The Domestic Price System of Economic Analysis

Abstract

Chapter 4 discussed the need to assess projects from a national point of view and explained the framework behind the procedures of economic valuation. This chapter extends the earlier discussion to show in detail how a project can be analysed using a domestic price numeraire—what we term using the domestic price system. The chapter first elaborates on the distinction between traded and non-traded goods or services produced or used by projects. It then turns to the treatment of the factors of production—labour, land, and capital—used by projects. The exchange rate for converting between foreign and national currencies is clarified, and a further analysis of the use of trade efficiency as a criterion for economic assessment is explained.

Appendices

Appendix 1: Applications of Economic Analysis with Irrigation Project Illustration

The Project

The project is an irrigation project providing water to farmers that enables them to increase crop yields. It can be classed as a non-traded infrastructure, but one which allows the expansion of tradable crops. Its benefits are in additional agricultural output and its costs are those associated with the construction and operation of an irrigation scheme plus the additional costs incurred by farmers as they increase yields. The example is deliberately simplified with a view to illustrating some of the basic principles discussed in Chaps. 4 and 5. Costs and benefits are decomposed into the resource categories identified in this chapter, border parity pricing used to value the additional agricultural output (Eq. 5.1), the simple formula for the SER (Eq. 5.9) is used, and a competitive local labour market is assumed, so the shadow wage rate factor is 1.0. The use of an adjustment for a relative price change is illustrated. Project results by the NPV and IRR indicators are shown for a discount rate of 10%.

The project is a scheme to irrigate 10,000 hectares of land that was previously rainfed. Two crops are grown on the land—wheat—which is at present imported into the country—and maize—which is exported. Approximately 6000 hectares are used for wheat cultivation and 4000 for maize. The project is run by a Water Authority and is financed solely by government equity. Total investment costs in constant Pesos are 50 million spread over a three-year period. The project will begin operations in year 4 and will have a working life of 22 years, terminating in year 25. Operating costs in constant Pesos are 1000 per hectare. The project will charge a tariff for irrigation water designed to cover its operating cost. The water itself is not scarce in the project area and has no direct opportunity cost in other uses. Basic data on project costs and revenue at financial prices from the perspective of the Water Authority are given in Table 5.5. The project itself is loss-making, with an NPV at financial prices of Pesos million −41.06, and the Water Authority will require a central government subsidy to cover the investment costs of the scheme.

Table 5.5 Financial returns to Water Authority (Pesos million)

The use of irrigation water combined with fertiliser and extra labour allows crop yields to rise significantly. Hence the incremental farm production is the economic benefit from the project. Crop yields per hectare without the project are 3000 kg for wheat and 5400 kg for maize. Without the project they are expected to remain constant for the first five years of project operations and then decline by 5% annually as soil fertility declines. However, with the project commencing in the second year of operations pre-project yields are expected to grow annually at a rate of 20%. This growth is maintained for four years after which point yields remain constant. Data on crop output with and without the project are shown in Table 5.6.

Table 5.6 Financial analysis, costs, and benefits to farmers

Farmers’ costs are increased as a result of the project. Without the project farm costs are local materials and farmers’ own time, with the latter valued at the prevailing wage for farm labour. With the project farmers’ own labour input increases and they will have expenditure on fertiliser and on irrigation water (Table 5.7). Farmers sell their output to a state-run Marketing Board that fixes farmgate prices.

Table 5.7 Farmers’ cost (constant prices per hectare)

Table 5.8 gives constant price estimates for cif and fob prices of wheat and maize, respectively, and the transport and distribution costs involved. Commodity price projections are available which imply that there will be a change in the relative price of these crops over the life of the project. Wheat prices are forecast to be constant in real terms until year 6 when they are projected to decline in real terms by 5% and to remain constant thereafter. Similarly maize prices are forecast to remain constant until year 9 and then in year 10 rise in real terms by 8% and to remain constant after that year. Farmers receive the border price net of all transport and distribution costs. The impact of the project on the financial position of farmers is seen in Table 5.6 by comparing incremental farmers’ costs (i.e. cost with the project minus costs without) and incremental farmers revenue (revenue with and without the project). The result is a financial NPV of 56.7 million Pesos at a 10% discount rate and a financial IRR for the farmers of 23% (Table 5.6).

