WOLAITA SODO UNIVERSITY

College of Business and Economics

Department of Economics

Module for Microeconomics (I, II) and

Development Planning and Project Analysis II

Prepared by:

1. Ayana Anteneh (Assi. Professor)

2. Abayneh Ayiso (Lecturer)

Edited by:

MARCH, 2023

WOLAITA SODO, ETHIOPIA

Table of Contents
MICROECONOMICS I ............................................................................................................................. 1
Introduction ................................................................................................................................................. 2
1. Consumer Preferences and Choices .............................................................................................. 2
1.1. Consumer Preference ..................................................................................................................2
2. Approaches to Measure Utility ...................................................................................................... 4
2.1.1. Assumptions of Cardinal Utility theory ............................................................................ 4
2.1.2. Total and Marginal Utility ..................................................................................................5
2.1.3. Law of diminishing marginal Utility (LDMU) ..................................................................5
2.1.4 Equilibrium of a consumer ........................................................................................................ 6
2.2. The Ordinal Utility Approach ....................................................................................................8
2.2.1. Assumptions of Ordinal Utility theory .............................................................................. 8
2.2.2. Indifference Set, Curve and Map .......................................................................................9
2.2.3. Properties of Indifference Curves: .................................................................................. 10
2.2.4. The Marginal rate of substitution (MRS) ....................................................................... 10
2.2.5. Special types of Indifference Curves ................................................................................ 11
2.3. The Budget Line or the Price line ............................................................................................ 12
2.3.1. Factors Affecting the Budget Line ................................................................................... 13
2.4. Optimum of the Consumer .......................................................................................................14
2.4.1. Effects of Changes in Income and Prices on Consumer equilibrium ................................. 16
Questions ................................................................................................................................................ 22
CHAPTER TWO .......................................................................................................................................23
CHOICE INVOLVING RISK AND UNCERTAINTY ......................................................................... 23
2.1. Introduction .................................................................................................................................... 23
2.2 Probabilities ..................................................................................................................................... 23
2.3 Expected Utility (Expected Value) ........................................................................................... 23
2.4. Individual’s Preferences Towards Risk .................................................................................. 25
2.5 Minimizing Risk ........................................................................................................................ 26
Questions ................................................................................................................................................ 27
CHAPTER THREE: THEORY OF PRODUCTION ............................................................................ 28
3.1 Introduction ............................................................................................................................... 28
3.2 Technological Relationship between Inputs and Output .......................................................28
3.3 Classification and Production Periods of the Variables ........................................................ 28
3.4 Theory of Short Run Production ............................................................................................. 28
 3.4.1 Production with a single variable input (Labor) ............................................................ 29
3.4.2 Stages of Production .................................................................................................................30
3.4.3 The Law of Variable Proportion ......................................................................................30
3.5 The Long-Run Production Function ....................................................................................... 31
3.5.1 Returns to Scale ........................................................................................................................ 32
Questions ................................................................................................................................................ 33
CHAPTER FOUR: THEORY OF COSTS .............................................................................................34
4.1 Cost Analysis ..............................................................................................................................34
4.2 Short-run Cost Functions ............................................................................................................... 35
4.3 Long-run costs ................................................................................................................................. 36
Questions ................................................................................................................................................ 37
CHAPTER FIVE: PRICE AND OUT PUT DETERMNATION UNDER PERFECT
COMPETTION ......................................................................................................................................... 38
5.1 Perfectly Competitive market structure ........................................................................................38
5.2 Short run equilibrium of the firm ............................................................................................39
5.3 The long-run Equilibrium .............................................................................................................. 40
Questions ................................................................................................................................................ 41
CHAPTER SIX: PURE MONOPOLY ....................................................................................................42
6.1 Introduction ..................................................................................................................................... 42
6.2 Source and kinds of monopoly ....................................................................................................... 42
6.3 Short run equilibrium under monopoly ........................................................................................ 42
6.4 Social costs of monopoly: the dead weight loss ............................................................................. 43
Question ..................................................................................................................................................44
REFRENCES .........................................................................................................................................45
MICROECONOMICS II ..........................................................................................................................46
CHAPTER ONE: MONOPOLISTIC COMPETITION ....................................................................... 47
1.1 Introduction ..................................................................................................................................... 47
1.2 Assumption of Monopolistic Competition .....................................................................................47
1.3 Product Differentiation and Demand Curve ......................................................................... 47
1.4 Demand and Revenue functions .....................................................................................................48
1.5 Cost of monopolistic competition ...................................................................................................48
1.6 The concept of product group and industry ................................................................................. 48
1.7 Equilibrium Under Monopolistic Competition Short-run Equilibrium ......................................49
1.8 Monopolistic Competition and Efficiency .....................................................................................51
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 1.9 Excess Capacity and Comparison with PC and Monopoly ......................................................... 51
Question ..................................................................................................................................................51
CHAPTER TWO: OLIGOPOLY ............................................................................................................52
2.1 Introduction ............................................................................................................................... 52
2.2 Characteristics of Oligopoly ..................................................................................................... 52
2.3 Causes of Oligopoly ................................................................................................................... 52
2.4 Equilibrium of a firm ................................................................................................................ 52
2.5 Classification of firms ............................................................................................................... 53
Questions ................................................................................................................................................ 61
CHAPTER 3: GAME THEORY ............................................................................................................. 62
3.1 Introduction ..................................................................................................................................... 62
3.2 Types of Games ................................................................................................................................63
3.3 The concept of Dominant Strategies .............................................................................................. 63
3.4 The Nash Equilibrium Concept ..................................................................................................... 64
3.5 Mixed Strategy .................................................................................................................................65
3.6 Repeated Games .............................................................................................................................. 65
3.7 Sequential Game ..............................................................................................................................66
3.8 Prisoners Dilemma .......................................................................................................................... 66
Question/s ............................................................................................................................................... 67
CHAPTER FOUR PRICING OF FACTORS OF PRODUCTION AND INCOME
DISTRIBUTION ....................................................................................................................................... 67
4.1 Introduction ............................................................................................................................... 67
4.2 Factor Pricing in A Perfectly Competitive Market ...................................................................... 68
Questions ................................................................................................................................................ 76
CHAPTER FIVE GENERAL EQUILIBRIUM ANALYSIS ................................................................77
5.1 Introduction ..................................................................................................................................... 77
5.2 General Equilibrium Theory ..........................................................................................................77
5.2.1 General Equilibrium of Exchange and Production ........................................................77
5.2.2 General Equilibrium of Production ........................................................................................79
5.3 Derivation of Production Possibility frontier (PPF) .................................................................... 79
5.4 General Equilibrium of Production and Exchange and Pareto Optimality ........................ 80
5.5 Perfect Competition, Economic Efficiency, and Equity .............................................................. 81
5.6 Efficiency and Equity ......................................................................................................................82
Questions ................................................................................................................................................ 82
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CHAPTER SIX INFORMATION ASYMETRY ................................................................................... 84
6.1 Introduction ............................................................................................................................... 84
6.2 Properties of Information ......................................................................................................... 84
6.3 Mixed Markets for Used Cars ..................................................................................................84
Questions ................................................................................................................................................ 86
REFERENCES ........................................................................................................................................... 87
Development Planning and Project Analysis II ......................................................................................88
Course Description .................................................................................................................................... 85
Course Objective ....................................................................................................................................... 85
Chapter One: Introduction: ..................................................................................................................... 87
An Overview of Project Analysis ............................................................................................................. 87
1.1 The Project Concept ..................................................................................................................87
1.1.1 Definition of Project .......................................................................................................... 87
1.1.2 Basic characteristics of a project ..................................................................................... 87
1.1.3 Classification of project .................................................................................................... 89
1.1.4 Why Project Planning? ..................................................................................................... 91
1.1.5 Organic Link between Policy, Development Plan and Projects ....................................92
1.1.6 The linkage between projects and programs .................................................................. 94
1.1.7 Uniqueness of Projects ...................................................................................................... 95
1.2 The project Cycle .......................................................................................................................96
1.2.1 Identification (Opportunity studies) ....................................................................................98
1.2.2 Project preparation: Analysis and Appraisal phase .......................................................... 99
1.2.2.1 Pre-feasibility Study (Pre-selection/ Preliminary Screening) ............................................99
1.2.2.2 Feasibility Study .................................................................................................................. 101
Chapter Two: Financial Analysis and Appraisal of Projects ..............................................................108
2.1. Scope and Rationale ................................................................................................................ 108
2.1.1. When to undertake financial Analysis ...............................................................................108
2.2. Identification of Costs and Benefits ....................................................................................... 108
2.3. Classification of Costs and Benefits ....................................................................................... 110
2.3.1. Tangible costs and benefits of a project ............................................................................ 110
2.3.1.1. Tangible costs of a project .............................................................................................. 110
2.3.1.2. Tangible Benefits ............................................................................................................. 114
2.3.2. Intangible costs and Benefits ............................................................................................... 114
2.4. The valuation of financial costs and benefits .......................................................................... 115
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 2.5. The cash flow in financial analysis ........................................................................................... 117
2.6. Investment Profitability Analysis ............................................................................................. 123
2.6.1. Non-discounted measures of project worth ....................................................................... 123
2.6.2. Discounted measures of project worth ............................................................................... 125
2.7. Sensitivity analysis ....................................................................................................................138
Chapter Three: Economic Analysis of Projects ........................................................................................ 139
3.1 An overview of economic analysis ...........................................................................................139
3.2 Identification costs and benefits of economic analysis .......................................................... 144
3.2.1 Sunk cost ............................................................................................................................... 145
3.2.2 Transfer payments, externalities and others ...................................................................... 145
3.3 Determining economic values ..................................................................................................147
3.3.1 Adjustment for transfer payments ...................................................................................... 147
3.3.2 Shadow pricing ......................................................................................................................148
3.3.3 Traded and Non-Traded commodities .................................................................................149
3.3.4 Valuation of Traded and Non-traded commodities ............................................................ 150
3.3.4.1 Valuation of Tradable commodities .................................................................................... 150
3.4 Border parity pricing .................................................................................................................151
3.5 National parameters and standard conversion factors .......................................................... 151
3.5.1 Conversion factors ................................................................................................................ 151
3.5.2 The standard conversion factor ........................................................................................... 153
3.5.3 The Economic valuation of foreign Exchange: .....................................................................154
3.5.4 valuation of non-traded goods ............................................................................................ 160
3.5.5 The valuation of primary factors of production: (Land, Labor, and Natural Resources) ...163
3.6 Social cost benefit analysis .......................................................................................................166
3.7 Cost-effectiveness .....................................................................................................................167
3.7.1 Cost-effectiveness Analysis .................................................................................................. 169
3.7.2 Weighted Cost-Effectiveness ................................................................................................172
Chapter Four: Project Implementation, Monitoring and Evaluation ........................................................177
4.1 Introduction: What is Monitoring and Evaluation .................................................................. 177
4.2 Why monitoring and Evaluation .............................................................................................. 178
4.3 Different Kinds of Monitoring and Evaluation ........................................................................ 179
4.3.1 Internal and External Project M&E ...................................................................................... 179

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 4.3.2 Monitoring Levels ................................................................................................................. 180
4.3.3 M&E and Stakeholder Participation .................................................................................... 181
4.4 Procedures in Monitoring and Evaluation ...............................................................................181
Chapter Five: Evaluation: Some Basics of impact evaluation .................................................................. 187
5.1 Impact assessment basics ........................................................................................................ 187
5.1.1 Qualitative versus quantitative impact Assessments ......................................................... 189
5.2 Methodologies in impact evaluation ....................................................................................... 190
5.2.1 Randomized evaluations ...................................................................................................... 194
5.2.2 Matching Methods- Propensity score matching (PSM) ...................................................... 198
References ................................................................................................................................................. 201

vi
WOLAITA SODO UNIVERSITY

DEPARTMENT OF ECONMICS

MICROECONOMICS I
(Econ2021)

MARCH, 2023 G.C

WOLAITA SODO UNIVERSITY

Introduction
Microeconomics deals with the behavior of individual economic units. Any individual or entity
such as consumers, workers, firms etc that play a role in the functioning of our economy
considered as an economic unit. Microeconomics explains how and why these economic units
make economic decisions. It also explains how consumers and firms buy out puts and sale inputs
and how their choices are affected by changing prices/costs and incomes/revenues. Consumers,
workers, firms etc are interested to know causes of price and output instability as well as
unemployment. Moreover, most of our issues and problems are related to economic matters. In
general, an individual who does not understand basic economic principles will not appreciate and
evaluate public issues that are most of them are related with economics.
General Objective
After successful completion of this course, you will be able to analyze and interpret economic
behaviors of firms and households.

CHAPTER ONE
THEORY OF CONSUMER BEHAVIOR AND DEMAND
The theory of consumer choice lies on the assumption of the consumer being rational to
maximize level of satisfaction.
The consumer makes choices by comparing bundle of goods.
1. Consumer Preferences and Choices
In this section you will see how consumers allocate their limited income among different number
of goods and services.
Moreover, you will learn how consumer’s allocation decisions determine quantity demand of
goods and services.
1.1. Consumer Preference
Given any two consumption bundles (groups of goods) available for purchase, how a consumer
compares the goods?
Does he prefer one good to another, or does he indifferent between the two groups.
Strict (strong) preference
Given any two consumption bundles(X1, X2) and (Y1, Y2), if (X1, X2)>(Y1,Y2) or if he chooses
(X1,X2) when (Y1,Y2) is available, the consumer definitely wants the X-bundle than Y.

2
Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent between
the two commodity bundles or if (X1,X2)  (Y1,Y2),the consumer would be equally satisfied if
he consumes (X1,X2) or (Y1,Y2).
Transitivity
It means that if a consumer prefers basket A to basket B and to basket C, then the consumer also
prefers A to C.
E.g. if consumption bundle (basket) which contains (x1, x2)> (y1, y2) and (y1, y2) > (z1, z2), then it
means that (x1,x2)> (z1,z2).
More is better than less
Consumers always prefer more of any good to less and they are never satisfied or satiated.
However, bad goods are not desirable and consumers will always prefer less of them.
1.2 Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service.
Definition

Utility is the level of satisfaction that is obtained by consuming a commodity or undertaking an

activity. In defining strict preference, we said that given any two consumption bundles (X1, X2)
and (Y1, Y2) the consumer definitely wants the X bundle than the Y bundle if (X1, X2) > (Y1,
Y2).
The concept of utility is characterized with the following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers.
 Utility is subjective. The utility of a product will vary from person to person. That means,
the utility that two individuals derive from consuming the same level of a product may not
be the same. For example, non-smokers do not derive any utility from cigarettes.
 The utility of a product can be different at different places and time. For example, the
utility that we get from meat during fasting is not the same as any time else.
A Consumer considers the following points to get maximum utility or level of satisfaction
(factors which may affect a satisfaction a person obtains from consuming a particular good or
service):

3
  How much satisfaction he gets from buying and then consuming an extra unit of a good
or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.
2. Approaches to Measure Utility
There are two major approaches of measuring utility. These are Cardinal and ordinal approaches.
2.1 The Cardinal Utility Theory
Neo-classical economists argued that utility is measurable like weight, height, temperature and
they suggested a unit of measurement of satisfaction called utils.
An util is a cardinal number like 1, 2, 3, etc simply attached to utility. Hence, utility can be
quantitatively measured.
Example: Suppose a consumer derived 5 utils of satisfaction from consuming the first bread and
7 utils from the second bread. By how much is higher the second bread than the first?

2.1.1. Assumptions of Cardinal Utility theory

1. Rationality of Consumers: The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.
2. Utility is cardinally measurable: According to this approach, the utility or satisfaction
of each commodity is measurable. Money is the most convenient measurement of utility.
In other words, the monetary unit that the consumer is prepared to pay for another unit of
commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money: According to assumption number two, money is
the most convenient measurement of utility. However, if the marginal utility of money
changes with the level of income (wealth) of the consumer, then money cannot be
considered as a measurement of utility.
4. Limited Money Income: The consumer has limited money income to spend on the
goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU): The utility derived from each successive units of
a commodity diminishes. In other words, the marginal utility of a commodity diminishes
as the consumer acquires larger quantities of it. This law is called LDMU.

4
 6. The total utility of a basket of goods depends on the quantities of the individual
commodities: If there are n commodities in the bundle with quantities, X 1 , X 2 ,...X n the

total utility is given by: TU=f ( X 1 , X 2 ...... X n )

2.1.2. Total and Marginal Utility

Definitions
Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a commodity at a particular time. As the consumer
consumes more of a good per time period, his/her total utility increases. However, there is a
saturation point for that commodity in which the consumer will not be capable of enjoying any
greater satisfaction from it.
Marginal Utility (MU): It refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting from
the consumption of one or more unit of a product per unit of time. Graphically, it is the slope of
total utility. Mathematically, the formula for marginal utility is:
TU
MU  Where, TU is the change in Total Utility, and,
Q
Q is change in the amount of product consumed.
2.1.3. Law of diminishing marginal Utility (LDMU)
Dear student, is the utility you get from consumption of the first orange is the same as the second
orange? The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc.
The Law of Diminishing Marginal Utility States that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each successive unit decreases, consumption
of all other commodities remaining constant. The LDMU is best explained by the MU curve that
is derived from the relationship between the TU and total quantity consumed.

Table1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Units of
0 1st 2nd 3rd 4th 5th 6th
Quantity(x)
Unit Unit unit unit Unit Unit Unit
consumed
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2
A
5
 MU TU 20
B
15 TUX

10

5
1 2 3 4 5 Quantity X

MUX
Fig.2.1Derivation of marginal utility from total utility
As the consumer consumes more of a good per time period,
o the total utility increases, at an increasing rate when the marginal utility is increasing and
o increases at a decreasing rate when the marginal utility starts to decrease and
o Reaches maximum when the marginal utility is Zero.
The total utility curve reaches its pick point (Saturation point) at point A. This Saturation point
indicates that by consuming 5 oranges, the consumer attains its highest satisfaction of 22 utils.
However, Consumption beyond this point results in Dissatisfaction, because consuming the 6th
and more orange brings a lesser additional utility than the previous orange.
Point B where the MU curve reaches its maximum point is called an inflexion point or the point
of Diminishing Marginal utility.

2.1.4 Equilibrium of a consumer

Single good consumption case: Diagrammatically,

MUx
 At any point where point C like point A where MUX>Px, it pays the consumer to
10 A
 consume more. At any point below point C like
C point B where MUX<Px the consumer consumes
5 
less of X. However, at point C where MUx=Px the
consumer is at equilibrium.
2  B
 B Mathematically, the equilibrium condition
MUX
of a consumer that consumes a single good X
2 5 10 PX

Figure 2.2 marginal utility of a consumer 6

 occurs when the marginal utility of X is
equal to its market price. MUX  PX
E.g. what amount of consumption of good X maximize utility of the consumer if utility function
of the consumer is estimated as U=2X2, with Px=8$?
Table 1.2 Utility schedules for a single commodity

Marginal utility
Quantity of Marginal utility
Total utility Marginal utility per Birr(price=2
Orange of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
For consumption level lower than three quantities of oranges, since the marginal utility of orange
is higher than the price, the consumer can increase his/her utility by consuming more quantities
of oranges. On the other hand, for quantities higher than three, since the marginal utility of
orange is lower than the price, the consumer can increase his/her utility by reducing its
consumption of oranges.
Multiple good consumption case
A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same utility.
For example, if the consumer consumes a bundle of n commodities i.e x1,x2,…,xn, he/she would
be in equilibrium or utility is maximized if and only if:
MU X 1 MU X 2 MU X n
  .........   MU m
PX 1 PX 2 PX n
Where: MUm –marginal utility of money (expenditure)

Table 1.3 Utility schedules for two commodities

Orange, Price=2birr Banana, Price=4birr

Quantity TUo MUo MUo/P Quantity TUB MUB MUB/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
7
5 13 0 0 5 45 5 1.25
6 11 -2 -1 6 48 3 0.75

Thus, suppose the income of the consumer is 20 birr, the consumer will be at equilibrium when
he consumes 2 quantities of oange and 4 quantities of banana,
MU orange MU banana 4 8
because    2
Porange Pbanana 2 4

Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:
1. The assumption of cardinal utility is doubtful because utility may not be quantified.
2. Utility cannot be measured absolutely (objectively). The satisfaction obtained from
different commodities cannot be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income increases, the
marginal utility of money changes.
2.2. The Ordinal Utility Approach
In the ordinal utility approach, utility cannot be measured absolutely but different consumption
bundles are ranked according to preferences.
The concept is based on the fact that it may not be possible for consumers to express the utility
of various commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is
always possible for the consumers to express the utility in relative terms.
It is practically possible for the consumers to rank commodities in the order of their preference as
1st 2 nd 3rd and so on.
2.2.1. Assumptions of Ordinal Utility theory
This approach is based on the following assumptions:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility given their
income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution is the
rate at which a consumer is willing to substitute one commodity (x) for another commodity (y)
so that his total satisfaction remains the same.

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 4. the total utility of the consumer depends on the quantities of the commodities consumed,
X 1 , X 2 ......X n
i.e., U=f ( )
5. Preferences are transitive or consistent: It is transitive in the senses that if the consumer
prefers market basket X to market basket Y, and prefers Y to Z, and then the consumer also
prefers X to Z.
The ordinal utility approach is expressed or explained with the help of indifference curves. Since
it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known as the
Indifference Curve Analysis.
2.2.2. Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of different quantities of goods for which the
consumer is indifferent, preferring none of any others.
Table.1.4. Indifference Schedule
Bundle (Combination) A B C D
Meat (X) 1 2 4 7
Bread (Y) 10 6 3 1
Each combination of good X and Y gives the consumer equal level of total utility. Thus, the
individual is indifferent whether he consumes combination A, B, C or D.
Indifference Curves: An indifference curve shows the various combinations of two goods that
provide the consumer the same level of utility or satisfaction.
It is the locus of points (particular combinations or bundles of good), which yields the same
utility (level of satisfaction) to the consumer, so that the consumer is indifferent as to the
particular combination he/she consumes. By transforming the above indifference schedule into
graphical representation, we get an indifference curve.
Indifference curve Indifference map
10 A

Indifference
B
6 Curve (IC)
bread (Y)

Good B

C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
Meat (X) 9
Fig2.4 indifference curves and indifference map.
Indifference Map: To describe a person’s preferences for all combinations bread and meat, we
can graph a set of indifference curves called an indifference map.
2.2.3. Properties of Indifference Curves:
Indifference curves have certain unique characteristics with which their foundation is based.
1. Indifference curves have negative slope (downward sloping to the right).This is because
the consumption level of one commodity can be increased only by reducing the
consumption level of the other commodity.
2. Indifference curves do not intersect each other. Intersection between two indifference
curves is inconsistent with the reflection of indifference curves. If they did, the point of
their intersection would mean two different levels of satisfaction, which is impossible.
3. A higher Indifference curve is always preferred to a lower one. The further away from
the origin an indifferent curve lies, the higher the level of utility it denotes: Baskets of
goods on a higher indifference curve are preferred by the rational consumer, because they
contain more of the two commodities than the lower ones.
4. Indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the left
downwards to the right. This assumption implies that the commodities can substitute one
another at any point on an indifference curve, but are not perfect substitutes.
5. Indifference curves cannot intersect each other.
6. By transitivity, the consumer must also be indifferent between points.
2.2.4. The Marginal rate of substitution (MRS)
Definition: Marginal rate of substitution of X for Y is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction.
Number of units of Y given up
MRS X ,Y 
Number of units of X gained
It is the negative of the slope of an indifference curve at any point of any two commodities such
as X and Y, and is given by the slope of the tangent at that point:
i.e., Slope of indifference curve
y
 MRS X ,Y
x

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The diminishing slope of the indifference curve means the willingness to substitute X for Y
diminishes as one move down the curve. MRS is negative. However, we multiply by negative
one and express MRS X ,Y as a positive value.

