985 forecast prices in 1976 constant terms)
Steps in the calculation
Relevant steps in Value
the Nigerian example perton
F.o.b. at point of export
Add local transport and marketing costs to relevant market Equals value at market Conversion allowance if necessary
Deduct transport
and marketing costs to relevant market
F.o.b. at point of export
Add freight to point of import Add unloading at point
of import Add insurance Equals c.i.f. at point of import Convert foreign currency
to domestic currency at shadow exchange rate Add local port charges
Using shadow exchange rate F.o.b. U.S. Gulf ports No. 2 U.S. yellow corn in bulk' US$116
Freight and insurance 31
(Included in freight estimate)
C.i.f. Lagos or Apapa US$147 Converted at an assumed shadow exchange rate of 4,q1 =
US$1.476 X100 Landing and port charges
(including cost of bags) 22 Transport (based on a
350-kilometer average)` 10
Wholesale value x#132
(Not necessary)
Primary marketing (includes assembly, cost of bags,
and intermediary margins)` - 12 Transport (based on a
350-kilometer average)` - 10 Storage loss (10 percent of
harvested weight) - 9
Deduct local storage, transport, and marketing costs
(if not part of project cost) Equals import parity value at farm gate
Add freight to point of import Add unloading at point
of import Add insurance Equals c.i.f. at point of import Convert foreign currency
to domestic currency at official exchange rate
Import parity value
at farm gate x#101 Using conversion factors
F.o.b. U.S. Gulf ports
No. 2 U.S. yellow corn in bulk' US$116
Freight and insurance 31
(Included in freight estimate)
C.i.f. Lagos or Apapa US$147 Converted at official
exchange rate of
:~il = US$1.626 X91
Nigerian naira.
Source: Adapted from World Bank, "Supplementary Annexes to Central Agricultural Development Projects," 1370-UNI (Washington, D.C., 1976; restricted circulation), supplement 11, appendix 2, table 4. The format of the table is adapted from Ward, "Calculating Import and Export Parity Prices," p. 10.
a. Forecast from Price Prospects for Major Primary Commodities (1976, annex 1, p. 12; see World Bank 1982a).
b. For purposes of illustration, there is assumed to be a foreign exchange premium of 10 percent. Thus, the dollar value of the naira at the official exchange rate of *1 = US$1.62 has been divided by 1.1 to give an assumed shadow exchange rate of =P-~ 1 = US$1.47 (1.62 - 1.1 = 1.47), whereas the standard conversion factor is 1 divided by I plus the foreign exchange premium, or 0.909 (1 - 1.1 = 0.909). In the appraisal report that is the source of this table, no foreign exchange premium was assumed.
c. Shadow prices were assumed for transport and for primary marketing because in the financial analysis the market wage overvalued the opportunity cost of unskilled labor. The value given is the opportunity cost in naira (before applying the standard conversion factor).
will be reduced by the tariff or quota. Given the policy prevailing, the project analysis will be an accurate indicator of the project's worth. Take fertilizer, for instance. If it is expensive to produce domestically, this is an indication that fertilizer production uses a large amount of scarce domestic resources relative to the resources necessary to produce some other product that could be exported to earn the foreign exchange needed to import the fertilizer from a foreign supplier. But if the domestic fertilizer must, in fact, be used for the project to move forward, then it will take a lot of domestic resources to produce the project's agricultural output, and the project will not, accordingly, make as much of a contribution to the national income as it could were imported fertilizer available. If the quota or prohibitive tariff against the input were removed, then the project investment would look quite different. A change in trade policy, however, will have implications ranging far beyond the boundary of the project itself, implications for both efficiencies in the economy and for noneconomic objectives. A change in trade policy may bring a wide range of changes in other prices in the economy as well as in the price of fertilizer used on nonproject farms, and to be valid an investment analysis would have to be run with the new price relations and include nonproject farms. Predicting these changes could be very difficult if the change in trade policy were significant. At best, the project analyst could run his analysis again using a c.i.f. price for fertilizer and making a broad guess about what the changes might be in the rest of the economy both within and outside agriculture., He could then turn to those responsible for trade policy and say that his project analysis signaled a need to consider with care removing the quota against fertilizer. But note that the project analysis is only a signal, not a criterion for decision; much, much more must go into a reevaluation of trade policy than the analysis of one project.