Table 5.8 Price data (Pesos per kg)

Economic Analysis

The main project items as well as less crucial items have to be converted from financial to economic prices. A way of organising the data to apply economic pricing is to decompose all project costs and benefits in financial prices of less crucial project items into a series of resource categories, which can then be revalued by a series of conversion factors (CFs). Different combinations of resource categories can be used, depending on the level of detail involved. In practice, as a minimum the categories are

• Traded goods (which are equivalent to foreign exchange)

• Non-traded goods (outputs valued at willingness to pay or inputs which cannot be broken down further)

• Skilled labour

• Unskilled labour

• Transfers (taxes, subsidies, and surplus profits)

Traded goods are revalued by the SERF, non-traded good output is adjusted by the ratio of willingness to pay to the financial price charged, skilled labour is normally assumed to be paid a wage equal to its productivity, so it has a CF of 1.0, and unskilled labour is revalued by the ratio of the shadow to the actual project wage. All transfers are multiplied by zero, so they are removed from the analysis. For items of key importance to a project, where particular care has to be taken in their estimation, it is usually preferable to estimate specific CFs.²⁵ In this case specific CFs are calculated for the main crop outputs and fertiliser a key input.

The approach rests on simplifications

• 1. All CFs are assumed to remain constant over the life of a project

• 2. Any indirect effects in terms of traded goods (e.g. in labour’s opportunity cost and in the production of non-traded inputs) are ignored or assumed to be unimportant.

The omission of indirect effects is an important omission and if they are judged to be important an approximate estimate will need to be made. A way to estimate indirect effects more rigorously requires a form of input-output analysis, which links a project with the domestic sectors that supply it. Chapter 6 explains the logic behind semi-input output analysis and illustrates the approach with a simplified example. However, this is not applied in this project case.

In this illustration costs of the irrigation project are decomposed into the resource categories, traded, non-traded, and labour, all taken as unskilled. In addition, specific CFs are used for the traded crops, with their valuation based on border parity pricing. In addition, a specific CF is used for fertiliser. For the purpose of the economic analysis the project cost net of taxes has been converted from foreign, local, and labour costs into the economic categories traded, non-traded, and labour.²⁶ All labour is treated as unskilled. The breakdown is as follows:

%	Investment	Operating
Traded	60.5	70
Non-traded	17.5	20
Labour	22.0	10

For farmers’ costs all local materials are treated as non-traded. Fertiliser is imported and is sold to farmers by a government agency at a subsidised price approximately 30% below the cif price. The transport and distribution element in the fertiliser price is not known and for simplicity it is treated as solely traded, that is a foreign exchange value. The labour market in the project area is judged to be reasonably competitive and farmers not working on their own land can get jobs as casual labourers in non-agricultural activity. The national discount rate is assumed to be 10%.

Little information is available on the economy in which the project is located. However, the following data on foreign trade has been collected for a recent year:

	(Pesos million)
Total imports	800
Total exports	500
Taxes on imports	200
Subsidies on imports	40
Taxes on exports	0

Using this data, a crude estimate of the SER/OER can be derived from (5.9) in the main text. In this case, from the data available:

$$ SER/ OER=\left(800+200240+500\right)/\left(800+500\right)=1.123 $$

As an example of an approximate approach, here the financial price is used to value all non-traded items (such as transport and distribution costs) and labour.

Project benefits are incremental farm output valued at border parity prices, derived as in Table 5.9. By comparison with the financial prices farmers actually receive for their crops these border parity prices give agricultural crop conversion factors of:

Wheat	1.40/0.8 = 1.75
Maize	0.91/0.65 = 1.40

Table 5.9 Border parity prices (in Pesos/kg)

Crop conversion factors allow farmers’ revenue from crop sales to be converted to a flow of economic benefits. In deriving crop conversion factors, commodity price projections are used. These allow for relative price shifts in future years. Annual crop conversion factors are given in Table 5.10.