In the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more unit of
Orange. Marginal Utility and Marginal rate of Substitution

Y 4 It is also possible to show the derivation of the

MRS X ,Y (between point s A and B   4
X 1
MRS using MU concepts.
The MRS X ,Y is related to the MUx and the MUy is: MRS X ,Y 
MU X

MU Y

2.2.5. Special types of Indifference Curves

Convexity or down ward sloping is among the characteristics of indifference curve and this
shape of indifference curve is for most goods. In this situation, we assume that two commodities
such as x and y can substitute one another to a certain extent but are not perfect substitutes.
However, the shape of the indifference curve will be different if commodities have some other
unique relationship such as perfect substitution or complementary.
Here, are some of the ways in which indifference curves/maps might be used to reflect
preferences for three special cases.
I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially the
same), the indifference curve becomes a straight line with a negative slope. MRS for perfect
substitutes is constant. (Panel a)
IC3 IC1 IC2 IC3
IC2
IC1
Out dated

IC3
Right
Total

shoe

IC2
books

IC1

Panel a Mobil Panel b Left shoe Panel c Food

Fig.2.6 Special cases of indifference curves

II. Perfect complements: If two commodities are perfect complements the indifference curve
takes the shape of a right angle. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. Additional right or left shoes provide
no more utility for him/her. MRS for perfect complements is zero (both MRS XY and MRS YX is
the same, i.e. zero).
11
III. A useless good: Panel C in the above figure shows an individual’s indifference curve for
food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical axis). Since
they are totally useless, increasing purchases of out-dated books does not increase utility. This
person enjoys a higher level of utility only by getting additional food consumption. For example,
the vertical indifference curve IC 2 shows that utility will be IC 2 as long as this person has some
units of food no matter how many out dated books he/she has.
2.3. The Budget Line or the Price line
Indifference curves only tell us about the consumer’s preferences for any two goods but they
cannot tell us which combinations of the two goods will be chosen or bought.
In reality, the consumer is constrained by his/her money income and prices of the two
commodities.
This constraint is often presented with the help of the budget line
The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices.
Assumptions for the use of the budget line

In order to draw the budget line facing the consumer, we consider the following assumptions:

1. there are only two goods, X and Y, bought in quantities X and Y;

2. each consumer is confronted with market determined prices, Px and Py, of good X and good Y
respectivley; and
3. the consumer has a known and fixed money income (M).
 By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:
M  PX X  PY Y Where, PX=price of good X; PY=price of good Y;
X=quantity of good X; Y=quantity of good Y; M=consumer’s money income
Suppose for example a household with 30 Birr per day to spend on Meat (X) at 5 Birr each and
bread (Y) at 2 Birr each. That is PX  5, PY  2, M  30birr .
Therefore, our budget line equation will be:
5 X  2 Y  30
Table 1.6 Alternative purchase possibilities of the two goods
Consumption Alternatives A B C D E F
Kgs of Meat (X) 0 1 2 3 4 6
12
Units of bread(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30
 At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15).
 And at alternative F, the consumer is spending all his income for good X. mathematically;
it is the x-intercept (6, 0). We may present the income constraint graphically by the
budget line whose equation is derived from the budget equation.
By rearranging the above equation we can derive the general equation of a budget line,
M
M PX = Vertical Intercept (Y-intercept), when X=0.
Y  X PY
PY PY
PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY

M/PY

B

A


M/PX
Fig.1.7. Derivation of the Budget Line
 Pt A is attainable but not all of income is the consumer is exhaustively used.
 Pt B is unattainable within current income of the consumer.
Therefore, the budget line is the locus of combinations or bundle of goods that can be purchased if the
entire money income is spent.

2.3.1. Factors Affecting the Budget Line

Effects of changes in income

 Increase in income causes an upward shift of the budget line that allows the consumer to buy
more goods and services and decreases in income causes a downward shift of the budget line
that leads the consumer to buy less quantity of the two goods for normal goods. The slope of
the budget line (the ratio of the two prices) does not change when income rises or falls.

13
 Effects of Changes in Price of the commodities
Changes the prices of the commodities change the position and the slope of the budget line. But,
proportional increases or decreases in the price of the two commodities (keeping income
unchanged) do not change the slope of the budget line if it is in the same direction.
Let us now consider the effects of each price changes on the budget line
o What would happen if price of x falls, while the price of good Y and money incme remaining
constant?
Y

M/py A

Here Px ’<Px, hence M/Px<M/Px1

B B’ X M/Px M/Px '

Fig. 1.10 Effect of a decrease in price of x on the budget line

 Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of
Y by spending the entire money income on Y regardless of the price of X.
 We can see from the above figure that a decrease in the price of X, money income and
price of Y held constant, pivots the budget line out-ward, as from AB to AB’.
What would happen if price of x rises, while the price of good Y and money incme remaining constant?
What would happen if price of Y rises, while the price of good X and money incme remaining constant?
 Since the X-intercept (M/Px) is constant, the consumer can purchase the same amount of
X by spending the entire money income on X regardless of the price of Y. Fig.2.13
Effect of a fall in price of Y on the budget line
 Since Py decreases, M/Py increases thereby the budget line shifts outward.
 On the other hand decline in Py and Px by the same amount result in the entire outward
shift of budget line in both axis without changing slope of the line and
 Rise in Py and Px by the same amount result in the entire inward shift of budget line in
both axis without changing slope of the line.

2.4. Optimum of the Consumer

A rational consumer seeks to maximize his utility or satisfaction by spending his or her income.

14
It maximizes the utility by trying to attain the highest possible indifference curve, given the
budget line. This occurs where an indifference curve is tangent to the budget line so that the
slope of the indifference curve ( MRS XY ) is equal to the slope of the budget line ( PX / PY ).
Thus, the condition for utility maximization, consumer optimization, or consumer equilibrium
occurs where the consumer spends all income (i.e. he/she is on the budget line) and the slope of
the indifference curve equals to the slope of the budget line MRS XY  PX / PY .
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y A

B
E
IC4

C IC3

IC2
D
IC1

Figure 1.14 Consumer equilibrium

 This equilibrium occurs at the point of tangency between the highest possible indifference
curve and the budget line. Put differently, equilibrium is established at the point where the
slope of the budget line is equal to the slope of the indifference curve.
 Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU X MU Y MU X P
MRS XY  , But we know   .......MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY

Question

15
A consumer consuming two commodities X and Y has the following utility function
U  XY  2 X .If the price of the two commodities are 4 and 2 respectively and his/her budget is
birr 60.
a) Find the quantities of good X and Y which will maximize utility.
b) Find MRS X ,Y at optimum.

2.4.1. Effects of Changes in Income and Prices on Consumer equilibrium

A. Changes In Income: Income Consumption Curve and the Engel Curve
In our previous discussion, we noted that an increase in the consumer’s income (all other things
held constant) results in an upward parallel shift of the budget line. This allows the consumer to
buy more of the two goods. And when the consumer’s income falls, ceteris paribus, the budget
line shifts downward, remaining parallel to the original one.
If we connect all of the points representing equilibrium market baskets corresponding to all
possible levels of money income, the resulting curve is called the Income consumption curve
(ICC) or Income expansion curve (IEC).
The Income Consumption Curve is a curve joining the points of consumer optimum (equilibrium)
as income changes (ceteris paribus). Or, it is the locus of consumer equilibrium points resulting
when only the consumer’s income varies.
Commod

ICC
E3
E2
E1
Commodity X

Engle Curve
Incom

I3
I2
e

I1
X1 X2 X3 Commodity X
Figure 1.15 the income –consumption and Engel
curve
 From the Income Consumption Curve we can derive the Engle Curve. The Engle curve is
named after Ernest Engel, the German Statistician who pioneered studies of family budgets
and expenditure positions

16
 The Engle Curve is the relationship between the equilibrium quantity purchased of a good
and the level of income.
B. Changes in Price: Price Consumption Curve (PCC) and Individual Demand Curve
 Here, we hold money income constant and let price change to analyze the effect on
consumer behavior.
 The fall in the price of x will result in out ward shift of the budget line that makes the
consumer to buy more of good x.
 If we connect all the points representing equilibrium market baskets corresponding to each
price of good X we get a curve called price-consumption curve.
 The price-consumption curve is the locus of the utility-maximizing combinations of
products that result from variations in the price of one commodity when other product prices,
the money income and other factors are held constant.
 We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when price of
commodity X decreases from Px1 to Px2 to Px3 .
Commodity Y

PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3 demand curve

X1 X2 X3 Commodity X
Figure2.17 the PPC and derivation of the demand curve

2.4.1. Income and Substitution Effects

o Let us Consider the case of a price-decline:
 First a decrease in price increases the consumer’s real income (purchasing power), thus
enhancing the ability to buy more goods and services to some extent. Second, a decrease in
17
 the price of a commodityinduces some consumers (the consumer) to substitute it for others,
which are now relatively expensive (higher price) commodities.The 1st effect is known as the
income effect, and the 2nd effect is known as the substitution effect. The combined effect of
the two is known as the total effect (net effect).

Note that:
I/py1
X 1 X 3 =NE= Total (net) effect
X 1 X 2 = SE=Substitution effect
I’/py1 X 2 X 3 = IE=Income effect
A B IC2
 
C IC1


I
x1 x2 IE x3 I’/px2 I/px2
SE
NE
Px1
Figure2.18 Income and Substitution effect for a normal good
Suppose initially the income of the consumer is I 1 , price of goodY is Py 1 , and Price of good X
I I
is Px1 , we have the budget line with y-intercept and X-intercept . The consumer’s
Py1 Px1
equilibrium is point A that indicates the point of tangency between the budget line and
indifference curve IC 1 . As a result of a decrease in the price of X from Px1 to Px 2 the budget
I I
line shifts outward with y-intercept & X-Intercept . The consumer’s new equilibrium
Py1 Px 2
will be on point B.
 The total change in the quantity purchased of commodity X from the 1st equilibrium point at
A to the second equilibrium point at B shows the Net effect or total effect of the price
decline (change).
 The total effect of the price change can be conceptually decomposed into the substitution
effect and income effect.
The Substitution Effect
18
 The substitution effect refers to the change in the quantity demanded of a commodity
resulting exclusively from a change in its price when the consumer’s real income is held
constant; thereby restricting the consumer’s reaction to the price change to a movement along
the original indifference curve.
 Now, imagine that we decrease the consumer’s income by an amount just sufficient to return
to the same level of satisfaction enjoyed before the price decline. Graphically, this is
accomplished by drawing a fictitious (imaginary) line of attainable combinations with a slope
corresponding to new ratio of the product price Px 2 so that it is just tangent to the original
Py 1

indifference curve IC 1
 The point of tangency is the imaginary point C (imaginary equilibrium). The movement from
point A to the imaginary intermediate equilibrium at point C, which shows increase in
consumption of X from X1 to X2 is the substitution effect.In other words, the effect of a
decrease in price encourages the consumer to increase consumption of X than Y.
The Income Effect
o The income effect may be defined as the change in the quantity demanded of a commodity
exclusively associated with a change in real income.
o In figure 2.18, letting the consumer’s real income rise from its imaginary level (defined by
the line of attainable combinations tangent to point C) back to its true level (defined by the
line of attainable combinations tangent to point B) gives the income effect. Thus, the
income effect is indicated by the movement from the imaginary equilibrium at point C to
the actual new equilibrium at point B, the increase in the quantity of X purchased from X2
to X3 is the income effect.
o This movement does not involve any change in prices
When we look at both the substitution and income effects, the magnitude of the substitution
effect is greater than that of the income effect. The reason is that:
 Most goods have suitable substitutes and when the price of good falls, the quantity of the
good purchased is likely to increase very much as consumers substitute the now cheaper
good for others.
Spending only a small fraction of his /her income, i.e. with the consumers purchasing many
goods and spending only a small fraction of their income on any one good, the income effect of a
price change of any one good is likely to be small.
19
Usually, the income and substitution effects reinforce one another i.e. they operate in the same
direction. The substitution effect is always positive. i.e. if the price of a good X increases and
real income is held constant, there will always be a decrease in the consumption of good X, and
vise versa. However, the income effect in most cases, one would expect that increases in real
income would result in increases in consumption of a good. This is the case for so called Normal
goods.
In short in the case of normal goods, the income effect and the substitution effect operate in the
same direction –they reinforce each other. But not all goods are normal. Some goods are called
inferior goods. For an inferior good, a decrease in the price of the commodity causes the
consumer to buy more of it (the substitution effect), but at the same time the higher real income
of the consumer tends to cause him to reduce consumption of the commodity(the income effect).
We usually observe that the substitution effect still is the more powerful of the two; even though
the income effect works counter to the substitution effect, it does not override it. Hence, the
demand curve for inferior goods is still negatively sloped.
Let us consider the following diagram that shows the income, substitution and net effect for an
inferior commodity in the case of a decline in the price of good X.

Y KEY:
X1X3= NE=Net effect
X1X2= SE=Substitution effect
X2 X3= IE=Income effect
E3

IC2
E1
E2

X1 X3 X2 X
IE IC1
NE

SE

Numerical Example

Suppose that the consumer has a demand function for good X is given by

20
 2
X  20  MPX

Originally his income is $ 200 per month and the price of the good is 5$ per killogram.

Therefore,his demand for good X will be 200 per month.

20   28
52

Suppose that the price of the good falls to 4 per kilogram.Therefore,the new demand at the new
200
price will be: 20   32.5 per month.
42

Thus,the total change in demand is 4.5 that is 32.5-28.

When the price falls the purchasing power of the consumer changes.Hence,in order to make the
original consumption of good X,the consumer adjusts his income.This can be calculated as
follows:

M 1  P1' X  PyY
M  P1 X  PyY

Subtracting the second equation from the first gives:-

M 1  M  X [ P1'  P1 ]
M  XP1

Therefore, new income to make the original consumption affordable when price falls to 4 is:
M  XP1
M  28 * [4  5]  28

Hence,the level of income necessary to keep purchasing power constant is

M 1  M   M  200  28  172

The consumers new demand at the new price and income will be :

172
X (4,172)  20   30.75
42

Therfore,the substitution efffect will be:

 X  X ( 4,172 )  X (5, 200 )  30 .75  28  2 .75

The income effect will be:

21
 X ( 4, 200 )  X ( 4,172 )  32 .5  30 .75  1 .75

Since the result We obtained is positive we can conclude that the good is a normal good.

Questions
I. Choose the correct answer from the given alternatives!
1. What happen on budget line if the price of good/s changed?
A. The budget line shift to the right when the price of the goods grow up
B. The slope of budget line remain the same if the change in price is not proportional
C. When the price of one good decreases, the budget line shifts to the right on the side
of the good
D. The intercept of the budget line remain the same even the price of the goods
changed
2. Why indifference curves do not intersect with each other?
A. Because they are at same satisfaction level
B. Their combination of goods are different but they offer equal utility
C. Since they are different give different utility to the consumer
D. Because of assumption of constant utility along ICs
3. are goods whose demand increases as price of a commodity increases.
A. Giffen goods B. Normal goods C. Inferior goods D. complementary
goods
II. Workout
1. A consumer’s Utility function is given by: U(x, y) = 2X0.6Y0.4. If the consumer’s income is
Birr 900 and the price of X is Birr 8 per unit and the price of Y is Birr 12 per unit.
A. What is the utility maximizing level of X and Y?
B. What is the marginal rate of substitution x for y at equilibrium level?

22
 CHAPTER TWO
CHOICE INVOLVING RISK AND UNCERTAINTY
2.1. Introduction

Information on prices and income is known by the consumer (decision maker). But many of the
choice problems that the consumers face entail uncertainty about the possible outcomes of income,
price and other variables. Information is a key input in decision making. Decision made under
uncertainty of information involves some kind of risk.

Uncertainty: is a situation which can result in a number of outcomes but one is not sure as to which
outcome is to be materialized.

Risk: is a consequence that one has to face as a result of the variability of outcomes from uncertain
situation.

2.2 Probabilities
Even though you don’t know what the value of uncertain investment1 (for example investment in stock)
will be next year, you can still describe what it might be. In particular, suppose you know that over the
next year, one of three things will happen to your $100 investment:
• Its value could go up by 20 percent to $120 (outcome A).
• Its value could remain the same (outcome B).
• Its value could fall by 20 percent to $80 (outcome C).
For any lottery, the probabilities of the possible outcomes have two important properties:
1. The probability of any particular outcome is between 0 and 1.
2. The sum of the probabilities of all possible outcomes is equal to 1.
Utility Function under Uncertainty
If the consumer has reasonable preferences about consumption in different circumstances, a utility
function can be used to describe these preferences.
However, under conditions of uncertainty some additional structure, called probability, needs to be
added to the choice problem.
2.3 Expected Utility (Expected Value)
Expected Value– is outcome expected on average. It is the weighted average of all possible outcomes
of an event (the weights being probabilities).

23
Example: Take an event that can result in two possible outcomes; X1 = Outcome 1and X2 = Outcome 2.
Let 1 is the probability of outcome 1 and  2 is the probability of outcome 2, then the expected value
(E(X) of the event is given by:
�(�) = 1 �1 +  2 �2.
Variability – refers to the extent to which the individual outcomes are likely to vary from their expected
value. We use variance or standard deviation to see the variation of individual outcomes from their
expected value.
�

�������� = �2 = ��(�� − �)2

�=1

� = �1 [(�1 − � � ] + �2 [(�2 − � � ]2 +…+ �� [(�� − � � ]2

2 2

Suppose you are choosing between two part time sales jobs that have the same expected income of 1500
birr.
 The first job is based entirely on commission; i.e., the income earned depends on how much you
sell. There are two equally likely payoffs for this job: 2000 birr for a successful sales effort
and1000 birr for one that is less successful.
 The second job is salaried. It is very likely (0.99 probabilities) that you will earn 1510 birr, but
there is 0.01 probability that the company will go out of business, in which case you would earn
510 birr in separation pay.
Note that these two jobs have the same expected income:
For job 1: Expected Income = 0.5(2000 ����) + 0.5(1000 ����) = 1500 ����
For job 2: Expected Income = 0.99 1510 ���� + 0.01 510 ���� = 1500 ����
However, the variability of the two job offers is different. We measure variability by recognizing that
large differences between actual and expected payoffs (whether positive or negative) imply greater risk.

The variability for the two jobs can be calculated by the using the formula for variance:

�2 = �1 [(�1 − � � ]2 + �2 [(�2 − � � ]2

����������� 1 = �2 �1 = 0.5[2000 − 1500]2 + 0.01[1000 − 1500]2

�2 �1 = 0.5 500 2
+ 0.01[ − 500]2 = 250,00

����������� 2 = �2 �2 = 0.99[1510 − 1500]2 + 0.01[510 − 1500]2

�2 �2 = 0.99 10 2 + 0.01[ − 990]2 = 9900

24
We can also measure variability by using the standard deviation (SD) formula. SD is the square root
of variance.

�� = � = �2 = �1 [(�1 − � � ]2 + �2 [(�2 − � � ]2

����� 1 = ��1 = �1 [(�1 − � � ]2 + �2 [(�2 − � � ]2 = �2 �1 = 250,00 = 500

����� 2 = ��2 = �1 [(�1 − � � ]2 + �2 [(�2 − � � ]2 = �2 �2 = 9900 = 99.5

Thus, job 1 entails higher risk because the variability associated with its payoffs are greater than job
2 (i.e., 500 > 99.5). But, this does not mean that rational decision makers will choose job 1 to job 2.
The choice of alternatives with different risk levels depends on the attitudes or preferences that
individuals have towards risk.
2.4.Individual’s Preferences Towards Risk

a. Risk Aversion: is a tendency to prefer a given amount of income with certainty than taking a
gamble with high possible return and possible loss. For a risk-averse person the utility from a given
amount of income is greater than the expected utility from different levels of income with similar
expected value.
Now suppose the women currently has 20,000 birr and she is considering to take a new but risky job that
will increase her wealth to 30,000 if it succeeds but will reduce her wealth to 10,000 if it fails. Each
success and failure has equal probability of 0.5. The level of utility increases from 10 to 16 to 18 as
income increases from 10,000 birr to 20,000 birr to 30,000 birr. However, note that her marginal utility
is diminishing, falling from 10 to 6 when income increases from 10,000 to 20,000 and falling from 6 to
2 when income increases from 20,000 to 30,000.
To evaluate the new job, she can calculate the expected value of the resulting income. Because we are
measuring value in terms of the women’s utility, me must calculate the expected utility E(U) that she
can obtain.
�(�������) = 0.5 × ������� �� 10,000 ���� + 0.5 × ������ ��(30,00 ����)
= 0.5(10) + 0.5(18)
�(�) = 14
The women decides to take or not to take the new job by comparing the utility associated with the
original job (i,e., U(20)) with the expected utility of the new job (i.e., E(U)). The woman prefers the
original job to the new risky job because the expected utility of the new job (14) is less than the utility

25
from her original job. For a risk-averse consumer the utility of the expected value of wealth, u(20), is
greater than the expected utility of wealth, .5u(10)+.5u(30).
b. Risk Loving
A consumer is Risk Loving if he/she prefers a risk income to a certain income with the same expected
value. Risk loving is a situation where the utility from a given amount of wealth (income) is less than the
expected utility.
Let’s suppose that the utility of 10,000 birr will be 3, the utility from 20,000 birr will be 8 and the utility
from 30,000 birr will be 18. Marginal utility increases from 3 to 5 to 10 as income increases from 10 to
20 to 30 thousands of birr.