The other important case in which a change in a quota proves very difficult for the project analyst is that of a quota against imports that would compete with the output of a proposed project. If the imports are prohibited, the output of the project will sell for more in the protected market, and what otherwise might not be a very attractive project may now make sufficient contribution to national income to be justified. Again, i f policies are not going to be changed, this is an accurate indicator of the contribution to the national income. But if the domestic cost per unit of project output-say, apples-valued at shadow prices is greater than the c.i.f. cost of imported apples, then this is an indication that it would be more efficient from the standpoint of the economy as a whole for the project to produce something else, export it to earn foreign exchange, and then use the foreign exchange to import apples. Under the circumstances, the project analyst may want to run his analysis again using an import parity price and perhaps also adjusting some of the other price relations in the direction he thinks might prevail under a change in trade policy. He may find that domestic production would not make enough of a contribution to national income at these prices to justify the investment required. He might also want to determine the domestic resource cost of the import substitute along the lines discussed in the section of chapter 10 devoted to that topic; this will show that it costs more to save a unit of foreign exchange by producing apples domestically than the shadow exchange rate indicates the foreign exchange to be worth. His analysis has now signaled that trade policies should perhaps be reviewed. Again, it is only a signal; the analysis of this one project does not itself provide a complete decision criterion. The trade policy change will have many other effects that will be felt far beyond the boundary of the project itself.
Valuing Intangible Costs and Benefits
The methodology outlined for converting financial prices to economic values is one that is most appropriate for tangible costs and benefits. When intangible costs or benefits enter into investment considerations, they raise difficult issues of valuation.
Intangible factors have come up frequently in earlier discussions of identifying costs and benefits and of valuing them. They comprise a whole range of considerations-economic considerations such as income distribution, number of jobs created, or regional development; national considerations such as national integration or national security; and environmental considerations that can be both ecological and aesthetic, such as the preservation of productive ecosystems, recreation benefits, or famous spots of scenic beauty. [Lee (1982) discusses ecological considerations to be kept in mind when designing agricultural projects for tropical regions.]
The question of how to treat intangible factors most often arises when we are considering the benefits of a project. Many development projects are undertaken primarily to secure intangible benefits--education projects, domestic water supply projects, and health projects are a few common ones. Intangible benefits are usually not the major concern in agricultural projects, although many agricultural and rural development projects include components such as education or rural water supply from which intangible benefits are expected. Whether in agricultural projects or in other kinds of projects, intangible benefits, even though universally agreed to be valuable, are nevertheless virtually impossible to value satisfactorily in monetary terms. Yet costs for these projects are in general tangible enough, and the considerations of financial and economic valuation we have discussed earlier apply unambiguously.
Intangible costs are not uncommon, however, and prove just as difficult to bring within a valuation system as benefits. Often costs are merely the inverse of the benefits that are sought: illiteracy, disease, unemployment, or the loss of a productive environment or treasured scenic beauty.
Some costs in agricultural projects, while tangible, are very difficult to quantify and to value. Siltation, waterlogging, salinization, and soil loss are examples. These costs should not be ignored, and if they are likely to be substantial they should be treated in the project analysis in a manner analogous to intangible costs.
When considering projects in which intangible benefits or costs are important, the least the project analyst can do is to identify them: lives that will be saved, jobs created, kind of education provided, region to be developed, location of a park, ecosystem or kind of scenery to be preserved.
Very often, the analyst can also quantify intangibles: number of lives saved, number of jobs created, number of students to be enrolled, number of people expected to use a park. Even such simple quantification is often a substantial help in making an investment decision.
Economists have tried repeatedly to find means to value intangibles and thus bring them within the compass of their valuation system. The benefits of education have been valued by comparing the earnings of an educated man with those of one who is uneducated. Health and sanitation benefits have been valued in the number of hours of lost work avoided by decreasing the incidence of disease. Nutrition benefits have been valued in terms of increased productivity. Population projects have been valued by attaching a value to the births avoided. Although work in these areas continues-especially with regard to environmental impact-few applied project analyses in developing countries currently attempt to use such approaches to valuing intangible costs and benefits. For one thing, such efforts generally greatly underestimate the value of the intangibles. The value of an education is much more than just the increase in income-ask any mullah, monk, or priest. Good health is a blessing far in excess of merely being able to work more hours. Good nutrition is desirable for more reasons than just increased productivity. Moreover, the methodological approaches used to value intangibles turn out to be unreliable and open to serious question. Finally, there may be moral issues involved-many who support population programs do so out of considerations that extend far beyond any benefit-cost calculation.