Economic costs are both the costs of the irrigation project itself and the incremental farm costs excluding the charge for water. The water tariff paid by farmers is not included as an economic cost since the cost of supplying the water is given by the project cost and to include the water tariff would be double counting. By assumption, the water has no opportunity cost in the project area, so that its cost is only its supply cost, which is included in the operating cost of the irrigation project.

In this analysis all non-traded costs and labour are valued at their financial prices (CF = 1) on the assumption that these prices reflect economic values. Fertiliser is assumed to have a tradable content of 100%; however, it is sold at a subsidised price to farmers and its foreign exchange value is 143% of its price to farmers.²⁷ Multiplication of the financial price by 1.43 gives the traded content, which is then adjusted by the SER/OER. This procedure is equivalent to applying a specific CF for fertiliser of 1.6 (as 1.43 × 1.123 = 1.6).

In summary, the following conversion factors are used to adjust the financial values of project and farm costs and crop output:

Traded	1.123
Non-traded	1.00
Labour (project)	1.00
Labour (farmers’ time)	1.00
Fertiliser	1.60
Wheat	1.75
Maize	1.40

The economic analysis under the assumptions used is shown in Tables 5.11 and 5.12. It gives an NPV of 89 million Pesos at a 10% discount rate and an IRR is 17.8%. The project has a high economic return; however, its financial sustainability is questionable. The Water Authority requires a government subsidy since water tariffs cover only operating cost. Further, while the project raises the income of farmers significantly there is a short-term reduction in their income, which would act as a disincentive for them to use the water to improve their farming methods. The implication is that from the viewpoint of economic efficiency, it would be preferable to charge farmers the full cost of the water (which would remove the need for a subsidy and encourage more efficient use of the water), but pay them a higher proportion of the economic value of the crops, since the pricing policy of the Marketing Board is equivalent to an implicit tax on farmers.

Table 5.10 Economic analysis, costs, and domestic price system

Table 5.11 Economic analysis, benefits, and domestic price system

Appendix 2: Irrigation Project and Domestic Cost Ratio

The irrigation example from Appendix 1 can be used to illustrate the application of the Domestic Resource Cost (DRC) ratio. Here since the absolute values of the OER and SER are not given, the DRC is calculated using Eq. (5.12) from the main text. The numerator of the ratio is the present value of non-traded costs (non-traded investment costs, non-traded operating cost, and local materials used by farmers) plus all labour costs (unskilled labour used in the construction and operation of the irrigation project and farmers’ time). In addition, there are non-traded transport and distribution costs associated with wheat and maize. For wheat, which is an import substitute, local production saves transport and distribution, so that the value of these costs saved is a non-traded benefit to be subtracted from the non-traded costs in the numerator. For maize as an export crop transport and distribution costs are incurred, so that these are additional non-traded costs to be added to the numerator.

The denominator of the DRC ratio in (5.12) gives the net foreign exchange effect of the project converted into local currency at the SER. Foreign exchange benefits are the value of wheat and maize at world prices. Foreign exchange costs are the traded component of investment and operating costs of the irrigation project and the imported fertiliser required by farmers. Table 5.12 sets out the data. The resulting DRC of 0.46 indicates that the project is efficient. The result is consistent with the NPV and IRR calculations, which also indicate efficiency. Further the data in the DRC ratio can be rearranged to give the original economic NPV. Total costs are non-traded costs (40.14 million) plus labour costs (41.98 million), while total benefits are net foreign exchange (163.45 million) plus non-traded benefits (7.42 million). The difference between total benefits and costs is 88.75 million, which, apart from minor differences due to rounding, is the economic NPV from Table 5.11. The DRC is 0.46 indicating that the domestic resources required to generate a unit of foreign currency are less than half the worth of that currency in foreign currency terms to the economy.

Table 5.12 DRC illustration