1 u (10 )   2 u (30 )
The expected utility from the new job is E(U)= 10.5. The
1 1
E(U)=  3   (18)
2 2 utility from the original job is U(20,000 birr)= 8. Thus, 10.5 >

1.5  9  10.5 8 and the consumer prefers to take the new risky job.

c. Risk Neutral
If a person is indifferent between a given amounts of wealth with certainty and uncertain income
with the same expected value the person is said to be risk neutral.
For instance, given the utility from income as: U(10)= 6, U(20) =12 and U(30) = 18, the risk neutral
consumer is will be indifferent between the original job and the new risky job. This is because
U(20,000 birr) = E(U). The expected utility from the new job is: 0.5U(10)*0.5U(30) = 0.5*6 +
0.5*18= 3 + 9 =12.
d. Risk Premium
The risk premium is the amount of money that a risk-averse person would pay to avoid taking a risk.
2.5 Minimizing Risk
Four ways that consumers use to reduce risks are:
1. Diversification: Given that a consumer is a risk averse, he/she minimizes the risks of
uncertainty by diversifying his holding or assets.
2. Purchase of Insurance: Let’s imagine that you are risk averse and you have just purchased a
new car. You can minimize the risk by buying the insurance for your car. Because a risk-
averse decision maker prefers a sure thing to a lottery with the same expected value, you will
prefer to buy a fair insurance policy that provides full coverage against a loss rather than buy
no insurance at all.
26
3. Obtaining more information: If more information were available, consumers would make
better predictions and reduce risk.
4. Risk Spreading: In the absence of formal insurance, a group of individuals can agree to
share a loss incurred by each individual from their group.
Questions
I. Select the correct answer for the following questions
Based on the following information, answer the questions 1, 2 and 3
Suppose a man currently has 38,000 birr and he is considering taking a new but risky
job that will increases his wealth to 50,000 birr with likelihood of 0.6 if it succeeds but
will reduce his wealth to 20,000 birr with probability of 0.4 if it fails.
The utility level associated with 38,000 birr is 20 and the utility level associated with an
income of 20,000 birr and 50,000 birr is 15 and 30, respectively.
1. What is the expected utility of the new job?
A. 22.5 B. 26 C. 30 D. 24
2. What will be the type of risk?
A. Risk Aversion C. Risk Neutral
B. Risk Premium D. Risk Loving
3. Expected income of the new job is
A. 45,200 B. 23,200 C. 38,000 D. 35,000
4. is a consequence that one has to face as a result of the variability of
outcomes from uncertain situation.
Uncertainty B. Risk C. Variability D. Expected value

27
 CHAPTER THREE: THEORY OF PRODUCTION
3.1 Introduction
What is Production?
Production is the process of transforming inputs into outputs. Production is the process of
converting economic resources (inputs) into consumable forms (goods and services).
What is Production Function?
It describes the relationship between the amount of inputs and the amount of output that can be
obtained.
3.2 Technological Relationship between Inputs and Output
It can be given as Q = f (labor, capital, natural resource, etc.)
Inputs are resources (raw materials or factors of production) used in the process of production.
 Land. The economy’s NRs such as land, trees, and minerals.
 Labor. The mental and physical skills of individuals
 Capital. Goods-such as tools, machines, and factories-used in production.
 Entrepreneurship- is special talents of human being that helps to organize and manage
other factors of production like land, labor and capital.
 Q=f(L, K,…) , where L and K are the amount of labor and capital, respectively.
3.3 Classification and Production Periods of the Variables
Inputs can be broadly divided into two: Fixed and variables inputs
Fixed inputs are inputs whose quantity cannot be easily varied over a short period of time to change
the level of output. Land, building, heavy machines, etc.. are examples of fixed inputs.
Variable inputs are inputs that can be varied easily according to the desired level of output.
– E.g. Labour, raw material, etc…
Economists identify two periods of productions:
The short run: Is a period of time during which firms or producers can adjust production by
changing only variable factors but cannot change fixed factors.
The long run: Refers to a period of time, which is long enough to allow changes in the level of all
inputs. In the long run all inputs are variable and there are no fixed inputs.
3.4 Theory of Short Run Production
Short run production theory tells us the relation between inputs and output when at least one input
is fixed. This relation can be shown by the concepts of Total, Marginal and Average Products.

28
Assume we have the following a short run production: Q = F(K, L) Labor is the only variable input
and K is fixed at some level.
Suppose that the production of maize require land, fertilizer, water machinery, etc.--, all fixed at
certain quantities. The only input the producer can adjust is labor. Thus, labor is the only variable
input. If labor input (measured in, say, worker/days) is 0, the output of maize is, off course 0.
As we increases the variable input (labor input), the producer will increases the output of maize.
But, a point will come where increasing labor will not increase the output of wheat at all and, in
fact, might even decrease it.
3.4.1 Production with a single variable input (Labor)
Total Product (TP) is the total amount of efficiently utilizing specific and fixed input. The total
amount of output that can be produced by utilizing different quantities of L and fixed is K.

Generally, the short run TP function follows a certain trend: It initially increases at an increasing
rate, then increases at a decreasing rate, reaches a maximum point and eventually falls as the
quantity of the variable input rises. This tells us what shape a total product curve assumes.

Marginal Product (MP)

 It is the change in output attributed to the addition of one unit of the variable input to the
production process, other inputs being constant.

 or MP = dTP/dQ for functional form

 or MP = dTP/dQL for functional form. In other words, MPL measures

the slope curve of the total product at a given point.
In the short run, the marginal product of the variable input first increases, reaches its maximum
and then decreases to extent of being negative.

29
Average Product (MP)
Average product of an input is the level of output that each unit of input produces, on the average.
It tells us the mean contribution of each variable input to the total product.

Mathematically, it is the ratio of total output to the number of variable input.

If MP is positive then TP is increasing. If MP is negative then TP is decreasing.TP reaches a
maximum when MP=0 If MP > AP then AP is rising. If MP < AP then AP is falling. When
either MP=AP or slope of AP is zero, AP will be maximum. MP reaches maximum if slope of
MP is zero. I.e. dMP/dQL = 0.

3.4.2 Stages of Production

Based on MP behaviour, there are three stages of production:
Stage 1: Positive Marginal Returns: This stage of production covers the range of variable
input levels over which the average product (APL) continues to increase.
It goes from the origin to the point where the APL is maximum (where MPL=APL). This stage is
not an efficient region of production though the MP of variable input is positive.
The reason is that the variable input (the number of workers) is too small to efficiently run the
fixed input so that the fixed input is under-utilized (not efficiently utilized).
Stage 2: Diminishing Marginal Returns: Throughout this stage the average product (APL)
decreases Ranges over point where the APL is maximum until MPL is zero. MPL is decreasing
due to the scarcity of the fixed factor. That is, once the optimum capital-labour combination is
achieved, employment of additional unit of the variable input will cause the output to increase at
slower rate, thus, MP diminishes. This stage is efficient region of production. Additional inputs
contributing to TP and optimum utilization of fixed input in the production. Hence, an efficient
region of production is where the marginal product of the variable input is declining but positive.
Stage 3: Negative Marginal Returns: Throughout this stage MPL is negative; aTPL is
decreasing. The volume of the variable inputs is quite excessive relative to the fixed input;
 The fixed input is over-utilized and a rational firm should not operate in stage III.
3.4.3 The Law of Variable Proportion
The law states that the contribution of successive units of a variable input (labour) to total output
is eventually diminishing in the short run.

30
3.5 The Long-Run Production Function
In the long run, a firm has enough time to change the amount of all its inputs. All inputs are
variable.The long run production process is described by the concept of returns to scale.
Isoquants show combinations of two inputs that can produce the same level of output.
Prosperities of isoquants
Isoquants have the same properties as indifference curves.
1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope.
2. The further an isoquant lays away from the origin, the greater the level of output it
denotes. Higher isoquants (isoquants further from the origin) denote higher combination
of inputs and outputs.
3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
4. Standard isoquant curves are convex to the origin….due to diminishing marginal rate of
technical substitution
5. Isoquants must be thin. If isoquants are thick, some points on the isoquant will become
inefficient.
Isoquants can have different shapes (curvature) depending on the degree to which inputs can
substitute each other.
1-Linear isoquants
• Isoquants would be linear when labor and capital are perfect substitutes for each other.
• This case the slope of an isoquant is constant.
• As a result, the same output can be produced with only capital or only labor or an infinite
combination of both.
2. Input-output isoquants
• The isoquants are L-shaped. It is also called Leontief isoquant.
• This assumes strict complementarities or zero substitutability of factors of production.
• In this case, it is impossible to make any substitution among inputs.
• Each level of output requires a specific combination of labor and capital.
3. Kinked isoquants
• This assumes limited substitution between inputs. Inputs can substitute each other only at
some points.
31
 • The isoquant is kinked and there are only a few alternative combinations of inputs to
produce a given level of output.
• These isoquants are also called linear programming isoquants or activity analysis
isoquants.
Isocost lines represent all combinations of two inputs that a firm can purchase with the same
total cost.
C  w L  r K Where, C is total cost; w is wage rate of labour; r is cost of capital.
C w
K   L
r r

Equilibrium is attained at MRTSLK = w/r, where the tangency point of isocost line and isoquant
curve. MRTSLK(slope of isoquant curve) = MPL/MPK; w/r(slope of isocost line).
The production function that generates linear Exp. Path keeping input price constant is called
Homothetic production function

3.5.1 Returns to Scale

• Constant returns to scale – a situation in which a proportional increase in all inputs
increases output in the same proportion
• Increasing returns to scale – a situation in which output increases in greater proportion
than input used.
• Decreasing returns to scale – a situation in which output increases less than
proportionally to input used.
If all inputs into the production process are doubled, three things can happen:
– output can more than double: increasing returns to scale (IRTS)
– output can exactly double: constant returns to scale (CRTS)
– output can less than double: decreasing returns to scale (DRTS)

32
Economists hypothesize that a firm’s long run production function may exhibit at first increasing
returns, then constant returns, and finally decreasing returns to scale.
Questions
I. Choose the correct answer
1. If Q = 3L + 6K, which of the following is false?
A. MRTS is a constant equal to ½ if L is on the horizontal axis
B. MPL = 3 units of output for each additional unit of L input
C. The production function displays constant returns to scale
D. K and L are perfect complements in production
E. K and L are perfect substitutes in production
2. When firm is producing in stage I,
A. MP is greater than AP C. Slope of AP curve is negative
B. The fixed input is over utilized D. a and b.
3. Considering short run production function, when MP rises
A. AP also rises C. TP declines
B. AP equals MP D. TP reaches maximum
4. A firm’s marginal product of labor is 10 and its marginal product of capital is 40. If the
firm adds two unit of capital, but does not want its output quantity to change, the firm
should
A. Reduce its use of labor by 8 units. C. Reduce its use of labor by 2 units.
B. Maintain the same level of labor utilization. D. Also increase labor by 2 units.
II.Workout
1. Suppose a certain contractor wants to maximize profit from building drainage. The
contractor uses both labor and capital, and efficient combinations of labor and capital that
are sufficient to make drainage is given by the function: Q (L, K) = 2 L1/2 K1/2. If the
prices of labor (w) and capital (r) are birr 10 and birr 20, respectively, cost is birr 600.
a. Find the optimum combination of L and K

33
 CHAPTER FOUR: THEORY OF COSTS
4.1Cost Analysis
What are Costs?
To produce goods and services, firms need factors of production or simply inputs.
These factors of production are owned by households. To acquire inputs, they have to buy them
from resource suppliers. Cost is, therefore, the monetary value of inputs used in the production
of an item.
The cost of production is the sum of all payments made to the suppliers of inputs. Inputs could
be supplied by the owner of the business or owners of inputs. It can be classified in to explicit
and implicit costs.
Explicit (accounting) cost refers to actual expenditure/out of pocket expenditure/monetary
payment by the firm to outsiders for those who supply factors of production.
Example: These are wage of workers, ccost of power (electricity and fuel), cost of raw materials,
and ect.
Implicit cost refers to the value of inputs owned by the firm and used by the firm in its own
production process.
Example: The owner can be the manager of the firm or the owner can use his/her own building
as a production place. Since these inputs are used for the purpose of producing the item, their
value has to be estimated. If a teacher quits his job and becomes the manager of his/her own
small farm.
Hence, economic cost is the summation of explicit and implicit costs.
 Accounting profit is total revenue minus explicit cost and economic profit is total
revenue minus economic cost (explicit + implicit cost)
 Normal profit is the minimum payment required to retain an entrepreneur in the business.
 i.e. a firm is said to be earning normal profit, when its economic profit is zero. That
means, E∏ = TR- (ExC+ImC) 0= TR- ExC- ImC, since E∏ = 0, 0=A∏ - EC, since TR-
ExC = A∏ (accounting profit) A∏ = EC
 Thus, when the firm earns normal profit accounting profit is equal to (A∏) = explicit
cost (ExC)

34
 4.2 Short-run Cost Functions
Total, Marginal, and Average Costs
In the short-run we have two types of inputs: fixed & variable inputs. So in the short run, there
are total fixed costs, total variable costs and total costs.
Total costs (TC) are equal to the sum of total fixed costs and total variable costs, i.e.
TC=TFC+TVC
Total fixed costs (TFC) are the costs that the firm incurs in the short run for its fixed inputs;
these are constant regardless of the level of output and of whether it produces or not. An
example of TFC is the rent that a producer must pay for the factory building over the life of a
lease.
Total Variable costs (TVC) are costs incurred by the firm for the variable inputs it uses.
Examples of TVC are raw material costs and some labor costs.
Average fixed cost (AFC) equals total fixed costs divided by output
 Average variable cost (AVC) equals total variable costs divided by output
 Average cost (AC) equals total costs divided by output
 AC also equals AFC plus AVC
 Average total cost tells us the cost of a typical unit of output if total cost is divided evenly
over all the units produced.
Marginal cost (MC) equals the change in TC or the change in TVC per unit change in output
 Marginal cost tells us the increase in total cost that arises from producing an additional
unit of output.
Table 4.1 Total, Marginal and Average Costs in the Short-run

Output Q TFC TVC TC AFC AVC ATC MC

0 200 0 200 - - - -
1 200 50 250 200 50 250 50
2 200 90 290 100 45 145 40
3 200 120 320 66.7 40 106.7 30
4 200 140 340 50 35 85 20
5 200 150 350 40 30 70 10
6 200 156 356 33.3 26 59.6 6
7 200 175 375 28.6 25 53.6 19
8 200 208 408 25 26 51 33
9 200 270 470 22.2 30 52.2 62
10 200 350 550 20.0 35 55 80

35
When MC is below AC, AC will decline, when MC is above AC, the latter (AC) is rising, and
when MC is equal to AC, the latter will reach its minimum point.
The above relationship holds true for MC and AVC, i.e. when MC is below AVC, AVC will
decline, when MC is above AVC, the latter (AVC) is rising and when MC is equal to AVC, the
latter (AVC) will reach its minimum point.
AFC falls continuously because a constant total fixed cost is divided by increasing outputs.
But the AC, AVC and MC curves are U- shaped.
The MC curve reaches its lowest point at a lower level of output than either the AVC curve or
the AC curve. The rising portion of the MC curve intersects the AVC and AC curves at their
minimum point.
The Relationship between production and costs
 Unit products and unit cost curves are mirror images of each other, i.e. For instance,
consider the relationship between AP and AC. When AP is rising AC is falling; when
AP is falling AC is rising; and when AP is maximum AC is minimum
 To illustrate this relation, assume a variable input labor (L) which commands a wage rate
w, TVC = w*L AVC = TVC/Q= w*L/Q = w/Q/L=w/APL
4.3 Long-run costs
The long-run is a period of time of such length that all inputs are variable.
If a production technology is characterized by constant return to scale (CRS), doubling output
requires doubling of input, which implies doubling of total output (cost) for given factor prices.
The long-run total cost curve in this case is a straight line through the origin. This implies that
the long-run average and marginal costs are horizontal lines and equal (LAC = LMC).
If we consider the case where total cost first increase at a decreasing rate due to increasing
returns to scale (which implies economies of scale).
Then at an increasing rate attributed to decreasing returns to scale after the optimum size, the
long-run total cost curve will not look like CRS total cost line.
The LAC and LMC curves will be U-shaped. In the long-run, the source of the U-shape is
increasing and decreasing returns to scale.
When the LAC is falling, then LMC < LAC. When LAC is rising, LMC > LAC. The two curves
intersect at a point where the LAC curve achieves its minimum.

36
When LRAC is declining we say that the firm is experiencing economies of scale. Implies per-
unit costs are falling. When LRAC is increasing we say that the firm is experiencing
diseconomies of scale. Per-unit costs are rising.
Questions
I. Choose the correct answer
1. If marginal cost is below average cost,
A. The slope of average cost will be negative C. Average cost increase
B. Average variable cost increase D. Average cost reaches its minimum
2. If average fixed cost and total cost is 20 and 400, respectively, and then output produced
is 10 units, what will be the average variable cost of the firm?
A. 200 B. 600 C. 20 D. 2
3. In a short-run production process, the slope of marginal cost curve is positive and the
average variable cost is declining as output is rising. Thus,
A. average fixed cost is constant
B. marginal cost is above average variable cost
C. marginal cost is below average variable cost
D. marginal cost is below average fixed cost

37
 CHAPTER FIVE: PRICE AND OUT PUT DETERMNATION UNDER
PERFECT COMPETTION
The structure of a market is identified by referring to variables like, Number of seller and buyer,
Freedom of entry and exit out of the market; Control over price; Type of the product traded and
etc.

5.1 Perfectly Competitive market structure

Assumptions (A market is said to be PC, if the following assumptions hold true)
 Large number of sellers and buyers. Therefore the action of a single seller or buyer can
not influence the market price of the commodity, since the firm or (the buyer) is too
small in relation to the market.
 Products of the firms are homogeneous: uniform in terms of quantity, quality and the
services associated with sales and delivery are identical. i.e., products are perfect
substitutes for one another.
 Free entry and exit of firms
 The goal of all firms is profit maximization
 No government regulation: there are any discriminator taxes or subsidies, no allocation
of inputs by the procurement, or any kind of direct or indirect control.
 Perfect knowledge about market conditions: all sellers and buyers have a complete
knowledge: The price of the product, quality of the product, etc
Cost, Demand and Revenue functions under perfect competition
 AVC & AC have U –shape due to the law of variable proportions (in the short run)
and the law of returns to scale (in the long run).
 Under PC market structure large number of sellers selling homogenous products and each
seller is a price taker.
 If the seller charges higher price than the market price to get larger revenue, no buyers
will buy the product.
38
  Thus firms operating in a PC market sell any quantity demanded at the ongoing market
price and buyers buy any amount they want at the ongoing market price.
Hence, the demand function that an individual seller faces is perfectly elastic (horizontal line).
Total revenue of a firm operating under PC is given by the product of the market price and the
quantity of sales, i.e., TR = P*Q
Since the market price is constant at P*, the total revenue function is linear and the amount of TR
depends on the quantity of sales.
MR and AR are equal under perfectly competitive market since price is constant.
MR = dTR/dQ= d(PQ)/dQ = P*dQ/dQ = P; AR= TR/Q = P*Q/Q = P
Hence, for firm operating under PC market, P = MR = AR
5.2 Short run equilibrium of the firm
Under PC, the firm is said to be in equilibrium when it produces that level of output which
maximizes its profit, given the market price.
Short run equilibrium of the firm can be obtained in two ways:
 Total approach
 Marginal approach
1. Total Approach
 The profit maximizing level of output is that level of output at which the vertical distance
between the TR and TC curves are maxima. (Provided that the TR curve lies above the
TC curve at this point).
 The profit maximizing output level is Qe because it is at this output level that the vertical
distance between the TR and TC curves (or profit) is maximum.
2. Marginal Approach
The profit maximizing level of output is that level of output at which: MR=MC and given MC is
increasing (slope of MC is positive).This approach is directly derived from the total approach.
 The slope of the TR curve constant and is equal to the MR or market price and the slope
of the TC is equal to MC.
 The distance between the TR and TC curves () is maximum when MR equals MC.
In the short run, A PCM firm might be in one of the following three cases:
Case 1: Making Profit

39
If the ATC is below the market price at equilibrium, the firm earns a positive profit equal to the
area between the ATC curve and the price line up to the profit maximizing output. The firm earns a
MC
positive profit because price exceeds AC of production at equilibrium. AC

Case 2: Zero Profits

Costs
If the ATC is equal to the market price Revenue
Price
at equilibrium, the firm gets zero.
MR=AR
The firm is making zero profits because
at the equilibrium level of output (Qe),
Average Cost is exactly equal to Average Revenue or Price.
Q
Case 3: Making Loss
If the ATC is above the market price at equilibrium, the firm earns a negative profit (incurs a loss)
equal to the area between the ATC curve and the price line. In this case, you may ask that “why do
the firm continue to produce if it had to incur a loss?” In fact, the firm will continue to produce
irrespective of the existing loss as far as the price is sufficient to cover the average variable costs.
The short run supply curve of the firm and the industry
The word ’industry’ is defined as group of firms producing homogeneous products. Thus the
industry supply is the total supply or market supply.
The industry –supply curve is the horizontal summation of the supply curves of the individual
firms. The industry supply curve is obtained by adding the quantities supplied by all the firms
at each price. For example, at price which equals $ 6, firm 1 supplies 50 units, firm 2 supplies 80
units & firm 3 supplies 120 units. The market supply at $ 6 price is thus 250 units (50+80+120
units).
The short run industry- supply is derived by repeating the above process at each price levels.
5.3 The long-run Equilibrium
In the long run, firms are in equilibrium when they have adjusted their plant size so as to produce
at the minimum point of their long run AC curve, which is tangent to the demand curve defined
by the market price.
That is, the firm is in the long run equilibrium when the market price is equal to the minimum
long run AC.
First, if the firms existing in the market are making excess profits (the market price is greater
than their LACs) new firms will be attracted to the industry seeking for this excess profit. He
entry of new firms results in two consequences:

40
A. The entry of new firms will lead to a fall in market price of the commodity.
B. Moreover, the entry of new firms’ results in an upward shift of the cost curves due to the
increase of prices of factors as the industry expends.
Second, if the firms are incurring losses in the long run (P < LAC) they will leave the industry
(shut down).
Thus, due to the above two reasons, firms can make only a normal profit in the long run.
The condition for the long run equilibrium of the firm is that the long run marginal cost (LMC)
should be equal to the price and to the LAC i.e. LMC = LAC = P.
In the short-run the firm should continue production as far as the market price is greater than the
minimum AVC, If the market price falls below the minimum AVC, the firm is well advised to
shut down.
In long run the firm should shut down if its revenue is less than its avoidable or a variable cost
An industry is in the long-run equilibrium when the price is reached at which all firms are in
equilibrium. That is, when all firms are producing at the minimum point of their LAC curve and
making just normal profits, the industry is said to be in the long-run equilibrium.
Under these conditions there is no further entry or exit of firms in the industry (since all the firms
are getting only normal profit), so that the industry supply remains stable.
Questions
I. Choose the correct answer
1. Under perfectly competitive market, the firm is said to be in equilibrium when
A. Price is greater than marginal cost
B. Marginal cost is equal to marginal revenue and given marginal cost is decreasing
C. The slope of total revenue curve is equal to market price
D. The distance between the total revenue and total curves is maxima when MR exceeds
MC.
2. Which of the following factor(s) lead to imperfect competition?
A. Existence of large number of sellers and buyers
B. Perfect knowledge about market conditions
C. Price making
D. Production of homogeneous product

41
 CHAPTER SIX: PURE MONOPOLY
6.1 Introduction
PM is the market structure in which there is only one firm that produces a distinctive product
(E.g. Ethiopian electric power corporation, ethio-telecom, water supply, etc).
By distinctive product we mean a product which has no close substitute. There is considerable
entry barrier for a new firm due to legal and patent rights, control over essential raw material,
technical, economies of scale, or any other. A pure monopoly firm is a price setter, not price
taker. Non-price competition is not necessary. Example: pharmaceuticals with patents, regulated
utilities (although this is changing), gas stations, etc.
6.2 Source and kinds of monopoly
The fundamental cause of monopoly is barriers to entry of other firms in to the industry
The barriers to entry are therefore the sources of monopoly power. The major sources of barriers
to entry are legal restrictions- are created by law in public interest such monopoly may be created
in both public and private sectors, sole control over the supply of key raw materials, efficiency
and patent right.
6.3 Short run equilibrium under monopoly
Profit maximizing condition is MR=MC and MC is rising
If the monopolist raises the price of its good, consumers buy less of it. Look at another way, if
the monopolist reduces the quantity of output it sells, the price of output will increases.
A Monopoly’s Marginal Revenue
• A monopolist’s marginal revenue is always less than the price of its good.
o The demand curve is downward sloping.
o When a monopoly drops the price to sell one more unit, the revenue received from
previously sold units also decreases.
Comparing Monopoly and Competition
– For a competitive firm, price equals marginal cost. P = MR = MC
– For a monopoly firm, price exceeds marginal cost. P > MR = MC
– The monopolist will receive economic profits as long as price is greater than average
total cost.