In contemporary practice of project analysis in developing countries, the only method used to any extent to deal with intangible benefits is to determine on a present worth basis the least expensive alternative combination of tangible costs that will realize essentially the same intangible benefit. This is often referred to as "least-cost combination" or "cost effectiveness" (for an application of the method to sanitation projects, see Kalbermatten, Julius, and Gunnerson 1982, chapter 3). If the same education benefits can be provided by centralized schools that realize economies of scale but require buses or by more expensive smaller schools to which students can walk, which schools are cheaper? Can the same health benefits be provided at less cost by constructing fewer large hospitals but more clinics manned by paramedical personnel? By constructing a waterborne sewerage system or by installing low-cost household sanitation facilities that do not require sewers? Can the same number of lives be saved more cheaply by buying up all the property rights in a flood plain and moving people out than by constructing dykes and levees? Given two park sites that would give similar recreation benefits-perhaps one that would require buying warehouse sites and another that would require extensive filling and flood control along a river-which would be cheaper? Once it is determined that the least expensive alternative has been identified and its costs valued, then the subjective question can be more readily addressed: is it worth it?
Interestingly enough, electricity projects are customarily analyzed
using least-cost combination. The marginal value product of electricity is in general considered greatly understated by the administered price charged; in any event, much electricity is used for home lighting that is very difficult to value. In practice, most power projects simply compare alternative means of producing the same amount of power: steam generating stations versus a hydroelectric dam; a large generator with transmission costs and several years of idle capacity versus a series of smaller stations close to the demand centers.
A variation of the least-cost combination method can be used to deal with intangibles in multipurpose projects. From the total cost of the project are deducted all those costs that can be directly attributed to tangible benefits-flood damage avoided, irrigation, navigation, and the like. These costs are compared with their associated benefits to determine if the purpose is worthwhile at all. Is the flood damage avoided worth the direct costs incurred? Finally, the residual costs for the project are compared with the residual, intangible benefits. Is the number of lives saved by the project worth the residual cost that must be incurred? (A method of allocating residuals was outlined in the section on joint cost allocation in chapter 6.)
The problems with valuing intangibles are more common and more difficult to deal with in sectors other than agriculture. In agricultural projects, most of the benefits usually are tangible and can be valued. The costs and benefits can be compared directly to choose the highest-yielding alternative. There are, however, several aspects of intangible benefits that are frequently encountered in agricultural projects. Agricultural extension services, for example, are sometimes considered to give an intangible benefit in greater farmer education. For the most part, it is best to treat such costs that may give rise partly to intangible benefits-or, at least, the incremental amount of such costs-as necessary within a project if the total, tangible benefits are to be realized. If a dairy production project requires helping farmers to learn better sanitation procedures, then the extension agents who teach the procedures are essential to the success of the project, and the benefit of their effort is the tangible one of more and better milk.
In rural development projects, there are often components that are hardly essential to the main production objectives and that produce generally intangible benefits. This is the case when village schools, rural water supplies, rural clinics, or even agricultural research costs are included in a project. If these components are relatively small in comparison with total project costs, as they often are, then the problem of valuing the benefits may be ignored. But if such components form a significant part of total project cost, they probably should be separated out and treated on a least-cost combination basis. This procedure was followed in the analysis for the Korea Rural Infrastructure Project. The project included irrigation, feeder roads, community fuelwood plots, rural domestic water supply, and rural electrification. The irrigation, feeder roads, and community fuelwood components were analyzed by
comparing their tangible costs with their tangible benefits, but the components for rural domestic water supply and rural electrification were each dealt with separately on a least-cost combination basis.
Finally, if the proposed project is one in which the output is wholly intangible, a least-cost combination approach is appropriate. This would probably be the case for agricultural projects in which the major investment is in extension, agricultural education, rural water supply, rural health improvement, or research.
Decision Tree for Determining Economic Values
A "decision tree" for determining economic values is given in figure 7-1, parts A-D. Most issues of economic valuation in agricultural projects are covered by this diagram. The decision tree is used by taking an item to be valued in an agricultural project and tracing through the tree, following each alternative as it applies to the item until the end of the tree is reached, where a suggestion about how to value the item will be found.
To illustrate, we may trace through a few common elements in agricultural projects. Take fertilizer to be used in an irrigation project that will produce cotton. The fertilizer is tangible, involves real resource use, is traded, is a project input, and would be imported without the project. Therefore, it is valued at the import parity price. Or take agricultural labor to be used to apply the fertilizer. It is tangible, involves real resource use, is nontraded, is a project input, is nonproduced, is labor, and would be underemployed without the project. Therefore, it is valued by taking the marginal value product of the labor in its without-project employment. (Note that labor is defined as a tangible item, a possible source of confusion in using the decision tree.) Or take a tax on the fertilizer. It is tangible, is a direct transfer payment, is a payment to or from government, and is a tax. Therefore, it is omitted from the project economic account. Or, finally, take the cotton to be produced in the project. It is tangible, involves real resource use, is traded, is a project output, and will be an export. Therefore, it is valued at the export parity price.
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