Price Discrimination
Price discrimination is the business practice of selling the same good at different prices to
different customers, even though the costs for producing for the two customers are the same.
42
Price discrimination is not possible when a good is sold in a competitive market since there are
many firms all selling at the market price. In order to price discriminate, the firm must have
some market power.
 Perfect Price Discrimination
– Perfect price discrimination refers to the situation when the monopolist knows
exactly the willingness to pay of each customer and can charge each customer a
different price. Examples of Price Discrimination: Movie tickets, Airline prices,
Discount coupons, Financial aid, Quantity discounts.
6.4 Social costs of monopoly: the dead weight loss
In a competitive market, price equals marginal cost of production. Monopoly power, on the other
hand, implies that price exceeds marginal cost. Because monopoly power results in higher prices
and lower quantities produced, we would expect it to make consumers worse off and the firm
better off. But suppose we value the welfare of consumers the same as that of producers.
p

F
Dead
weight
41 = pm D
MC
A B Ec
Em
25 = pc
C
DD= Price = MR (for perfect competitor)
G Em
MR

0 Qm Qc Q
6 10
Fig.6.8

Here, we use consumers’ and producers’ surplus as a measure of welfare of each. Consumer
surplus is the area between the demand curve and equilibrium price and producer surplus is the
area between the equilibrium price and marginal cost curve.
A perfect competitor’s equilibrium occurs when MC equal price or marginal revenue at Ec and
the equilibrium price and quantity are PC &QC respectively. Here the consumer’s surplus is the

43
area above the dropped line Pc Ec and below the demand curve i.e. area of  Pc F Ec. On the
other hand the producer surplus is the area below the dropped line PcEc and above the MC curve.
A monopolist equilibrium occurs when MC = MR i.e. at Em and the equilibrium price and
quantity become Pm and Qm respectively. Hence, in monopoly lower quantity is sold at higher
price. The new consumers’ welfare is the area above the dropped line PmD and below the
demand curve (i.e. area of  PmFD) where as the producers surplus becomes the area below the
dropped line PmD and above MC curve to the left of Qm (i.e. the area GPm DEm)
Thus monopoly power reduces the consumers’ surplus by the amount which equals area A+B.
But increase the producers’ surplus by the area A-C. The net welfare effect (loss) is obtained by
deducting the welfare loss of consumers from the welfare gain of producers. i.e.
Net welfare = Welfare gain by producers – Welfare loss by consumers
= A-C – (A+B) = A-C – A-B = -C –B or – (C +B)
Thus, monopoly results in a welfare loss which is given by the area (C+B)
This area is called dead weight loss. It is gained neither by producers nor by consumers.
The other disadvantage (Social cost) of monopoly is that is discourages innovations. Monopolist
may feel secure and have no incentive to innovate new product (technology) since there are no
competitors.
Question
I. Choose the best answer
1. Which of the following factor(s) lead to imperfect competition?
a. Existence of large number of sellers and buyers
b. Perfect knowledge about market conditions
c. Price making
d. Production of homogeneous product

44
REFRENCES
1. A. Koutsoyiannis, Modern Microeconomics
2. H.S. Agrawal, Principles of Economics, 7th edition.
3. Hal R. Varian, Intermediate Microeconomics: A Modern Approach, Forth Edition
4. C. Ferguson, Microeconomic Theory
5. R.S Pindyck and D.L.Rubinifeld, Microeconomics
6. E. Mansfield, Microeconomics: Theory and Applications
7. Robert H. Frank, Microeconomics and Behavior

45
WOLAITA SODO UNIVERSITY

DEPARTMENT OF ECONMICS

MICROECONOMICS II
(Econ2022)

March, 2023 G.C

WOLAITA SODO UNIVERSITY
46
 CHAPTER ONE: MONOPOLISTIC COMPETITION
1.1 Introduction
Monopolistic competition is a market structure in which many firms sell differentiated products.
Monopolistic competition was developed by Edward Chamberlin and Joan Robinson in early
1930s. They were dissatisfied with the existing two extreme markets. This market structure lies
between the two extreme market structures of PC and Monopoly. Both monopoly and perfect
competition are rare to find. They don’t reflect the true behavior of the majority of the firms.
Examples: furniture, jewelry, leather goods, barber shops, restaurants, books, magazines, films
and movies, bottled water, etc.

1.2 Assumption of Monopolistic Competition

a. There are large numbers of sellers & buyers (but not as large as PC) in the product group

b. Differentiated product and yet close substitutes: firms get certain monopoly power to set
price of their product. No identical or standardized product.

c. Ease of entry and exit: long run normal profit

d. Objective of the firms is profit maximization

e. Firms are assumed to behave as if they knew their demand and cost curves with certainty

f. Heroic assumption: Both demand and cost curves for all products are uniform through the
output group

g. The naive assumption: firms are assumed not to learn from their past experience.

1.3 Product Differentiation and Demand Curve

Process of making a product appear different from other products. It is accomplished by

producing products that have distinct positive identities in consumers’ minds. The goal of PD is
to achieve market power. It changes the demand curve from horizontal to downward demand
curve.

Real product differentiation: products differ in terms of their inherent characteristics such as
inputs used, location, services etc. E.g. Shampoo with and without conditioner

Fancied (spurious) product differentiation: products are the same but producers convince
customers that their product is different. E.g. Differences which are created due to advertisement,
in packing, design, brand name and other sales promotion activities.

47
 E.g. Spring water( Yes Vs Abyssinia), Beer

1.4 Demand and Revenue functions

A firm gains certain monopoly power through product differentiation. This results in downward
sloping demand curve. Marginal revenue is also downward sloping but is less than the demand
curve. The firm did not loss its entire customer through price rise even though some of them may
switch to its competitors product. Small rise in price results in large fall in quantity demanded.
The demand curve is highly elastic, but not perfectly elastic, because of the existence of large
number of firms producing closely substitute products. Flatter demand curve compared to pure
monopolist and steeper compared to perfect competitive firm.

When other things do not remain the same, the firm faces a new type of demand curve called
actual sales/market share/ demand curve.

1.5 Cost of monopolistic competition

Firms often devote considerable resources to differentiate their product from their competitors
through devices such as quality and style variations, warranty, special services features, and
product advertisement. The firm faces a new type of cost called selling cost or cost of product
differentiation. Average and marginal selling costs curve of monopolistically competitive firm
have U-shaped.

– Reason: economies and diseconomies of scale of selling activities.

• TC= Production Cost + Selling cost

The average and marginal selling cost of monopolistically competitive firm is generally greater
than that of perfect competitive and monopolist firm.

1.6 The concept of product group and industry

Industry: is collection of firms with identical product.

Product group: formed by lumping together firms producing similar products (but not identical)
which are close substitutes.

– They are group of products with higher price and cross elasticity of demand.

Close substitution can be two types:

48
 – Technological substitute: products which satisfy the same demand. e.g. all motor
cars i.e. they provide transport, TV, Computers

– Economic substitute: products which have similar price and satisfy the same
demand.

We do not have a single equilibrium price for differentiated product, but a cluster of prices.

• Chamberlin assumed that every firm in the product group faces the same demand curve
with identical cost.

1.7 Equilibrium Under Monopolistic Competition

Short-run Equilibrium

At equilibrium, a firm should produce at a point where:

– MR = MC and

– Slope of MC is greater than that of MR

The firm charges the corresponding price (P) based on its demand curve. The nature of profit
earned at equilibrium depends on the relationship between P and AC. More specifically,

– When P > AC, the firm earns an economic profit. (AR>AC)

– When P < AC, the firm incurs a loss.(AR<AC)

– When P = AC, the firm earns normal profit (AR=AC) i.e. profit=0

Three distinct model of long run equilibrium

A. Long run equilibrium with free entry of new firms ( there is no price competition among
the existing firms)

B. Long run equilibrium with price competition among the existing firms ( there is optimal
number of firms)

C. Long run equilibrium with price competition among the existing firms and free entry of
new firms(the ultimate solution)

Long run equilibrium with free entry of new firms

In this model

49
 – the existing firms are assumed to be in the short run equilibrium realizing
abnormal profits;

– existing firms don’t have any incentive to adjust their price,

– but long run equilibrium is attained by new entrants who are attracted by the
lucrative (rewarding) profit margin

Long run equilibrium with price competition

 Long run equilibrium with price competition among the existing firms ( there is optimal
number of firms)

 This model assumes that the number of firms in the industry is optimal (no entry or exit)
and long run equilibrium is reached through price adjustment (price competition) of the
existing firms.

 According to the model the firm can not learn from its past experience.

A Long run equilibrium point

 MR=LMC

 LAC= P

 Demand curve becomes tangent to the LAC curve

50
  DD=dd=LAC; The market share demand curve passes through the tangency point
between perceived demand curve and LAC. Profit =0

1.8 Monopolistic Competition and Efficiency

In monopolistic competition, neither productive nor allocative efficiency occurs in long-run

equilibrium.

Productive Efficiency: is achieved when the output is produced at minimum average total cost
(ATC). Condition: P=min ATC

Allocative Efficiency: is achieved when the value consumers place on a good or service (reflected
in the price they are willing to pay) equals the cost of the resources used up in production.
Condition: P=MC

Since the firm’s profit-maximizing price (and average total cost) slightly exceed the lowest
average total cost, productive efficiency is not achieved.

Since the profit-maximizing price exceeds marginal cost, monopolistic competition causes an
under allocation of resources.

Monopolistic competition decision did not maximize social welfare since equilibrium price is
higher than MC and output is below social desired level.

1.9 Excess Capacity and Comparison with PC and Monopoly

Long run equilibrium of the firm under monopolistic competition is attained at a point where the
perceived demand curve is tangent to LAC curve. Compared to the LR equilibrium of perfectly
competitive firm, a monopolistically competitive firm: Produces smaller units of output, Charges
higher price, Price is above marginal cost of production, Operates on the falling part of the LAC
curve( it is at the min point of the LAC curve of PC).

Question

Consider an actual demand curve DD facing a firm

working under monopolistic competition is given by P = 25-2Q and firms LAC = Q2 – 22Q +
125. Find equilibrium Q & P.

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 CHAPTER TWO: OLIGOPOLY
2.1 Introduction

Oligopoly is a market structure in which a few firms dominate the supply of an industry’s output
and compete with each other for markets. The main difference b/n oligopoly and other markets is
the existence of strategic interdependence of firms. In perfect competition and pure monopoly
price and output decision of one firm do not affect other firms decision. In oligopoly it affects
decision of the other firm.

2.2 Characteristics of Oligopoly

 Few number of firms in a given industry: The limiting case of oligopoly market is where
there are only two firms and this is called duopoly.

 Firms produce homogenous or differentiated product

 Interdependence of firms in decision making

 Firms have some power to set price

 Firms have profit maximizing objective. Example (domestic firms like Beer industry, sealed
water industry,…

 Entry is difficult

2.3 Causes of Oligopoly

Economies of scale: only few firms reach minimum of LAC, firms with minimum LAC hinder
entrances.

Barriers to entry: Only strong firms successfully pass all the barriers inter the market. Collusion
(merger of small firms): Merging of firms create few powerful firms and others removed from
the market.

2.4 Equilibrium of a firm

There is no standard equilibrium solution in this market.

Two basic categories: Collusive models and non collusive models

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 2.5 Classification of firms

Based on the reaction pattern, firms an be classified into

A. Non collusive models

Each firm makes decision independently by making some assumption about its competitors
decision. No contractual agreement and cooperation in making optimal decision

Non-collusive oligopoly models include: Kinked demand model, Cournot’s duopoly model,
Bertrand’s duopoly model and Stackelberg’s duopoly model.

B. Collusive Oligopoly

Firms have implicit or explicit agreement in making optimal decisions. why collusion?

Collusion increases profit, decreases uncertainties, and can act as a barrier to entry of new firms.

The models of collusive oligopoly are:

a. Cartel: Cartels aiming at joint profit maximization & Market sharing cartel

b. Price leadership: Price leadership by the low cost firm, Price leadership by the
dominant firm,& Barometric price leadership.

A. Non- collusive

The kinked demand curve model

Price in the other three markets rapidly adjusted to change in demand and supply. Example if, for
a normal goods, if income of the consumer increase  dd shift out  P increase. If cost of
production decreases supply curve shifts right ward and price increases. But in in some
oligopoly model price is sticky (stable) due to – interdependency of decision and absence of
agreement. The model assumes that once equilibrium P is set at the intersection of actual and
planned sale demand curves of Chamberlin, firms are reluctant (unwilling) to change P. If it
increases P slightly, others will not follow a slight increase in P leads to high loss of market
share (%ΔP<%ΔQ). So planned demand (dd) is the elastic one. Therefore, the firm is unwilling
to increase price above equilibrium price.

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If it decreases P others also do the same and leads to price war that decreases profit of all firms,
by decreasing P it actually sells less than the planned a decrease in P increases sale by small
amount (%ΔP>%ΔQ). So, thus its demand is the less elastic one (DD). Since decrease in price
decreases profit of all firms a firm is unwilling to decrease P.

So the demand curve of a firm is kinked at equilibrium P, for above equilibrium P planned
demand curve and for below equilibrium P the actual demand curve. MR curve is discontinues
at the point of kinked. MC curve passes through the discontinuous gap. Equilibrium is the kinked
point even if MR is not cutting MC curve

• Critics: The model does not show equilibrium P is Set

Cournot Duopoly Model

Simple Cournot Model

Assumptions

• Two firms (A and B)

• Homogeneous product (mineral water)

• Equal (identical and constant) costs

• Naïve assumptions (firms do not learn from their past experience)

• Linear market demand curve

• Equilibrium price is set by the market

• Firms know that out put of one firm affects out put of the other through affecting
equilibrium P

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A market share of n number of firms in the market is measured by 1/(1+n). Example1; if total
demand of market at zero price is 120 units and 5 firms are there in the market, what is market
share of each firm and how much does a firm supply?

Market share = 1+(1+5) = 1/6 Supply of each = 1/6*120 = 20

Cournot’s Reaction Curve Approach

Assumptions

• Two firms (A&B)

• Homogeneous Product

• Different cost

• Both firms are naïve and set equilibrium quantity simultaneously assuming out put of the
other is constant

• Equilibrium Price is set by the market

• Price set by amount of out put of A and B (Q=QA+QB=SS) i.e. Change in either of QA or
QB or both affect SS and change equilibrium P because P is set where DD=SS

• Each firm, assuming maximum out put of the other is given, determine its out put that
maximize its profit ΠA=PQA - CA ΠB=PQB - CB

Example Firm A set QA assuming QB is maximum. If firm A expect that firm B will decrease QB
to QB0 , that affect profit of both firms, firm A can maintain its profit by constant by increasing
QA or decreasing QA. First firm A get ΠA from QA combined with QB. If B decrease QB  SS
55
decrease  P increase. So firm A can get the same profit (ΠA). By producing less (QA0) at
higher P or By producing more (QA1) that decrease P.

The curve along which the same amount of profit is derived from different combination of
quantity of both firms is called Isoprofit curve. On the other hand, firm A can react in other way
that increase or decrease its profit.

Properties of Isoprofot

1) Isoprofit of a firm for substitute goods is concave to the axis along which we measure
output of the firm

2) Isoprofit that lie far from the axis along which we measure output of the firm represent
less profit

3) Assumption

The pick point (maximum point) of successive isoprofit for one firm lies to the right of each
other and the other is to the left of each other.

Reaction curve: is a locus of highest point of Isoprofit that tell us how much to produce given
the output of its competitor.

Equilibrium of both firms

• Equilibrium is where the reaction curve of both firms intersect.

• At the intersection point actual production of a firm and the out put estimated (assumed)
by the other firm are equal.

• At equilibrium profit of each firm maximized, but industry’s joint profit is not
maximized because of naïve assumption (they don’t learn from past experience)

• Had they learn from past experience they make agreement and can get the same profit by
producing less output on the contract curve

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The Bertrand duopoly model

In Cournot model firms set their profit maximizing output and price set by the market. In
Berterend model firms set the profit maximizing price and how much they produce is set by the
market. So for Berterand the strategic variable upon which firms compete is price.

Profit depends on the price charged π(P1,P2)

• If firm A charges less than firm B, it supply the entire market and B supply nothing

• If firm A charges equal price with B, both supply half of the market

• If firm A charges higher price than firm B, firm A supply nothing and B supply the entire
market.


• Profit of A P1Y  C (Y )  
 ( P1 , p2 )  1 1
[ PY  C (Y )]  
2 2
P1 0  C (0)  0

Equilibrium of the model

57
If one firm charges price higher than the equilibrium price there is always action and reaction
that leads to equilibrium.

Had they made agreement, they can get higher profit from the current out put by charging higher
price at the tangency point of higher isoprofit curves of the two firms.

Stackelberg Duopoly model

It is similar with cournot reaction curve approach. All the assumptions, isoprofit curves, and
reaction curves are the same except,

a) in this model one firm is naïve and follower, and the other is sophisticated and leader

b) The leader knows every thing about the naïve and how the naïve react against its decision

c) So the leader set its equilibrium quantity on the most lower isoprofit curve tangent to the
reaction curve of the naïve firm.

d) Equilibrium decision is not simultaneously like Cournot but, sequentially. The leader
decide first and then the naïve make decision at the same point

The equilibrium is,

• On the most lower isoprofit that represent higher profit to the leader

• Tangent to the reaction curve of the naïve. If the equilibrium point is on the reaction
curve of the naïve firm, then since the naïve takes it as equilibrium it does not react
against the equilibrium

If both firms are sophisticated, both wants to be a leader to get higher profit. In this case, market
situation becomes unstable. Such situation is known as Stackleberg disequilibrium. The
instability continues until one surrender by price war or make agreement to produce on the
contract curve.

The leaders first determine the reaction function of its follower and then incorporate it to its own
profit function. Maximize its profit by setting marginal revenue equals to marginal cost.

Example: Assume there are two firms producing homogeneous product and demand equation is

P=60-2(y1+y2) and Cost of firm 1 is C1=y12 and cost of firm 2 is C2=4y2

a) Find Stackleberg equilibrium y1, y2, Y, P, π1, π2, Π if A is leader

58
b) Find Stackleberg equilibrium y1, y2, Y, P, π1, π2, Π if B is leader

Solution

a) y1=8, y2=10, Y=18, P=24, π1=128, π2=200 , Π=328

b) y1=5.5, y2=13.5, Y=19, P=22, π1=209, π2=90.75 , Π=299.75

B. Collusive Oligopoly

Collusion is the implicit or explicit (formal or informal)agreement between firms on decision

making.

Cartel

A cartel is a formal organization of firms producing the same product. Its objective is to
maximize the firms’ joint profit. The followings are examples of cartels.

a) Cartels aiming at joint profit maximization

b) Market sharing cartel

a) Cartels aiming at joint profit maximization

Member firms appoint a central agent that works to maximize the joint profit of the cartel. Cartel
knows about the cost of each firm and other information. Authority of the central agency are to
set equilibrium price, quantity and profit of the cartel, allocate the output among firms and
allocate the profit among the firms.

The central agency carryout its activities in this way: First estimate the cartel demand; Derive the
cartel marginal revenue (MR); Derive cartel marginal cost by summing up MC of each firm i.e.
MC=MC1+MC2; Equate the MR and MC and set equilibrium P, Q and calculate profit of the
cartel; Allocate the output and profit where MR=MC1, and MR=MC2.

Assume demand function of a Cartel having two members is P=60-2Y and cost of firm 1 is
C1=y12 and Cost of the second firm C2=4y2 MR =MC1=MC2

a) Find equilibrium y1, y2, Y, P,

b) Find equilibrium π1, π2, and π

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Solution

a) y1=2, y2=12, Y=14, P=32

b) π1=, π2=, and π=396

b) Market Sharing Cartel

In such cartel firms make agreement on how to share the market

Non- price competition, Sharing of the market by agreement on quotas, Regional sharing cartels

Price leadership

Price leadership agreement to cooperate is implicit without any formal discussion. Firms enter in
to such agreement voluntarily to avoid any uncertainty about the competitor reaction.

a) Low cost price leadership

Assumptions

Two firms, homogeneous product, different costs, firms may have equal or unequal market share.
The low cost firm become leader and set price; The other follow taking the price. If the follower
refused to take the price the low cost firm eliminate through price competition. But the follower
firm can influence the price set by the leader through supplying more or less than the expected
amount. So the leader has to make market share agreement formally or informally.

Thus, the leader set equilibrium price taking the market demand curve as its own and make
agreement with the follower how much to produce.

b) Dominant firm price leadership

Assumptions

There are few firms among which one is dominant; They supply homogeneous product; The
dominant firm knows market demand and MC of small firms.

The large (dominant firm), that supply more than the others set equilibrium price; Small firms
behave like prefect competitive firm and follow it.

 How does the dominant firm set equilibrium price?

The dominant firm estimate market demand function; Derives small firms SS curve by summing
up their MC. Equate market demand and small firms supply curve. Since small firms act as
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perfectly competitive firm the leader compare P and summation of MC (P=ΣMC). By decreasing
price, it derives its demand curve (residual demand curve). Residual DD = DD – small firms SS,
Derive its MR; Set equilibrium P by equating its MR and MC.

Example: Assume there are few firms supplying homogeneous product where there is one
dominant firm. If the estimated demand function of the market is D(P)=50-0.3p, Small firms
supply equation S(P)=0.2P, and the dominant firm cost function is C=2Y then

a) Find the dominant firm residual demand curve equation, MR and MC

b) Set equilibrium quantity of dominant and equilibrium P

c) what is the total quantity demanded at equilibrium

d) Small firms supply at equilibrium

e) What is the profit of the dominant?

Solution

a) Y=D(P)-S(P)P=100-2Y MR=100-4Y MC=2

b) Y=24.5, P=51 c) D(P)=34.7 d) S(p)=10.2 e) π=1200.5

c) Barometric price leadership

A firm which have good knowledge of the prevailing condition in the market and can forecast
better than other about the future development in the market.

Questions

Choose the correct answer from the alternatives

1. All are models in collusive oligopoly market structure except one

A. Cartel C. Low cost firm price leadership. E. None
B. Stackelberg duopoly model D. Dominant Firm price leadership
2. Which one is true about simple Cournot’s duopoly model?
A. There is identical cost between the firms. C. Heterogeneous products
B. The equilibrium quantity is set by market D. There is a leader and a follower
firm
3. Among the following identify correctly matched pairs of concepts

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 A. Oligopoly market – many sellers C. Monopolistic competition – homogeneous
product
B. Dominant firm price leadership – set equilibrium price D. Duopoly – two buyers
4. Market share cartel firms make contractual agreement on how to share market through
A. Price competition C. Regional sharing cartels
B. Sharing of the market by agreement on quotas D. All except A

Workout

1. Assume demand function of a cournot duopoly firms given by P = 75-2Q and cost of
firm 1 is C1= 2Q1 2 + 25Q1 and Cost of the second firm C2 = 15Q2. Where P, Q & C are
price, quantity of the product and cost of the firms, respectively. (Hint: Q = Q1 + Q2, C =
C1 + C2)
A. Find equilibrium Q1, Q2 and P
B. Find equilibrium profit (π) of each firm

CHAPTER 3: GAME THEORY

3.1 Introduction

In the oligopoly market we noted that competition is intense. That is, firms must consider the
likely responses of competitors when they make strategic decisions about price, advertising, &
other variables.
In other words, the actions & reactions of a firm depend on the move & countermove of the other
firm just like a game.
Thus the development & application of game theory is one of the most exciting areas in
microeconomics.
Game is the science of strategic decision making. It is an action where there are two or more
mutually aware players & the outcome for each depends on the action of all. It is also a situation
where the participants’ payoffs depend not only on their decisions, but also on their rivals’
decisions.
Four elements of a game:
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 Players: Each decision maker in a game. These players can be individuals, firms (as in
the Oligopolistic markets), or entire nation (as in the military conflict).

strategies: when each player moves, what are the possible moves, what is known to
each player before moving; Strategy is a decision rule of players

payoffs :The final return to the players of a game at its conclusion. How much money
each player receive for any specific outcome. E.g.. Payoffs for a firm can be profit

Rules: rules include whether the game is cooperative or noncooperative. Players

maximize individual gain or maximize their minimum return (risk averse).

3.2 Types of Games

A game is cooperative if the players can negotiate binding contracts that allow them to plan joint
strategies. An example of a cooperative game is the bargaining between a buyer and a seller over
price of a commodity.

A game is non cooperative if negotiation & enforcement of a binding contract are not possible.
Example is a situation in which two competing firms take each other’s likely behavior into
account & independently determine a pricing or advertising strategy to win market share

3.3 The concept of Dominant Strategies

Dominant Strategy: A strategy that yields a higher payoff than any other strategy, no matter
what strategy the other player follows. In any game each player has his own strategy that
enables him to win the game. That means the game’s likely outcome depends on the strategy the
player follows. Thus knowing the strategy help us to determine how the rational behavior of
each player will lead to an equilibrium solution.

A dominant strategy is a strategy that is optimal for a player no matter what an opponent
does.“I am doing the best I can no matter what you do.” “You are doing the best you can no
matter what I do.”

Payoff matrix of firms

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We can observe from this payoff matrix that if both firms decide to advertise, firm A will make
profits of 10, and firm B will make profits of 5. If firm A advertises and firm B doesn’t, firm A
will earn 15, and firm B will earn zero. Dominant Strategy of firm B is to Advertise; Dominant
Strategy of firm A is also to Advertise.

Therefore, the equilibrium solution of the above game is (Firm A, Firm B) = (10, 5)

3.4 The Nash Equilibrium Concept

Equilibrium Concept: An equilibrium concept is a solution to a game. The equilibrium concept

identifies, out of the set of all possible strategies, the strategies that players are actually likely to
play. “ I am doing z best I can given what you are doing.” “You are doing z best you can given
what am doing.”

 Solving equilibrium is similar to making a prediction about how the game will be played.

Nash equilibrium again is a set of strategies such that each player believes (correctly) that it is
doing the best it can, given the actions of its opponents. Since each player has no incentive to
deviate from its Nash strategy, the strategies are stable. In the example shown in table above, the
Nash equilibrium is that both firms advertise.

Two Nash equilibrium((top, left) & (bottom, right) are Nash equilibrium outcome))

Player B

Left Right
Player A
Top 1,2 0,0

Bottom 0,0 1,2

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The are games without Nash equilibrium

Players Player B
Left Right
Player A Top 0,0 0,-1
Bottom 1,0 -1,3
3.5 Mixed Strategy

So far we have been thinking that each agent as choosing a strategy once and for all (a one shot
game) and sticking to it. This is called a pure strategy. On the other hand, if agents are allowed
to randomize their strategies, to assign probabilities to each choice & to play their choice
according to those prob. we call the strategy as mixed strategy. Each player assign some
predicted prob, to the strategy of the rival. Given these prob., player computes the expected
payoffs.

Example : suppose palyer A (PA) expects player B(PB) to play left with a prob. of ‘q’ & right
with a prob of ‘1-q’.

Generally, PA expects PB to play a mixed strategy, (q, 1-q) &calculates the expected payoff
based on the prob. The expected payoff for PA: From playing top: 0(q) +0(1-q)=0 From playing
bottom: 1(q) +-1(1-q)=2q-1

If the expected payoff from playing top=the expected payoff from bottom, PA will be indifferent.
0=2q-1, q=1/2 If q>1/2, PA plays bottom, and If q<1/2, PA plays top

Similarly, let ‘r’ be z prob that PB expects PA to play ‘top’ & ‘1-r’ to play bottom. The expected
payoff for PB: From playing left: 0(r) +0(1-r)=0 From playing right: -1(r) +3(1-r)=3-4r

If the expected payoff from playing left=the expected payoff from right, PB will be indifferent.
Hence, 0= 3-4r, r=3/4. If r>3/4, PB plays left, and If r<3/4, PB plays right.

To find Nash eq/m, for every value q b/n 0&1, we find the value of r such that (r,1-r) is the best
response by PA to (q, 1-q) by PB. The Nash eq/m is attained when PB plays (r, 1-r)= (3/4,1/4) &
PA plays (q, 1-q) =(1/2, ½).

3.6 Repeated Games

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Repeated games are very usual in real life:

 Treasury bill auctions (some of them are organized monthly, but some are even weekly),

 Cournot competition is repeated over time by the same group of firms,

 OPEC(Organization of Petrollem Exporting Countries) cartel is also repeated over time.

It is possible to play a tit-for –tat strategy.

The tit-for-tat strategy is to start with cooperation and not confess, assuming the other agent
follows suit. For example, two competing economies can use a tit-for-tat strategy so that both
participants benefit. One economy starts with cooperation by not imposing import tariffs on the
other economy's goods and services to induce good behavior.

3.7 Sequential Game

A game where one player moves 1st & the other follows after observing the choice of the 1st . An
example is the Stackelberg model, when one player is a leader & the other player is a follower.

3.8 Prisoners Dilemma

Two individuals have been arrested for possession of guns. The police suspects that they
have committed 10 bank robberies;

if nobody confesses the police, they will be jailed for 2 years.

if only one confesses, she’ll go free and her partner will be jailed for 40 years.

if they both confess, they get 16 years

Matrix Representation of Prisoner Dilemma

Bontu
Confess Do not Confess
Chaltu Confess -16, -16 0, -40
Do not Confess -40,0 -2, -2

The application of Prisoners’ Dilemma in oligopoly market

 Let us look the following game that is played by firm 1 & firm 2.

66
Now let us assume that both firms have reached the agreement to cooperate by charging birr 6
for a product they sell and each one will receive birr 16 Profits.

However, if one firm cheats the other by charging 4 (the other charged as before 6) it would
increase its profit while the profit of the other will fall down.

Since both have the strong incentive to cheat the other, the final outcome will be to charge 4 &
both will have a profit of 12 w/c is less than the cooperative profits, 16.

Question/s

1. In game theory, Cournot equilibrium duopoly refers to a set of optimal strategies in which:

A. each player chooses its best strategy, no matter what the opponent does.

B. each player chooses its best strategy, given the optimal choice of its opponent.

D. each player chooses a strategy that entails doing to its rival whatever the rival has done in the
previous round.

E. each player tries to punish competitors that cheat on a price-fixing agreement

CHAPTER FOUR
PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION

4.1 Introduction

The mechanism of determination of factor price does not differ very much from that of
commodities. That is, factor prices are determined through the interaction of SS & DD in the
factor market. Factor inputs are generally divided into four. These are: Land, labour, capitat and
entrepreneurship.

The subject matter of the theory of income distribution is the study of the shares of factors of
production in the total output produced in the economy.

For simplicity, assume that we have 2 factors, L&K, their shares are defined as follows:

67
 •Shares of L= (W.L)/X Shares of K=(r.K)/X where - L&K are Qty Labor & capital
employed, w & r are wage rate and rental price of capitalX=value of output in the
economy.

The factor shares depend on:

 The state of technology w/c in turn defines the production function( z pr’n fu’n in turn
define factor intensities w/c is measured by K-L ratio)

 The relative factor prices: The factor intensity in the production of any commodity
depends on the substitublity of factors, w/c is measured by elasticity of substitution:

The equilibrium of the firm is defined by the tangency of isoquants and isocost lines:

MRTS L for K =w/r

4.2 Factor Pricing in A Perfectly Competitive Market

The dd for factors of production: Consider two cases

 When labour is the only variable factor of production

 When there are several variable factors

i. Demand for a single variable factor by a firm: Assumptions

o A single commodity Q is produced in a perfectly competitive market, which implies P

is given for all firms in the market

o The goal of the firm is profit maximization

o There is a single variable factor labour, whose market is perfectly competitive. The
price of labour to the individual firm is perfectly elastic. At the going market wage rate
(W) the firm can employ or hire any amount of labour it wants. Hence, W = MCL

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Technology is given & it is represented by the production function: Q = f(L,K)

The slope of the production function is the marginal physical product of labour (MPPL).
The MPPL declines at higher levels of employment b/c of the law of diminishing MPP

PQ.MPPL = VMPL (value of marginal product of labour) = (MRPL). In other words, the
equilibrium condition for a profit maximizing firm in labour market is MCL = VMPL = W =
MRPL.

MRPL = dTR/dL =d(P*Q)/dL = PdQ/dL= PMPPL = VMPL

MCL = dTVC/dL = d(WL)/dL = WdL/dL = W

ii. Demand of a firm for several variable inputs

When there are more than one variable factors of production the VMPL is not its DD curve. The
reason is that the various resources (inputs) are used simultaneously in the production of goods.
In this case a change in the P of one factor leads changes in employment of the others. A change
in the employment of other factors in turn shifts the MPP curve of the input whose P initially
changed.

Consider for instance a case where a firm uses two inputs (k & L). Further assume that the
wage rate falls. Now such changes have three effects: A substitution, An output effect and A
profit maximizing effect.

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The movement from A to B along the original isoquant represents the substitution effect.

To understand this mov’t we construct an isocost line DG known as the compensated isocost line.
It has the following two characteristics

 It is parallel to the new isocost and thus represents the new input price ratio.

 It is tangent to the old isoquant Q1 & thus makes the original inputs affordable.

This implies that the firm substitutes the cheaper L for the relative expensive K. Therefore, the
employment of L increases from L1 to L11 while that of capital decreases from K1 to K11.

The movement from B to C on the other hand represents the output effect. After the fall in the P
of L the firm doesn’t stay at B for the firm can buy more of L & more of K. Hence the firm can
produce the higher output Q3 using both L & K , L2 and K2. The increase of employment of L
from L11 to L2 & K from K1’to K2 (corresponding the movement from B to C) is the output effect.

The movement from C to D is the profit maximization effect. When wage rate falls, the MC of
production is reduced for every level of output. Therefore, the firm will increase its expenditure
in order to maximize its profit in a perfectly competitive market. Due to the increase in
expenditure, the isocost line EF1 must shift outwards parallel at a distance corresponding to the
increase in the firm’s total expenditure to JJ. The final equilibrium of the firm will then be
denoted by the point of tangency of the new isocost line JJ, with the new isoquant Q4 at point D.

Thus, the increase in employment from L2 to L3 and capital from K2 to K3 (corresponding to the
movement from C to D) is the profit maximizing effect.

Determinants of Demand for Productive Resources

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The price of the inputs - Negatively related; The price of output - Positively related; The MPP of
the factor –Positively related; The amount of the other factors combined with labour Eg.
Fertilizer- positively related; Technological progress (this first increases the MPPL of an input
& thus increases the demand for labour)______+vely related

The Market Demand for a Factor

The market DD for a variable input is like the market DD for a commodity. It is the sum total of
the individual firms DD. However, in the case of productive inputs the process of addition is not
a simple horizontal summation of the DD curve of the individual firms. This is b/c when all firms
expand or contract simultaneously, the market price of the commodity changes (decrease and
increases, respectively). For instance, when wage rate falls, all firms tend to demand more labour.
The increase in employment in turn leads to an increase in total output (SS). Therefore, the
market supply for the commodity produced shifts to the right.

Assume given fixed market DD, W declines. This in turn will reduce the price of a commodity.
The decline in the P of the commodity further reduces the VMPL at all levels of employment.

As a result, the VMPL curve (the individual demand curve for labour) shifts to the left.
iii. The Supply of Labour by an Individual Worker

The most important variable factors are raw materials, intermediate good, & labor. Hence their
market SS is derived in the same principle as the SS of any commodity.

The SS of L , however, requires a d/t approach. To begin with, assume that L is a homogenous
factor (all labor units are identical). This can be derived using indifference curve analysis.

 On the horizontal axis we measure hours available for leisure and work over a given
period of time.

 On the vertical axis we measure money income.

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72
What happens to the income line when wage rate increases to W2? The income line becomes
steeper.

The indifference curves (IC) represent the preferences of an individual b/n leisure/work &
income. When the wage rate is W1 an individual will earn 0A11 level of income by working ZA
hours & have 0A hours of leisure time.

If the wage rate increases to W2, the individual is in equilibrium at point B1 by working ZB &
earning is 0B11 income and devote 0B unit of time for leisure. If the wage rate increases to W3,
the individual is in equilibrium at point C1 by working ZC hrs and earning 0C11 income & spent
0C amount of hrs for leisure. As the wage rate increases, the amount of labor supplied increases.
However, the hours devoted for work may decline beyond some higher wage rate.

At wage rate W4, the individual will work ZD hrs & this is less than the amount worked when
the wage rate was W3, W2, & W1. When wage rate increase further to W5, the hrs devoted for
work decline even more. Therefore, up to W3, an increase in wage rate creates an incentive for
increased supply of labor. Above W3 LSS declines. This implies that higher wage rates create a
disincentive for longer hrs of work.

Thus, as wage rate increases, the individual’s income increases & this enables the workers to DD
more leisure than work. Hence, beyond a certain level of wage rate the SS of labor will decrease.

The Market Supply of Labour

Although there is general agreement that the SS curve for labor by a single individuals exhibits
the back-ward bending pattern, economists disagree as to the shape of the aggregate (market)
SS of labor. Consider the case of skilled (specialized) labor

Several economists argue that in the short run the market SS of labor may have segments of
positive & negative slope. However, in the long run the SS must have a positive slope because.
Young people may plan their education in line with the expected wages are high. Older worker
may undertake retraining & change job if the wage incentive is strong enough.

Other economists maintain that the backward bending supply curve of labor. As the standard of
living increases, people find that unless they have the time to enjoy leisure activities it is not
worthwhile to work harder in order to obtain the higher income required for more leisure.

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Thus, as income reaches the level required for a comfortable standard of living workers put
Determinants of Market Supply of Labour

The main determinants of market SS of labour are: The price of labour (wage rate), the tastes of
consumers which defines their trade off between leisure & work, the size of the population, The
labour force participation rate (at what age people start working?), and the occupational,
educational and geographical distribution of labour force.

The r/ship b/n the SS of L & wage rate defines the L SS curve. The other determinants are
considered (assumed) as fixed or given. The market SS is the summation of the SS of labour by
individuals.
4.3 Factor Pricing in Imperfectly Competitive Market

The same as perfect competitive mrkt, Z intersection of DD & SS determine the price of the
factor & the level of its employment when there are imperfections in the market.

However, the determination of the DD & SS are different in the case of market imperfection.
We will consider three models with various kinds of imperfections. These are

o MODEL A: When the firm has monopoly power in the product market & while the
factor market is perfect.

o MODEL B: When a firm has monopoly power in z product market & monopsony
power (the only buyer) in the factor (input) market.

o MODEL C: Bilateral Monopoly: When a firm has monopoly power in the product
market & the SS of labour is controlled (monopolized) by labour union.

MODEL A

a) DD of a monopolistic firm for a single variable factor

In this model we assume that the firm uses a single variable factor-labour whose market is
perfectly competitive. This means that the wage rate is given & the SS of labour to the individual
firm is perfectly elastic.

The dd curve for the product of a monopoly firm is down ward sloping, MR is smaller than P at
all level of output.

Note that, under perfect competitive market VMPL=MRPL b/c P=MR

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The dd for labour by a monopolist firm is not the VMPL curve but the MRPL, which is defined by
multiplying the MPPL by MR of the commodity produced.

b) Demand for a variable labour (factor) by a monopolistic firm when several factors
are used.

When more than one variable factor are used in the production process, the dd curve is derived
from points on shifting MRPL curves. A change in the price of L (i.e W) results in substitution,
output, & profit maximization effects as in the care of perfectly competitive firm.

The net result of these effects is a shift of the MRPL to the right (in general) that leads to the
equilibrium point B. Joining points such as A, B, & C at various levels of wage rates (W) we
obtain the demand curve for L (dL)

In both perfect competition & monopoly mrkt condition a firm employs a factor when MCL = W
= MRPL. But MRP equals VMP under perfect compt’n. B/c VMP = MPP.P & MRP = MPP.MR
& P = MR hence, MCL = W = MRPL (VMPL).

Under monopoly market, however, MRPL< VMPL because P>MR. Therefore, MCL = W = MRPL
< VMPL.
MODEL C: Bilateral Monopoly

In this model we assume that all firms are organized as a single body, which acts like a
monopsonist, while the L is organized in L union, which acts like a monopolist. Thus we have a
model in w/c the participants are two monopolists, one on the SS side & one on the DD side

In general, bilateral monopoly arises when a single seller (monopolist) faces a single buyer
(monopsonist). It can be shown that the solution to a bilateral monopoly solution is
‘indeterminate’. The model gives only the upper & lower limits with in w/c the wage rate will
be determined by bargaining.

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Questions

Choose the correct answer

1. Among the following statements one is correct about demand for single variable input in
the factor market
A. The value for labour exceeds marginal cost of labour for perfectly competitive firm if
the variable input is labour.
B. For perfectly competitive firm, selling price of the product is exactly the same with
that of marginal cost.
C. The slope of production function is marginal physical product of variable input
D. The equilibrium condition for a profit maximizing perfectly competitive firm result in
value of marginal product of labour is less than marginal cost of labour if the variable
input is labour
2. Marginal revenue product of labour is
A. The slope of total revenue of labour
B. The product of marginal revenue with marginal physical product of labour
C. Exceeded by value of marginal product of labour for imperfect competitive firm
D. A & B E. All
3. Which factors can determine demand for factors of production and its relation in input
market
A. The price of output - Negatively related C. The size of the population –
negatively related
B. The price of the inputs - Positively related D. The MPP of the factor –Positively
related

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 CHAPTER FIVE
GENERAL EQUILIBRIUM ANALYSIS

5.1 Introduction

General equilibrium model was introduced in 1874 by the great French economist, Leon Walras.
Thus, it is often called the Walrasian theory of market.

Partial Vs General Equilibrium

Partial Equilibrium

• Examines equilibrium and changes in equilibrium in one market in isolation.

• All prices other than the price of the good being studied are assumed to remain fixed.

• All market interactions are not taken into account

• Address how equilibrium is determined in single market

General Equilibrium

• Addresses how equilibrium is determined in all markets jointly.

• All prices are variable and equilibrium requires that all markets clear

• All of the interactions between markets are taken into account

• Addresses how equilibrium is determined in all markets jointly.

5.2 General Equilibrium Theory

A GE is defined as a state where the aggregate demand does not excess the aggregate supply for
all markets. The GE approach has two central features:

1. GE views the economy as a closed and interrelated system. In GE approach equilibrium

values of all variables of interests (all markets) are simultaneously determined

2. It aims at reducing the set of variables taken as exogenous to a small number of physical
realities

5.2.1 General Equilibrium of Exchange and Production

a. General Equilibrium of Exchange

Two individuals (A and B), & Two commodities (X and Y),

77
The tastes and welfare of individuals A and B are described by the following two utility
functions. UA = U(XA , YA) UB = U(XB , YB)

Theses functions are represented by the indifference curves

We can read from the edgeworth diagram that

The economy does have 10X and 8Y totally: X= 8= XA + XB Y = 10 = YA + YB

• Eg. A point such as C indicates that individual A has 3X and 6Y (viewed from origin OA),
while individual B has 7X and 2Y (viewed from origin OB ) out of the total of 1OX and 8Y.

Curve OA DEFOB is the contract curve for exchange. It is the locus of tangencies of the
indifference curves (at which the MRSxy are equal) for the two individuals where the economy is
in general equilibrium of exchange. Starting from any point not on the contract curve, both
individuals can gain from exchange by getting to a point on the contract curve.
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Along the contract curve for exchange, the marginal rate of substitution of commodity X for
commodity Y is the same for individuals A and B, and the economy is in general equilibrium of
exchange. Thus, for equilibrium, MRSA XY = MRSB XY

5.2.2 General Equilibrium of Production

We deal with a very simple economy that produces only two commodities (X and Y) with only
two inputs, labor (L) and capital (K).

Suppose that the technological relationships in the economy are as follows:

X = X(Lx , Kx)

Y = Y(Ly , Ky) Where, X and Y are the annual outputs. L and K are, respectively, labor
and capital whose subscripts indicate the corresponding output for which they are used.

L = LX + LY

K = K X + KY where, LX , LY , KX and KY are variables with values to be solved in the

general equilibrium model. L and k are assumed to be in fixed supply.

Curve 0xJMNOy is the contract curve for production. It is the locus of tangency points of
the isoquants for X and Y at which the marginal rate of technical substitution of labor for
capital is the same in the production of X and Y. That is, the economy is in general
equilibrium of production when MRTSX LK = MRTSY LK

5.3 Derivation of Production Possibility frontier (PPF)

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PPF shows the alternative combinations of commodities that the economy can produce by fully
utilizing all of its resources with the best technology available to it. To determine the conditions
for simultaneous equilibrium in both exchange and production: Derive the Production Possibility
Frontier (PPF) from Edgeworth contract curve for production & Bring the PPF and Edgeworth
Box for exchange.

The absolute value of the slope of the PPF measures the amount of Y foregone in order to
produce one extra unit of X. It is called the marginal rate of transformation of X for Y
(MRTXY). Clearly, transformation of X for Y is made by releasing enough amount resources
from production of Y that enables production of an extra unit of X. In other words, marginal rate
of transformation is equal to the ratio of marginal cost of X to marginal cost of Y: MRTXY =
MCX /MCY.

5.4 General Equilibrium of Production and Exchange

and Pareto Optimality

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For example: at M if MRTXY = 1.5 or MCX /MCY =1.5, meaning that the economy gives up 1.5
amount of Y in order to produce an extra unit of X.

To be simultaneously in general equilibrium of production and exchange, the marginal rate of

transformation of commodity X for commodity Y in production must be equal to the marginal
rate of substitution of commodity X for commodity Y in consumption for individuals A and B.
That is, MRTXY = MRSA XY = MRSB XY =1.5

Pareto optimal or efficient by which some individuals are made better off (in their own judgment)
without making someone else worse off. Any change that improves the wellbeing of some
individuals without reducing the wellbeing of others clearly improves the welfare of society as a
whole and should be undertaken. This will move society from a Pareto non optimal position to
Pareto optimum.

Thus, a point where MRTXY = MRSA XY = MRSB XY , production and consumption are
economically efficient and society maximizes welfare.

5.5 Perfect Competition, Economic Efficiency, and Equity

At equilibriu: Perfectly competitive firms produce where MCx = Px and MCy = Py MCx / MCy =
Px/ Py = MRTxy

The third marginal condition for economic efficiency and Pareto optimum in production and
exchange: MRTxy = Px/ Py , for all consumers consuming both commodities.

• MRTxy = MRSxy , for all consumers consuming both commodities.

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5.6 Efficiency and Equity

• The first theorem of welfare economics, equilibrium in competitive markets is Pareto

optimal.

• The second theorem of welfare economics, which postulates that when indifference
curves are convex to their origin, every efficient allocation is a competitive equilibrium
for some initial allocation of goods or distribution of inputs (income).

• At perfect competitive market,

Py = MRy = MCy

On the other hand, if commodity X is produced by a firm with monopoly power,

Px > MRx and Px >MCx

Then, MRTxy = MCx/MCy= MRx/MRy< Px/Py But, Px/Py = MRSxy. If so, MRTxy < MRSxy

Therefore, the third condition for Pareto optimum and economic efficiency is violated.

If PI is the price of the input, and the input market is perfectly competitive, VMP = MRP = PI.
Otherwise, VMP = MRP > PI(Monospony market). Where VMP is value of marginal product,
MRP is marginal resource product, and PI is price of input.

Questions

Choose the correct answer

1. In general equilibrium,
A. All prices other than the price of the good being studied are assumed to remain fixed.
B. Address how equilibrium is determined in single market
C. Addresses how equilibrium is determined in all markets jointly.
D. All
2. Which statement is true regarding to general equilibrium of exchange?
A. The functions of utility represented by using isoquant curves
B. The tastes and welfare of individuals are described through utility functions
C. Contract curve of exchange is the locus of tangencies of the isoquant curves (at which
the MRTSLK are equal) for individuals where the economy is in general equilibrium
of exchange

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D. Along the isoquant curve for exchange, the economy is in general equilibrium of
exchange.

83
 CHAPTER SIX
INFORMATION ASYMETRY

6.1 Introduction

In the real world, impossible to gain accurate information about the quality of the goods
being sold. Such difference in access to relevant knowledge is called information asymmetry.

6.2 Properties of Information

 Information is not a homogeneous good.

 It is hard to quantify the amount of information obtainable from various actions.

 Information is a durable good.

 Information is a pure public good. It is nonrival and nonexcludable.

 The cost of acquisition of information varies significantly among individuals.

6.3 Mixed Markets for Used Cars

Example: Market for used cars

Suppose that prospective buyers cannot distinguish between low quality cars (lemons) and high
quality cars (plums). If the sellers of used cars know more than
the buyers. Because buyers cannot distinguish between lemons and plums, there will be a single
market for the two types of used cars. Lemons and plums will be sold together in a mixed market
for the same price.

To determine price in mixed market, we must answer three questions:

i. How much is a consumer willing to pay for a plum (a highquality car)?

ii. How much is a consumer willing to pay for a lemon (a lowquality car)?

iii. What is the chance that a used car purchased in the mixed market will turn out
to be a lemon?

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Measuring loss due to information asymmetry

If buyers express demand only for lemons, only lemons will be sold, Even though both buyers
and sellers of good quality cars would be better off if high quality goods
could be identified and sold for high price. This is market failure.

85
The gain in producer’s surplus from ‘overconsumption’ is PuBAPI. The loss in consumer’s
surplus from overconsumption is: APIE – (OECQU OPuBQu) =APIE – (PuEF – FBC)
= APIPuF+FBC

So, the net loss to society from ‘overconsumption’ is loss in consumer’s surplus less gain in
producer’s surplus =APIPuF+(AFB+ABC) (ApIpuF+AFB) =ABC.

Questions

1. Suppose that due to asymmetric information, consumers in a town are not able to
exactly distinguish between original, high quality (plum), MP3 song collections
and the duplicated, low quality (lemon) MP3. The consumers do perceive the
average quality. Indeed, through time the lemons have driven out the plums out of
markets. As a result, only the former exist and the town is served with the lemon market,
where the supply function is N = 20 +p; N is number of MP3 per week. The demand in the
town could have been Ninfo = 30 – 2p. However, the existing demand is uninformed one
given by: Nuninfo = 40 – 3p.
i. Find the equilibrium numbers MP3 CDs sold per week and corresponding prices.
a. With uninformed demand
b. Had demand been informed
ii. Due to the information asymmetry, how much is:
a. gain in producer surplus?
b. consumer surplus loss?
c. net loss to the society?

86
 REFERENCES
1. A. Koutsoyiannis, Modern Microeconomics
2. D.N .Dwivedi, 1997, Micro Economic Theory, 3rd Ed., Vikas Publishing
3. R.S. Pindyck & D.L. Rubinfeld, Microeconomics.
4. Hal R. Varian, Intermediate Microeconomics: A Modern Approach, 6th Ed.
5. C.L.Cole, Micro Economics: A Contemporary Approach.
6. Ferguson & Gould’s, 1989, Microeconomic Theory, 6th Ed.
7. R.R. Barthwal, Microeconomic Analysis.
8. E. Mansfield, Microeconomics: Theory and Applications.
9. D.S. Watson, Price Theory & Its Uses.

87
WOLAITA SODO UNIVERSITY

Department of Economics

Development Planning and Project Analysis II

Course Code: - Econ 4132

MARCH, 2023 G.C

WOLAITA SODO, ETHIOPIA

88
Course Description

This course is the continuity of development planning and project analysis I and focuses on
development project planning and analysis. This course "Development Planning and Project
Analysis II" introduces the students how to formulate and analyze development projects and
assessing the benefits and the costs of under taking a project and leads to the selection of the
most premising project.
As you know one of the basic economic problems facing all countries in this actual world is that
of allocating limited resources to a variety of different uses in such a way that the net benefit to
society is as large as possible. A good understanding of project planning and analysis is vital for
checking the profitability of a particular investment project made by public or private firms.
Hence, it helps to allocate and use our limited natural and human resources to the maximum
economic profit benefits.
The fundamental objective of this course is to acquaint students of economics with the
methodology for project planning and analysis across different sectors and to explain how to
apply quantitative analysis of cost and benefit to evaluate projects from multiple perspectives,
i.e., from the point of view of the private sector, the public sector, and the country as a whole.
Moreover, this course focuses on project implementation, monitoring and evaluation. The subject
matter of project analysis is outreaching beyond the Cost-Benefit analysis. This time government
and non- government organization are highly demanding experts with a knowledge of
monitoring and impact evaluations. The course is organized into four major chapters. The first
chapter is devoted to the basic concepts and cycles of a project. The second chapter deals with
financial analysis and appraisal of projects. The third chapter builds on the economic analysis of
the project. Chapters four discuss the concepts of project monitoring and evaluation. Chapter five
explains impact evaluation with its methodologies.

Course Objective
After the end of this module students are expected
o To understand basic project preparation technique
o To understand and apply financial analysis of projects, the valuation of financial costs
and benefits, discounted and non-discounted project assessment criteria

85
o To understand the basic methodology for monitoring and impact evaluations for
different interventions
o To explain basic monitoring and impact evaluation theories and methodologies
o To understand and apply impact evaluation techniques

86
 Chapter One: Introduction:

An Overview of Project Analysis

This chapter introduces you an overview of project analysis. Planning Projects are one of the
several instruments to achieve particular objectives in a process of development. Thus, projects
have to be discussed as an integral part of the national development strategy for they have to be
evaluated in close reference to the overall development policy of a country. Projects have been
described as "the cutting edge" of development, they embody the policy choices flowing from
development objectives and acts as the vehicle or the medium of the described social changes.
As such then, projects are the means through which development targets are achieved and are
considered to be a tangible benefit for the project beneficiaries. Without visible projects on the
ground, policies, strategies, and plans for development are simply administrative.
1.1 The Project Concept
1.1.1 Definition of Project

A project is a proposal for an investment to create, expand and/or develop certain facilities in
order to increase the production of goods/services/ during a certain period of time in a
community, region, country, market area and/or certain organization (firm, public organization,
NGO, etc. It is a complex set of activities where resources are used in expectation of return and
which lends itself to planning, financing and implementing as a unit. A project can alternatively
be defined as a group of tasks performed in a definable time period in order to meet a specific set
of objectives. There are different types of projects: public, private, private individual, small,
large, agricultural, industrial, etc. An insurance company is planning to install a computer system
for information processing; the government of Ethiopia and the Sudanese government are
thinking of an ambitious plan to link Port Sudan with the town of Moyale; Abebe a graduate
student is planning to buy a book on econometrics. All these situations involve a capital
expenditure decision. Each of them represents a scheme for investing resources, which can be
analyzed and appraised reasonably independently.

1.1.2 Basic characteristics of a project

In all project types there are basic characteristics of capital expenditure (also referred to as a
capitalinvestment or capital project or just project). Another way of defining a project is to
outline these basic characteristics that a project exhibits, which include the following.
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1. A project involves the investment of scarce resources in the expectation of future benefits;
2. There are measurable Objectives of a project. Projects have specific of benefits that can be
identified, quantified and valued, either socially or monetarily/commercially/. Related to the
specificity of objectives, is the fact that projects have specific beneficiaries or clientele
group, which needs to be specifically spelt out during project planning studies.
3. A project is the smallest operational element unit. A project can be planned, financed and
implemented as a unit. Often projects are the subject of special financial arrangements and
have their own management. Despite the fact that a project constitutes many activities and
tasks, it is defined as the smallest operational unit. The major reasons why a project is
defined as the smallest operational unit are the fact that a project is bounded by different
factors. The boundaries of projects make them distinguishable from each other.
o Projects are conceptually bounded. The problem and specific objective or needs that
justify the project involves conceptual delimitations.
o Projects are geographically bounded. Projects exist in space and we say that projects are
geographically/locationally bounded.
o Projects are organizationally bounded. Projects require the establishment of a special
organization or the crossing of traditional organizational boundaries. i.e. there should be
certain organizational unit responsible for project implementation.
o Projects are time bounded. One factor that makes projects bounded is the time/life cycle/ of
a project. Projects have specific lifetime, with a specific start and end time in which a clearly
defined set of objectives are expected to be achieved. It is a unique, one-time investment
scheme.
1. Uncertainty and risks is inherent in any project. Achieving project objectives can not be
predicted in advance with accuracy. The factors that make project risk are:
o Significant and multiple types of scarce resources committed today expecting outcome in
the future;
o Benefits are expected to be generated in the future, which is less predictable;
o Capital investments are irreversible, i.e. the assumption of perfect exit assumption of the
perfect competition model is refuted.
2. It has a scope that can be categorized into definable tasks. Projects usually have well defined
sequence of investment and production activities

88
3. It may require the use of multiple resources. This has an implication on management of
project implementation. The more diverse the types of resources are mobilized the more
complex will the management be. The outcome of project and hence development endeavor
is sensitive to the management of each type of resources.

1.1.3 Classification of project

The projects are basically defined in to two aspects or categories: one is defensive project
andother is aggressive project.
Defensive Project: is the project initiated to stabilize and sustain the current business situation.
Aggressive Project: is the project initiated to enter into new business in a commercial
mannerand majorly depends upon the future prospective rather than the current scenario.
There is other classification of projects as well which is based on the need of execution and
thetime, these can be categorized as:
o Normal Project: Where the time limits are set and adequate.
o Brash Project: Where additional cost are involved to gain time.
o Disaster Project: Anything is allowed to gain time.
Projects can be further classified into various other classifications like national and international
projects, industrial and non-industrial projects, on the basis of technology, size, ownership,public
orprivate projects, need, expansion or diversification projects.Each of these is discussed as
follows:
1. National and International Projects: This kind of projects is categorized on the basis
ofgeographical location set as countries. If one country tries to build projects with
otherforeign country, such projects are said to be international projects and when it is done
inone’s owncountry, then it is said to be a domestic or national project.
2. Industrial and Non-industrial Projects: The projects initiate in one’s own country withan
objective to make money and for commercialization, are called industrial projects.
Forexample, acar manufacturing is an industrial project. While the project which are donefor
the upliftment ofthe society and majorly done with social welfare objectives, arecalled non-
industrial projects. Forexample,building of a canal, agricultural developmentcomes under
non-industrial projects; these are mainly carried up by the government.
3. Projects based on Technology: These are largely high technology projects whichrequire
lots of investment and works on new or non-existent technologies like rocketlaunch project,

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 space projects, etc. and some other are those projects which usetechnology which are already
proven like a software ERP project, automobile automationproject, etc.
4. Projects based on its size: These projects are based on investment size or capacity ofplant to
offer goods or services. This can be further classified down to small, medium andlarge-scale
projects. Project above the investment of 100 million dollars is considered aslarge projects.
5. Project based on ownership: This can be further classified as public sector project,private
sector project and joint sector project.
i. Public Sector Projects: Projects which are of the state, center or both forms ofgovernments,
are known as public sector projects.
ii. Private Sector Projects: Projects with a complete ownership of promoters andinvestorsis
known as private sector projects. Owners may be an individual,partnership firm or acompany.
These projects are mostly done with an objectiveto earn profit and thus have a commercial
nature.
iii. Joint Sector Projects: In these projects, there exist a partnership between theentrepreneurs
and the government; it may be from state government or the centralgovernment. These types
of partnership occur on the grounds of expertise andlaisioning work and government arranges
for the fund in large amounts. Forexample, Project of Metro Train, Dams, Information
technology parks, Electricityplants and other similar natured projects.
6. Need based projects: Projects are basically driven by certain needs of the
organizationandthese needs furthers forms the basis of project categorization as Balancing
Project,Modernization Project, Expansion Project, Diversification Project, Rehabilitation
Projectand Plant Relocation Project.
i. Balancing Project: Augmenting or strengthening the capacity of particular areawithin a
chain of entire production plant with a purpose of scaling to the capacityin order to have
optimum utilization, is balancing project.
ii. Modernization Project: Upgrading the technology to increase the productivityand
inevitable approach of technology is called modernization project.
iii. Expansion Project: When the production capacity of goods and services is to beincreased,
the project that is undertaken is known as expansion project.
iv. Diversification Project: Project undertaken by the organization to completelydivert from
itscore business is called diversification project. For example, if aPetroleum company

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 decides toenter into Information Technology business, thenthe project will be known as
diversificationproject.
v. Rehabilitation Project: When a project is started to revive a loss bearingcompany, is
knownas rehabilitation project.
vi. Plant Relocation Project: When an organization decides to shift his plant fromone
locationto another, the project started will be known as relocation project.
1.1.4 Why Project Planning?

The quest for socio-economic development, inevitably involves the basic economic problem of
scarcity in the face of unlimited needs and hence the need to make choices on the means and
ends of development, which involves the rational use of limited resources to attain the economic
ends. Thus investment decisions are an essential part of the development process. The more
sound the investment decision is the more success will be in the development endeavor. The
need for project planning, preparation and study emanates from:

i. The quest for change: dissatisfaction with the present and/or pressure or incentive for
different tomorrow;
ii. Change involves investment/commitment of resources to realize the objectives. Investment
may be defined as a long-term commitment of economic resources made with the objective
of producing and obtaining net gains in the future. The main aspect of such commitment is
the transformation of liquidity (the investor’s own and borrowed funds) into productive
assets, and the generation of liquidity again during the use of these assets. Yet once the
resources are committed, there is no way of recovering it apart from conducting profitable
operation. That is exit costs are not zero, as it is assumed in the perfect competition model.
iii. The scarcity of investible resources and unlimited development/business needs;
iv. Investment is all about resource commitment into the future, which is less predictable;
v. Since investment schemes involve substantial resources commitment and are invested for the
future, there is an inherent high risk involved.
vi. The costs and benefits are temporally spread and particularly the large part of the costs are
incurred earlier and the benefits are generated later on, 10-20 years for industrial projects and
20-50 years for infrastructural projects. Then the saying goes “ a bird at hand is better than
two birds in the bush”. This raises the question of comparing and equating the future and
present values.
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vii. In such a situation decision-making is not simple and perfect as it is assumed in orthodox
economics.

These features of investment decisions constitute the reasons that justify the significance and
relevance of project planning and the major constraints and challenges faced by any project
planner and decision maker in project viability studies. Thus, decision makers have to make
every effort to systematically rationalize their decisions by undertaking rigorous viability studies,
which involve conducting studies and appraisal/evaluation of the same.This presupposes that the
major decisions involving substantial resources and that have wider implications on the success
of an operation are not instantaneous as the conventional assumption of rationality imply.

1.1.5 Organic Link between Policy, Development Plan and Projects

In the context of the preceding introductory remarks, the policy framework defines the context
for periodic development plans (short-, medium- and long-terms plans) which then require
specific instruments for implementation. Projects are the policy and plan instruments, a particular
decision scheme meant to convert policies and plans into reality. So we have this generic scheme:

Policy → Development Plans → Programs→ Projects →Outcomes / impacts /Changes

Governments and corporate entities considering their vision into the future, the external
environment and the performance of competitors set up policies which serve as a basis for
strategic /medium- and long-terms/ plans, which in turn serve as a basis for project identification
and its selection.

If there is no organic link between policies, plans and projects, then the effectiveness and
efficiency of investment decisions could be compromised. Accordingly, one has to ensure
adequate and properresponses to the following questions.

a) What is the major objective of the project? The actual aims / quotas / milestones to be
reached within a specified time, according to client requirements specified.
b) What is the basis for the demand or need for the goods/services to be produced by the
project?
c) What problem or opportunity is the project addressing?

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d) How does the project contribute to the wider goals of the sector/organization/ region? I.e.
whether the project is consistent with the priorities set in policy and development plan
documents of a country, region, zone, woreda or a specific organization.
e) What alternative ways of addressing the problem/opportunity/ have been considered? What
Path (_Strategy) to be followed and actions to be taken to reach the aims and objectives.
f) Why is the proposed project the most appropriate way of addressing the
problem/opportunity;
g) What is the approximate cost and timescale Schedules of the project? _This is a plan
showing when individual / group activities will start and end and at what cost.
h) Who are the major stakeholders and beneficiaries of a project? In what ways are they
expected to participate?
i) Which institution is the most appropriate for implementation? This is about organizing and
Assigning specific people to a specific objective, as well as the specific responsibilities for
each task
j) Are there additional or special circumstances relevant to the project?
k) Standards and Determining quality for each action

The decision making process could include both the public and the private sectors. In the public
sector, there will be a political context in which policies and development plans are set. In the
corporate decision-making, there are corporate strategic plans, which include the vision, major
objectives, strategies and periodic plans. In both types of contexts of decision-making, there is a
need for projects, as the cutting edges for converting ideas, intents, plans into deeds, achieving
objectives and bringing changes.

Project planning and evaluation has a long history in financial and business analysis. Project
planning has always been used as a means of checking the profitability of a particular investment
by private firms. Recent experiences show that project analysis has attracted the attention of
development economists.But the inclusion of project analysis in development economics did not
necessarily amount to a new analytical discovery, rather to a new approach. Projects are now
assessed from the economy’s viewpoint instead of only from the firm’s perspective. The
selection criteria have also included economic criteria on top of financial criteria.

Promoting projects without having development policies and plans will lead to
scattered/dispersed and unorganized development endeavours.Policies and plans without projects
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means non-implementation, paper tiger decision makers, having policy and plan documents for
other purposes.Governments usually have plans and development plans for publicity and
propaganda sake or to respond to external or internal pressures. Projects are the cutting edges of
development plans. Development endeavour without projects is unperceivable.

In this line developing countries are negotiating, requesting, struggling with bilateral and
multilateral donors and lenders for budget support instead of project financing. This is because
project financing has been less effective to transform economies and bring about expected results.
Multilateral institutions, though are accepting and appreciating the significance of budget support
and limitations of project financing, they argue against budget support on the pretext that
governments abuse donor’s money. Governments can use donor’s money for their specific
political ends and abuse or they have weak implementation capacity and hence supervisory and
monitory capacity.

1.1.6 The linkage between projects and programs

Most developing countries in general have some sort of national planning of course the degree
and complexity of such development plans vary from country to country and even in a particular
country from time to time. For instance, in Ethiopia, Planning was much centralized in the 1974-
91 periods compared to either before or after this period. Project formulation is an integral part
of a more broadly focused and continuous process of development planning.

Projects can also be understood as an activity for which more will be spent in expectation of
returns and which logically seems to lend itself to planning, financing, and implementing as a
unit. It is the smallest operational element prepared and implemented as a separate entity in a
national plan or program. In general, thus, sound development plans require good and realistic
projects for the latter are the concrete manifestation of the pan as noted above.

Projects in such context are the concrete manifestations of the development plans and programs
in a specific place and time. One can think of projects as subunits and bricks of programs, which
constitute a component of or the entire national plan.

It is necessary to distinguish between projects and programs because there is sometimes a

tendency to use them interchangeably. While a project refers to an investment activity where
resources are used to create capital assets, which produce benefits over time and has a beginning
and an end with specific objectives, a program is an ongoing development effort or plan
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involving a number of projects. Programs may or may not necessarily be time bounded. Yet
programs cannot live forever, they have limited life cycle, which however, may or may not be
explicitly stated. So in effect in terms of time delimitation, there is only relative difference
between programs and projects.

A development plan is a statement of action meant to realize and implement economic policy.
National development plans are further disaggregated into a set of sectoral plans which involve a
number of programs and projects. A development plan or a program is therefore a wider concept
than a project. It may include one or several projects at various times whose specific objectives
are linked to the achievement of higher level of common objectives.

Note that projects can stand alone without being part of certain program. So one can visualize the
possibility of policies → development plans → projects. Projects, which are not linked with
others to form a program, are sometimes referred to as “stand alone” projects.

Program study that incorporates a multiple of projects requires three steps:

 The analyst must appraise each project independently.

 The analyst must appraise each possible combination of projects.
 The analyst must appraise the entire program, including all the projects, as a package.

Examples could be a road development program, a health improvement program, a nutritional

improvement program, a rural electrification program, institutional reform program, management
system reform program, etc.

A health program may include a water project as well as a construction of health centers both
aimed at improving the health of a given community, which previously lacked easy access to
these essential facilities.

1.1.7 Uniqueness of Projects

In general every project is unique in the sense that there are factors that distinguish projects from
others. Some of the main factors which bring about differences in the nature of projects and that
determine the breadth and depth of project studies include:

 size/scale/, small-, medium- and large- scales of projects;

 markets; projects catering to regional, national or international markets,
 Technologies, heavy, light, mature or newly evolving technology, factor intensity, etc.

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  Economic and locational context: Rural and urban projects, projects in LDCs and DCs,
etc.
 financial and other resources availability,
 the macro economic situation at which the particular project is being considered,
 the level of competition, high or low competition, local or global competition,
 The type of sector/industry of a project eg. Good (soap, computer) or service (education,
health, banking, insurance), public good or private good, industrial or agricultural project,
etc.
 Ownership (private and public projects) which has wider implication on the breadth and
depth of coverage.
 Impact/outcome: Projects could be different because of their major impacts. There are
differences in projects in terms of their social and environmental impacts, which may be
(and are gaining importance since the recent past decades) important variables that
determine the level and type of studies required.

It has to be noted that the exercise of identifying the factors that distinguish a project from
another one is not by itself an end in the practical world. Rather the concern is in identifying the
variables that have significant implication on the viability of a project and the need for explicit
consideration of the same in the same study.

So apart from discussing the principles and major procedures that need to be adhered to, one
cannot reflect the specific behaviors of different projects, be agricultural, manufacturing, service-
rendering projects in such level of treatment.

It is therefore the task of the project analyst to decide which characteristic of the project must be
underlined.

1.2 The project Cycle

A project cycle is a sequence of events, which a project follows. These events, stages or phases
can be divided into several equally valid ways, depending on the executing agency or parties
involved. Some of these stages may overlap. Capital expenditure decision is a complex decision
process, which may be divided into the following broad phases.

1. Identification/Opportunity study/
2. Project preparation, which include:

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  Pre-feasibility Study
 Feasibility (technical, financial, economic)`
 Support study
 Appraisal/evaluation/
3. Implementation/investment
4. Ex-post evaluation

Alternative categorization is (UNIDO, 1991 pp 10-22):

1. Pre-investment phase;
a. Identification/opportunity study/
b. Pre-feasibility study/ pre-selection/
c. Feasibility study
d. Support study;
e. Appraisal study.
2. Investment phase;
 Negotiating and contracting;
 Engineering design;
 Construction;
 Procurement
 Erection and installation
 Pre production marketing;
 Manning and training
3. Operation phase.
a. Commissioning and hand over and starting of operation
b. Post project evaluation/appraisal/
c. Replacement/rehabilitation
d. Expansion/innovation

Throughout the project cycle, the primary preoccupation of the analyst is to consider alternatives,
evaluate them, and to make decision as to which of them should be advanced to the next stage. If
it is decided to proceed to the next stage, the results (out puts) of a given stage serve as the input
or part of the input of the next sage.

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1.2.1 Identification (Opportunity studies)
The first stage in the project cycle is to find potential projects. It is the identification of
investment opportunities.Project ideas can emanate from a variety of sources. Much depends on
the experience, and even the imagination, of those entrusted with the task of initiating project
ideas. In general, one can distinguish two levels where project ideas are born: The macro level
and the micro level. At the macro level, project ideas emerge from:

1. National policies, strategies and priorities as may be initiated from time to time;
2. National, sectoral, sub-sectoral or regional plans and strategies supplemented by special
studies, sometimes called opportunity studies, conducted with the aim of translating
national and sectoral sub-sectoral and regional programs into specific projects;
3. General surveys, resource potential surveys, regional studies, master plans, statistical
publications which indicate directly or indirectly investment opportunities;
4. Constraints on the development process due to shortage of essential infrastructure
facilities, problems in the balance of payments, etc.;
5. Government decisions to correct social and regional inequalities or to satisfy basic needs
of the people through the developments of projects;
6. A possible external thereatthat necessitates projects aiming at achieving, for example,self
sufficiency in basic materials, energy, transportation, etc;
7. Unusual events such as draughts, floods, earth-quake, hostilities, etc.;
8. Government decision to create project-implementing capacity in such areas as
construction, etc.
9. At the macro-level, Project ideas can also originate from multilateral or bilateral
development agencies and as a result of regional or international agreements on which the
country participates.

In addition, individual/entrepreneurial/ inspiration, institutions, workshops, trade fairs,

development experiences of other countries may point to some interesting project ideas.

At the micro-level, the variety of sources is equally broad. Project ideas may emanate from:

1. The identification of unsatisfied demand or needs

2. The existence of unused or underutilized natural or human resources and the perception of
opportunities for their efficient use

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3. The need to remove shortages in essential material services, or facilities that constrain
development efforts
4. The initiative of private or public enterprises in response to incentives provided by the
government.
5. The necessity to complement or expand investments previously undertaken, and
6. The desire of local groups or organizations to enhance their economic status and improve
their welfare

Project proposals could also originate from foreign firms either in response to government
investment incentives or because they consider production within the country a better way to
secure a substantial share of the domestic market for their products.

1.2.2 Project preparation: Analysis and Appraisal phase

Once project ideas have been identified and selected for further examination, the process of
project preparation and analysis starts. Project preparation must cover the full range of technical,
institutional, economic, and financial conditions necessary to achieve the project’s objective.
Critical element of project preparation is identifying and comparing technical and institutional
alternatives for achieving the project’s objectives. Different alternatives may be available and
therefore, resource endowment (labor or capital) would have to be considered in the preparation
of projects. Preparation thus require feasibility studies that identify and prepare preliminary
designs of technical and institutional alternatives, compare their costs and benefits, and
investigate in more details the more promising alternatives until the most satisfactory solution is
finally worked out. It involves generally three steps:

 Pre-feasibility studies
 Feasibility studies
 Support studies;
 Appraisal of studies
1.2.2.1 Pre-feasibility Study (Pre-selection/ Preliminary Screening)
The identification process will give the background information for defining the basic concept
project, which leads to the feasibility study stage. Once a project proposal is identified, it needs
to be examined. Once some project ideas have been put forward, the first step is to select one or
more of them as potentially promising. To begin with, a preliminary project analysis is done. A
prelude to the full blown feasibility study, this exercise is meant to assess:
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 1. whether the project is prima facie worthwhile to justify a feasibility study and
2. what aspects of the project are critical to its variability and hence warrant an in –depth
investigation.
At this stage, the screening criteria are rough and vague, becoming specific and refined as project
planning advances. During preliminary selection, the analyst should eliminate project proposals
that are technically unsound and risky, have no market for their output, have inadequate supply
of inputs, are very costly in relation to benefits, assume over ambitious sales and profitability, etc.
Some kind of preliminary screening is required to eliminate ideas, which prima facie, are not
promising. For this purpose the following aspects may be looked into:
Compatibility with the promoter
 Consistency with government priorities
 Availability of inputs
 Adequacy of market
 Reasonableness of cost, and
 Acceptability of risk level
When a firm evaluates a large number of project ideas, it may be helpful to stream line the
process of preliminary screening. For this purpose, a preliminary evaluation may be translated
into project rating index. The steps involved in determining the project-rating index are as
follows:
1. Identify factors relevant for project rating
2. Assign weights to these factors (the weights are supposed to reflect their relative
importance)
3. Rate the project proposal on various factors, selecting a suitable rating scale
4. For each factor multiply the factor rating with the factors weight to get the factor score
5. Add all the factor scores to get the overall project-rating index.
Once the project-rating index is determined, it is compared with a pre-determined hurdle value to
judge whether the project is prima facie worthwhile or not.
As a result of the preliminary screening exercise, a project profile, an opportunity study report, or
an identification study report, as appropriate, is prepared showing which project alternatives
should be rejected and which ones may be advanced to the next stage.

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1.2.2.2 Feasibility Study

The major difference between the pre-feasibility and feasibility studies is the amount of work
required in order to determine whether a project is likely to be viable or not. If the preliminary
screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing,
technical, financial, economic, and ecological aspects is undertaken. Feasibility study provides a
comprehensive review of all aspects of the project and lays the foundation for implementing the
project and evaluating it when completed. The focus of this phase of capital budgeting is on
gathering, preparing, and summarizing relevant information about various project aspects, which
are being considered for inclusion in the capital investment. Based on the information developed
in this analysis, the stream of costs and benefits associated with the project can be defined. At
this stage a team of specialists (Scientists, engineers, economists, sociologists) will need to work
together. At this stage more accurate data need to be obtained and if the project is viable it
should proceed to the project design stage. Appraisal should cover major aspects like technical,
institutional, economic and financial.
The final product of this stage is a feasibility report. The feasibility report should contain the
following elements:
2. Background of the project
3. Market analysis /identifypotential buyers, associated marketing costs
4. Technical analysis(materials & Inputs, Technology and engineering works, construction,
infrastructure)
5. Organizational analysis:- Will the solution work in the organization if implemented
6. Financial analysis:-how much start-up capital is needed, sources of capital, returns on
investment, etc.
7. Economic analysis :- cost/benefit analysis
8. Social analysis, and
9. Environmental analysis
Support Studies
Support or functional studies cover specific aspects of an investment project, and are required as
pre requisites for, or in support of, pre-feasibility and feasibility studies of particularly large-
scale investment proposals, the viability of which critically depends upon the quantity and
quality of certain input or aspect of that project.

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This type of study is justified when a detailed study required for a specific aspect/input/ is too
involved to be undertaken as part of the feasibility study. Alternatively, the decision towards
undertaking a feasibility study could be dependent upon the outcome of a support study.

Example: Cement processing is tied to the source of major raw materials, which are lime stone
and sandstone. Since the requirement is bulky, one cannot think of a cement factory located at a
distance from the source of these raw materials. So there is little room for outsourcing from
distant locations or imports. Since cement production is critically dependent upon the availability
of adequate quantity and the right quality of these raw materials, a support study is justified
before commissioning a full-fledged feasibility study.

Appraisal of an investment Decision(ex ante evaluation)

Thus project appraisal can be defined as a second look at the project report by a team of
professionals, who were not participated in the preparation of the study but qualified and
experienced to evaluate such studies. It is or should be an independent assessment of the project
to identify the weaknesses and strengths of the study that have a bearing on the decision to invest,
and/or to finance the project. Appraisal is the comprehensive and systematic assessment of all
aspects of a project study, addressing particularly issues like:

 Specificity of objectives;
 Clarity of problems;
 Methodology: type and source and appropriateness of data collection techniques and
analysis techniques;
 Project specific factors.

When a feasibility study is completed the various parties involved in the project will carry out
their own appraisal of the investment project in accordance with their individual objectives and
evaluation of expected risks, costs and gains.

The prime objective of project appraisal should be to identify the weaknesses that have bearing
on decision-making and identify means of strengthening it adequately to ensure final success of
the project. The main objective is then to improve and revamp the project.

The appraisal report concentrates on the health of the company to be financed, the returns
obtained by equity holders and the protection of its creditors. The techniques applied to appraise
the project in line with these criteria center around technical, commercial, market, managerial,

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organizational, and financial and possibly also economic aspects. The findings of this type of
appraisal enter into the appraisal report.

Appraisals as a rule deal not only with the project but also with the industries in which it will be
carried out and its implications for the economy as a whole. For large-scale projects, appraisal
report will require field missions to verify the data collected and to review all those factors of a
project that are conditioned by its business environment, location and markets and the
availability of resources.

Implementation/Investment phase/
After the project design is prepared negotiations with the funding organization starts and once
source of finance is secured implementation follows. Implementation is the most important part
of the project cycle. The better and more realistic the project plan is the more likely it is that the
plan can be carried out and the expected benefits realized.

Project implementation must be flexible since circumstances change frequently. Technical

changes are almost inevitable as the project progresses; price changes may necessitate
adjustments to input and output prices; political environment may change.

Translating an investment proposal into a concrete operational unit is a complex, time consuming
and risk fraught task. Delays in implementation, which are common, can lead to substantial cost
overrun. For expeditious implementation at a reasonable cost, the following are helpful.

1. Adequate formulation of projects. A major reason for the delay is inadequate formulation of
projects. Put differently if necessary homework in terms of preliminary studies and
comprehensive and detailed formulation of projects is not done, many surprises and shocks are
likely to spring on the way. Hence the need for adequate formulation of the project cannot be
overemphasized.

2. Use of the principle of responsibility accounting. Assigning specific responsibilities to

project managers for completing the project within the defined time frame and cost limits is
helpful in expeditious execution and cost control.
3. Develop project management competence: Use of network techniques. For project planning
and control two basic techniques are available - PERT (program evaluation Review Technique)
and CPM (Critical Path Method). These techniques have lately merged and are being referred to

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by common terminology that is network techniques. With the help of these techniques,
monitoring becomes easier.
The investment phase can be divided into the following stages:
1. Establish project management office which involve establishing of the legal, financial and
organizational basis for the implementation of the project
2. Technology acquisition and transfer, including basic and detailed engineering, which include
 tender preparation (hence developing the terms of reference), tendering, tender analysis,
selection of a supplier,
 negotiation and contracting;
 Procurement of major technology for installation and other inputs necessary for
construction and installation of the system;
3. Engineering design;
4. Construction work
5. Installation and erection;
6. Pre-production marketing, including the securing of supplies and setting up the administration
of the firm
7. Recruitment and training of personnel, and

8. Plant commissioning and start-up (Alternatively, this function may be categorized in the
operation phase).

This implementation basically involves capability in project management. The function of

project management is to foresee or predict as many of the dangers and problems as possible and
to plan, organize and control activities so that the project is completed successfully in spite of the
risks. Project management is the planning, organizing, directing, and controlling of resources for
a specific time period to meet a specific set of one-time-objectives. This process starts before any
resources are committed and must continue until all work is finished. The aim is for the final
result to satisfy the project sponsor or purchaser, within the promised timescale and without
using more money and other resources than those, which were originally set aside or budgeted
for. Since there are different types of projects, the management of these different types of
projects is also different reflecting the peculiarity of the projects.

The Common contraints in implementation

1. Over optimistic estimate at inception (economic policy and social environment)
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2. Inappropriate technology choice.
3. Shortage of qualified and experienced personnel.
4. Lack of prompt decisions on certain issues, like selection of sites for carrying out project
activities.
5. High cost of input (feed shortage for livestock projects)
6. Inefficiency of the contracting firms resulting in delays on finalization of
construction/machinery delivery.
7. Change of project personnel (trained personnel leave jobs before implementation is
completed).
8. Natural calamities caused by floods, road blots due to landslides, and disruption of the
operation of important service facilities.
9. Lack of proper communication facilites between the field units, project headquarters and the
creditor/s.
10. Unhealthy atmosphere created by political upheaval in the project area, (labor strike,
change in government etc.).
11. Corruption.

The operational phase

Project operation involves the running and maintenance of new entity in accordance with set
objectives and planned tasks.

The problems of the operational phase need to be considered from both a short-and long-term
viewpoint. The short-term view relates to the initial period after commencement of production
when a number of problems may arise concerning such matters as the application of production
techniques, operation of equipment or inadequate labour productivity owing to a lack of qualified
staff. Most of these problems have their origin in the implementation phase. The long-term view
relates to chosen strategies and the associated production and marketing costs as well as sales
revenues. These have a direct relationship with the projections made at the pre-investment phase.
If such strategies and projections are proved faulty, and remedial measures will not only be
difficult but may prove to be highly expensive.
The operational phase involves the following main functions.
1. Commissioning and starting of commercial production;
2. Post-project evaluation

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3. Replacement/rehabilitation
4. Expansion /innovation.

Aspects of Project Preparation and Analysis

1. Marketing and Demand (Commercial) Aspect
 concerns with arrangement of markets for project inputs and outputs
Inputs: quality, quantity and price on the right time
Outputs: where to sell project products
 Factors to be considered (different sides of the market)
Consumption trends of the past and future
Production possibilities and constraints
Import and export analysis
Nature of competition
Elasticity of demand and supply
Consumer’s behavior, preferences, attitudes
 This calls for Situational analysis! Asking Qs like …
o Who are the consumers of the product?
o What kind of substitutes?
o What kind of marketing arrangements and institutions will be involved?
 This may require use of
o Primary Market survey information
o Secondary information

2. Technical aspect
Involves technicians like engineers, soil scientists', agronomists, economists, livestock experts,
etc. In technical analysis every person involved in the project should know how to examine
 Material inputs & utilities (raw materials like organic materials, mineral deposits, forest
products, marine products; processed materials and utilities like energy, water, telephone,
etc.)
 Auxiliary materials (oils, paints, grease, etc.)
 Manufacturing (production) processes (type of technology: capital or labor intensive)
 Plant capacity (medium, large or small)
 Location and site
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  Machinery and equipment
 Structure and other civil works

3. Institutional aspects

Institutions are the laws, rules, regulations, customs, justice systems, religions, and social
pressures that encourage or constraint people in the quest to maximize their welfare. It may
affect
 Working behavior of the society
 Land tenure
 Local committees like water, capital, etc
 Local money rotational systems

4. Organizational aspect

Relationship b/n project administrative organization and the existing agencies

 Is separate project authority needed?
 The authority & responsibility of the executive staff &agencies should be clearly defined
and linked
5. Managerial and administrative aspect: Is the project run by a separate staff or the
beneficiaries also run the project?
6. Social aspects: Refers to the project's contribution to the society:
 employment generation
 Income distribution
 Minimization/mitigation of side effects (displacements, waste products, etc )
 Concerning quality of life

7. Financial aspects: analyze the financial impact of the projects on participants and measure
efficiency, incentives, credit worthiness and liquidity so created
8. Economic aspects: refers to determination of likelihood that the proposed project would
contribute to the overall economic dev’t of the society & justify to add sufficient returns for
the resources used
9. Ecological analysis:environmental impact of the project

In general,
 A project should include all or part of these aspects depending on its size and impact.
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 Of these aspects financial and economic analysis are the concerns of economists

Chapter Two: Financial Analysis and Appraisal of Projects

2.1. Scope and Rationale
2.1.1. When to undertake financial Analysis
A financial analysis must be undertaken if it is necessary to determine the financial profitability
of project to the project implementer. It will be worthwhile to carry out a financial analysis if the
output of the project can be sold in the market or can be valued using market prices. This applies
to private and public investments. A private firm will primarily be interested in undertaking a
financial analysis of any project it is considering and seldom will it under take an economic
analysis. But commercial government authorities that are selling out put such as
telecommunications, electric power, etc will usually under take a financial and an economic
analysis of any project it is undertaking. Even non-commercially oriented government
institutions may sometimes wish to choose between alternative facilities on the basis of
essentially financial objectives. For example, in the case of a hospital service the management of
the hospital may be required to provide the cheapest services. Under such circumstances a cost
minimization or cost effectiveness exercise will be undertaken.
2.2. Identification of Costs and Benefits
In project analysis, the identification of costs and benefits is the first step. The costs and benefits
of a project depend on the objectives the project wants to achieve. So, the objectives of the
analysis provide the standard against which cost and benefits are defined. A cost is anything that
reduces an objective, and a benefit is anything that contributes to an objective. However, each
participant in a project has many and different objectives.
Whatever the nature of the project, its implementation will always reduce the supply of inputs ("
consumed" by the project). With out the project, the supply of these inputs and outputs to the rest
of the economy would have been different. (Examining this difference between the availability
of inputs and out puts with and with out the project is the basic method of identifying its costs
and benefits.) In many cases the Situation without the project is not simply a continuation of the
status quo, but rather the Situation that is expected to exist if the project is not under taken,
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because some increases in output and costs are often expected to occur any way. Different
participants in a project have many and different objectives.

For example:
1. For a farmer, a major objective of participating may be to maximize family income. But this
is only one of his objectives. He may also wish his children to be educated, which reduces the
available labor force for farm work. Taste preferences may force the farmer to continue growing
a traditional variety although a new and high yielding variety may be available. He may also
wish to avoid risk and thus continue cropping a variety, which he knows well.
2. For a private business firm or government corporations a major objectives is to maximize net
income, yet both have significant objectives other than simply making the highest possible profit.
Both will want to diversify their activities to reduce risk. A public corporation bus may for
instance decide to maintain Services even in less densely populated areas or at off peak hours
and there by reduce its net income.
3. A Society as a whole will have as a major objective increased national income, but it clearly
will have many significant, additional objectives. One of the most important of these is income
distribution. Another may be to increase the number of productive job opportunities so that
unemployment may be reduced- which may be different from the objective of income
distribution. Another may be to increase the number of productive job opportunities so that
unemployment may be reduced - which may be different from the objective of income
distribution it self. An other objective may be to increase the proportion of saving for future
investment, or there may be other broader objectives such as increasing regional integration,
raising the level of education, improve rural health, or safeguard national security. Any of these
may lead to the choice of a project that is not the alternative that would contribute most to
national income narrowly defined.
No formal analytical technique could possibly take in to account all the various objectives of
every participant in a project. Some selection will have to be made. Most often the maximization
of income is taken as the dominant objective of the firm because the single most important
objective of an individual economic agent is to increase income and increased national income is
the most important objective of national economic policy. Anything that reduces national income
is a cost and anything that increases national income is a benefit. Thus anything that directly
reduces the total final goods and services is obviously a cost, and anything that directly increases
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them is a benefit. The task of the economic analyst will be to estimate the amount of the increase
in national income available to the society i.e. to determine whether, and by how much, the
benefits exceed the costs in terms of national income.
Quantification
Once costs and benefits are enumerated the next step is accurate prediction of the future benefits
and costs which then be quantified in Dollars and cents. Thus, quantification involves the
quantitative assessment of both physical quantities and prices over the life span of the project.
The financial analysis of projects is typically based on accurate prediction of market prices, on
top of quantity prediction. It is worth thinking about the impact of the project it self on the level
of prices; and the independent movement of prices due other factors. The same principle applies
in the Sense of economic analysis the only difference being the price needs to be changed to
reflect net efficiency benefits to the nations at large. One widely accepted" efficiency" measure is
its actual or potential value as an import or export; similarly the opportunity cost of any input is
related to the question of its potential contribution to foreign exchange. In other words, world
prices are considered as efficiency price indicators compared to domestic prices. However, to
take account of the distribution impact of project further adjustment of such price is required.
This lends itself too the social cost-benefit analysis.
2.3. Classification of Costs and Benefits
2.3.1. Tangible costs and benefits of a project
The first question that the project analyst needs to know is whether it is one project that is to be
evaluated or several alternatives? Determining the relevant alternative project based perhaps on
technology, size, or length of time required for the phasing out of the project etc, is critical
problem.
2.3.1.1.Tangible costs of a project
In almost all project analyses costs are easier to identify and value than benefits. In examining
costs the basic question is whether the item reduces the net benefit or the net income of a firm
(project owner). The prices that the project actually pays for inputs are the appropriate prices to
use to estimate the project's financial costs. These prices may include taxes, tariffs, monopoly or
monophony rents, or be net of subsidies. Some of the project costs are tangible and quantifiable
while many more are intangible and non quantifiable. The costs of a project depend on the exact
project formulation, locations, resource availability, or objective of the project.

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Conceptually; the cost of project represents the total of all items of out lay associated with a
project, which are supported by long-term funds. It is the sum of the outlays on the following
items:
 The cost of land and site development
 Land charges
 Payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells
 The cost of buildings and civil works
 Buildings for the main plant and equipments
 Buildings for auxiliary services (steam supply, work shops, laboratory, water supply etc.)
 Ware houses and shower rooms
 Non-factory buildings like guesthouse, canteens.
 Silos, tanks, wells, basins, etc
 Garages and work shops
 Other civil engineering works
 The cost of plant and Machinery
The cost of plant and machinery, typically the most significant component of project cost,
consists of the following.
 Cost of imported machinery: This is the sum of (i) FOB (Free on board) value, (ii)
shipping, freight, and insurance cost, (iii) import duty, and
(iv) Clearing, loading, unloading, and transportation charges.
 Cost of local machinery:
 Cost of stores and spares
 Foundation and installation charges
The cost of plant and machinery is based on the latest available quotation adjusted for possible
escalation. Generally, the provision for escalation is equal to the following product: (latest rate of
annual inflation applicable to the plant and machinery) x (length of the delivery period)
 Technical know-how and Engineering fees.

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Often it is necessary to engage technical consultants or collaborators from local or abroad for
advice and help in various technical matters like preparation of project report, choice of
technology, selection of plant and machinery, detailed engineering, and so on. While the amount
payable for obtaining technical know-how and engineering services for setting up the project is a
component of project cost, the royalty payable annually, which is typically a percentage of sales,
is an operating expense taken in to account in the preparation of the projected profitability
statements.
 Expenses on Foreign Technicians and Training of local technicians abroad. Services of
foreign technicians may be required for Setting up the project and supervising the trial runs.
Expenses on their travel, boarding, and loading along with their Salaries and allowances must be
shown here. Likewise, expenses on local technicians who require training abroad must also be
included here.
 Miscellaneous Fixed Assets
 Fixed assets and machinery, which are not part of the direct manufacturing process, may
be referred to as miscellaneous fixed assets. They include items like furniture, office machinery
and equipment, tools, vehicles, railway siding, laboratory equipments, workshop equipmentsetc,
and deposits made with the electricity board may also be included here.
 Preliminary and capital issue expenses
 Expenses incurred for identifying the project, conducting the market Survey, preparing
the feasibility report, drafting the memorandum and articles of association are referred to as
preliminary expenses.
 Expenses borne in connection with the raising of capital from the public are referred to as
capital issue expenses. The major components of capital issue expenses are: Under writing
commission, brokerage, fees to managers and registrars, printing and postage expenses,
advertising and publicity expenses and stamp duty.
 Pre-operative Expenses
Expenses of the following types incurred till the commencement of commercial production are
referred to as pre-operative expenses:
 Establishment expenses
 Rents, taxes and rates
 Traveling expenses
 Interest and commitment charges on borrowings
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 Insurance charges
 Mortgage expenses
 Interest on deferred payments
 Start up expenses
 Miscellaneous expenses.
 Provision for contingencies
A provision for contingencies is made to provide for certain unforeseen expenses and price
increases over and above the normal inflation rate, which is already incorporated in cost
estimates.
To estimate the provision for contingencies; (i) Divide the project cost items into two categories,
i.e. firm cost items and non-firm cost items (firm cost items are those which have already been
acquired or for which definite arrangements have been made.) (ii) Set the provision for
contingencies at 5 to 10 percent of the estimated cost of non-firm cost items. Alternatively, make
a provision of 10 percent for all items (including the margin money for working capital) if the
implementation period is one year or less. For every additional one-year, make an additional
provision of 5 percent.
Commercial banks and trade creditors provide the principal support for working capital.
However, a certain part of working capital requirement has to come from long-term sources of
finance. Referred to as the "margin money for working capital" this is an important element of
the project cost.
To meet the cost of project the following means of finance are available: Share capital, Term
loans, Debenture capital, Deferred credit, Incentive Sources, andMiscellaneous Sources
Share capital: There are two types of Share capital- equity capital and preference capital. Equity
capital represents the contribution made by the owners of the business, the equity shareholders,
who enjoy the rewards and bear the risks of owner ship. Equity capital being risk capital carries
no fixed rate of dividend. Preference capital represents the contribution made by preference
shareholders and the dividend paid on it is generally fixed.
Term loans: Provided by financial institutions and commercial banks, term loans represent
secured borrowings, which are a very important source for financing new projects as well as
expansion, modernization, and renovation schemes of existing firms.
Debenture capital: Debentures are instruments for raising debt capital. There are two broad
types of debentures: non-convertible debentures and convertible debentures. Non-convertible
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debentures are straight debt instruments. Typically they carry a fixed rate of interest and have a
maturity period of 5 to 9 years. Convertible debentures, as the name implies, are debentures,
which are convertible, wholly or partly, in to equity shares. The conversion period and price are
announced in advance.
Deferred credit: Many a time the suppliers of plant and machinery offer a deferred credit
facility under which payment for the purchase of plant and machinery can be made over a period
of time.
Incentive sources: The government and its agencies may provide financial support as incentive
to certain types of promoters or for setting up investment in certain location.
Miscellaneous sources: A small portion of project finance may come from miscellaneous
sources like unsecured loans, public deposits, and leasing and hire purchase finance.
2.3.1.2.Tangible Benefits
Tangible benefits can arise either from increased production or form reduced costs. The specific
forms, in which tangible benefits appear, however, are not always obvious and valuing them
might be difficult. In general the following benefits can be expected.
 Increased production
 Quality improvement
 Changes in time of sale changes in location of sale
 Changes in product form
 Cost reduction through technological advancement
 Reduced transport costs
 Other kinds of tangible benefits.
2.3.2. Intangible costs and Benefits
There may be some costs and benefits that are intangible. These may include the creation of new
employment opportunities, better health and reduced infant mortality as a result of more rural
clinics, better nutrition, reduced incidence of waterborne diseases, national integration, or even
national defense. Such intangible benefits. However, do not readily lend them selves to valuation.
Under such circumstances one may have to resort to the least cost approach instead of the normal
benefit cost analysis.
Although the benefits may be intangible most of the costs are tangible. Construction costs for
schools, hospitals, pipes for rural water supply, etc are all quantifiable. However, cost such as the

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disruption of family life, the increased pollution as a result of the project, ecological imbalances
as the result of the project, etc, are difficult to capture and quantify. But effort should be made to
identify and quantify wherever possible.
2.4. The valuation of financial costs and benefits
How to value project costs and benefits in financial analysis
The financial benefits of a project are just the revenues received and the financial costs are the
expenditures that are actually incurred by the implementing agency as a result of the project. If
the project is producing some goods and services for sale the revenue that the project
implementer expects to receive every year from these sales will be the benefits of the project.
The costs incurred are the expenditures made to establish and operate the project. These include
capital costs, the cost of purchasing land, equipment, factory buildings vehicles, and office
machines, working capital as well as its ongoing operating costs; for labor, raw material, fuel,
and utilities.
In financial analysis all these receipts and expenditures are valued as they appear in the financial
balance sheet of the project, and are therefore, measured in market prices. Market prices are just
the prices in the local economy, and include all applicable taxes, tariffs, trade mark-ups and
commissions. Since the project implementers will have to pay market prices for the inputs and
will receive market prices for the out puts they produce, the financial costs and benefits of the
project are measured in these market prices. In a freely perfectly competitive market, without
taxes or subsidies the market price of an input will equal its competitive supply price at each
level of production. This is the price at which producers are just willing to supply that good or
service. The supply curve will reflect the opportunity cost, or the value in their next best
alternative use of the resources used to produce that input. In equilibrium the supply price of an
input will equal to its demand price at the market-clearing price for that input.
The financial benefit from a project is measured in terms of the market value of the project's
output, net of any sales taxes. If the project's out put is sold in a competitive market with no
rationing or price control for the good concerned, and the project is small and does not change
the good's price, its market price will equal its competitive demand price. This is a minimum
measure of what people are willing to pay for a unit of the good or service (produced by the
project, at each level of out put demanded).
Secondary costs and benefits.

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We may distinguish between primary and secondary costs. The former is concerned with the
direct project outputs and inputs. The latter, however, exist where the project enables more
efficient use of resources to be made elsewhere or leads to external claims on resources
elsewhere. Project might lead to benefits created or costs incurred outside the project it self. So
project analyst must also consider the external or secondary costs so that they can be properly
attributed to project costs investment. This is more a problem of economic analysis and not a
concern of financial analysis. The tracing through of Secondary effects is the proper subject of
economic analysis.
The Treatment of Transfer payments in Financial Analysis
Some payments that appear in the cost streams of the financial analysis do not represent direct
claims on the nation's resources but merely reflect a transfer of the control over resource
allocation from one member or sector of society to an other. For example, the payment of interest
by the project entity on a domestic loan merely transfers purchasing power from the project
entity to the lender. Direct transfer payments include taxes, subsidies, loans, and debt Services.
Taxes: taxes that are treated as a direct transfer payment are those representing a diversion of net
benefit to the society. A tax does not represent real resource flow it represents only the transfer
of a claim to real resource flows. In financial analysis a tax is clearly a cost. When a firm pays
taxes its net income reduces. But the payment of taxes does not reduce national income. Rather it
transfers income from the firm to the government so that this income can be used for social
purposes presumed to be more important to the society than the increased individual
consumption (investment had the firm retained the amount of the tax. So, in economic analysis
taxes will not be treated as a cost in project account.
No matter what form a tax takes, it is still a transfer payment-whether a direct tax or an indirect
taxes such as sales tax, an excise tax, or tariff or duty on an imported input for production.
Whether a tax should be treated as a transfer payment or as a payment for goods and services
needed to carry out the project or merely a transfer, to be used for general purposes, of some part
of the benefit from the point to the society as a whole.
Subsidies: are simply direct transfer payments that flow in the opposite direction from taxes.
Direct subsidies represent the transfer of a claim to real resources from one enterprise, sector or
individual to another. Subsidies may be open or disguised and are provided on the input or out
put side. On the input side subsidies reduce costs to the project. If the subsidy is granted on the
output side, i.e. increase the revenue of the project; we should deduct the amount of the subsidy
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from the revenue that includes subsidy. If a firm is able to purchase an input at a subsidized price
that will reduce his costs and thereby increase his net benefit, but the cost of the input in the use
of the society's real resources remains the same. The resources needed to produce the input or to
import it from abroad reduce the national income available to the society. Hence, for economic
analysis of a project we must enter the full cost of the input.
Credit Transactions: These are the other major form of direct transfer payments. A loan
represents the transfer of a claim to real resources from the lender to the borrower. When the
borrower repays loans or pays interest he is transferring the claim to the real resource back to the
lender-but neither the loan nor the repayment represent in itself, use of the resources. In other
words, the loan itself and its repayment are financial transfers. The investment, however, or other
expenditure that the loan finance involves real economic costs. The financial cost of the loan
occurs when the loan is repaid, but the economic cost occurs when the loan is spent. The
economic analysis does not, in general, need to concern itself with the financing of the
investment; that is, with the sources of funds and how they are repaid.
The preceding rule is subject to one important exception. Although transfer payments such as
taxes and interest are not a source cost, they do have an impact on the distribution of income and
possibly on savings. And if the government wishes to use project selection as a means of
improving income distribution or increasing savings, then this should be taken into account when
determining the costs and benefits of a project and should be reflected in the shadow prices of
factor inputs and incomes.
2.5. The cash flow in financial analysis
The three basic steps in determining whether a project is worthwhile or not are
(a) Estimate project cash flows
(b) Establish the cost of capital;
(c) Apply a suitable decision or appraisal rule or criterion.
Whether one is calculating financial or economic rate of return, a key part of the analysis will be
to work out the actual flows of income and expenditure. The financial cash flow of a project is
the stream of financial costs and benefits, or expenditures are receipts that will be generated by
the product over its economic life, and will not be produced in its absence.
Note that when one is working with market prices, the cash flow stream is referred to as financial
cash flow. When these prices are adjusted to reflect national efficiency and equity objective (i.e.

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When shadow prices are used) it is referred to as Economic Net benefit stream and social Net
benefit stream respectively.
In carrying out a financial cash flow, record year by year through out the expected life of the
project, all expected expenditure payments for goods and services for the project (including
capital expenditures) and all expected receipts from the project. For each year, the subtraction of
the former from the latter shows how much cash the firm gains or loses as a result of the project.
Borrowing and lending, and interest or dividend payments, are normally excluded from the
concept of " cash flow" when this is used for the purpose of assessing the profitability of a new
investment.
The difference between cash flow accounting and most forms of normal commercial accounting
are:
(i) In normal accounting income and expenditure represent the values of goods or services
delivered (some times in to stock) and received; not the cash received and paid out for them.
(ii) Normal accounting shows financial liabilities, with respect to interest and tax, not payments.
There are sometimes large differences of timing here.
(iii) A financial allowance for depreciation and obsolescence of capital is made in normal
accounting. In cash flow accounting there is no such provision, but anticipated renewals and
replacements will be included as well as the scrap value of the equipment.
In financial cash flow, the total cost stream is subtracted from the total revenue to obtain the
financial in flow.
Example: Consider a project that has 20 years of estimated life. It is assumed that it will take
some years before the project yields some positive returns. The project starts producing positive
results only after year 1. Operation stops with no scrap value at the end of year 20. Total cost
starting at year 1 is birr 945 million, which increases to birr 1267 million in year 2.
Table1: Simple financial cash flow for x project (in million birr)
Cost Year
1 2 3 4 20
Capital Costs
Fixed assets
Pipes 400 500 300 0 -70
Pumps 50 100 90 0 -30
Storage tanks 140 230 160 0 -100
Jack hammers 20 10 0 0 -5
Construction 200 250 190 0 0

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Total fixed assets 810 1090 740 0 -205
Working capital 20 30 40 0 -90
Total capital costs 830 1120 780 0 -295
Operating costs
Project management 80 100 120 90 90
Fuel 5 7 8 10 10
Maintenance 30 40 50 50 50
Total costs 945 1267 958 150 -145
Benefits (sales revenue) 0 200 250 500 500
Net benefits (benefits-costs) -945 -1067 -708 350 645

Costs are typically broken in to investment and operating costs. The former basically covers
capital expenditure (such as plant and machinery) while the latter (incurred only once the project
is under way) is in turn divided into variable and fixed components. The former covering such
things as raw materials and labor inputs (which varies with out) while the latter includes items
such as maintenance, administration and managerial charges (which will be relatively fixed with
respect to volume of production).
For Financial analysis that is carried out from the point of view of the project entity, tax and
subsidy elements in cost (and revenue) components will be left in the calculation. For financial
analysis from national point of view, tax and subsidy elements will normally be netted out of the
calculation (Since these are transfer payments to and from the government.) Depreciation will
also be omitted, this being no more than an accounting device for putting aside funds for
replacement.
When detailed economic analysis is done the cost break down used in the standard procedure
will not be sufficient. We need to reclassify all project inputs and out puts into traded and non-
trade goods and basic factors of production. This is another part of project analysis. Basic
principles for measuring project cash flow. For developing the stream of financial costs and
benefits the following principles must be kept in mind.
 Incremental principle
The cash flow of the project must be measured in incremental terms. To ascertain a project's
incremental cash flows one has to look at what happens to the cash flows of the firm with the
project and with out the project. The difference between the two reflects the incremental cash
flows accounting of the project.
 Long term funds principle

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 A project may be evaluated from various point of views: total funds point of view, long term
funds point of view, and equity point of view. It is usually recommended that project be
evaluated from the point of view of the long-term funds (which are provided by equity stock
holders, preference stockholders, debenture holders and long term lending institutions) because
the principle evaluation is long-term profitability. Hence, for determining the costs and benefits
of an investment project we will have to ask what is the sacrifice made by the suppliers of long
term funds? And what benefits accrue to the suppliers of long-term funds?
 Exclusion of financing costs principle
The exclusion of financing costs principle means that
(i) The interest on long-term debt is ignored while computing profits and taxes there on and (ii)
the expected dividends are deemed irrelevant in cash flow analysis. If interest on long term debt
and dividend on equity capital are deducted in defining cash flows, the cost of long term funds
will be counted twice, which is an error.
 Post-tax principle
Tax payments like other payments must be properly deducted in deriving the cash flows, put
differently cash flows must be defined in post tax terms.
Components of the cash flow stream
The cash flow stream associated with a project may be divided into three basic components.
(a) An initial investment
(b) Operating cash in flows, and
(c) A terminal cash flow
The initial investment costs are defined as the sum of fixed assets (fixed investment costs plus
pre-production expenditures) and net working capital, with fixed assets constituting the resources
required for constructing and equipping an investment project, and net working capital
corresponding to the resources needed to operate the project totally or partially. In short, the
initial investment represents the relevant cash flow when the project is set up.
The operating cash inflows are the cash inflows that arise from the operation of the project
during its economic life. The terminal cash flow is the relevant cash flow occurring at the end of
the project life on account of liquidation of the project.
Initial Investment:
The manner in which the initial investment is defined depends on whether the project is a new
project or a replacement project as shown below:

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New project Replacement project
Cost of capital assets Cost of replacement capital cossets
+ Installation costs + Installation costs
+ Working capital margin - Post - tax proceeds from the sale of old
capital assets
+ Preliminary and pre-operative expenses + Change in working capital margin
- Tax shield, if any, on capital assets + Preliminary and pre-operative expenses
- Tax shield, if any, on replacement capital
assets.

Operating cash inflows: For deriving the operating cash inflows, the projected profitability
statements are the starting point. Since there is a difference between the recognition of revenues
and expenses in accounting and the incidence of cash flows, a rigorous analysis requires that
each item of revenue and expense be examined to find out the cash flows associated with it.
When we are interested in defining the cash flows on a year basis, as is done commonly in
project appraisal, a significant portion of such detailed analysis is redundant because it helps in
getting only a more refined picture of intra-year cash flows. So from a practical point of view, it
suffices if depreciation and other non- cash charges, which are deducted in computing profits
from the accounting point of view, are added back because they do not result in cash out flows.
This means that the operating cash inflow for a given year is defined as flows.
New project Replacement project
Profit after tax Change in profit after tax
+ +
Depreciation Change in deprecation
+ +
other non-cash charges Change in other non-cash charges
+ +
Interest on long- term debt (1-tax rate) Change in interest on long term debt (1-tax rate)

Terminal cash flows: The cash flow resulting from the termination or liquidation of a project at
the end of its economic life is called its terminal cash flow. It is defined as follows:
New project Replacement project
Post-tax proceeds from the sale of capital Post-tax proceeds from the sale of replacement
assets capital assets.
+ +
New recovery of working capital margin - post - tax proceeds from the sale of old
capital assets
+
Net recovery working capital margin
* Post-tax proceeds are also referred to as the net salvage value.

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Net Salvage value of capital Assets: Usually, the sale price of a capital asset exceeds its book
value. There fore, the net salvage value is equal to:
Sale value - Tax, if any, on sale
If however, a loss is incurred on sale, the net salvage value is equal to:
Sale value - Tax shield, if any, on sale.
It is difficult to estimate the sale value of a capital asset as it is influenced by factors like
technological innovations, inflation, shifts in demand, and physical wear and tear. In view of
these difficulties, an approach that is commonly followed is to assume that the sale value would
be equal to either the book value at the time of sale or a small fraction (Say 5 percent) of the
original value. Since this approach is rather naive and unrealistic, the following method can be
used to get a first approximation of the Sale value.
1. Find the ratio of the market price of a machine used for n years ( n is the planning
horizon ) to the market price of a new machine. Denote this by r.
2. Determine the annul compound rate of growth of the price of a new machine over the last
five years. Denote this by "g".
3. Project the price of new machine after n years using the formula: A (1 + g) n where, A
represents the price of the new machine now.
4. Estimate the sale price of machine (bought new now) after n years of use, employing the
formula. A (1 + g) n. r
Example: A firm, having a planning horizon of ten years, is considering the acquisition of a new
machine, which costs birr 1.2 million now. The cost of a similar new machine five years ago was
birr 0.8 million. The market price of a comparable machine which has been used for ten years is
now birr 0.4 million. Given the above information, the sale value of a new machine, now bought
for 1.2 million, after ten years (the planning horizon) is obtained as follows.
The ratio of the market value of a ten-year old machine to the market value of a new machine is
4
r
12
The annual compound rate of growth 4 in the price of a new machine is
1
12  5
g    1  0.09  9%
8
The sale price of a new machine after ten years is 1.2 million (1.09)10 = 2.4 million.

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The sale price of a machine (bought new now) after 10 years of use would be equal to:
4
2.4 million x = 0.948 million
12
The equation for g is obtained as follows.
8 (1 g )5 13
12
So (1 g )5 
8
1
12  5
(1  g )   
8
1
12  5
g   1
8
Net recovery of working capital margin: Working capital is normally expected to be liquidated
at its face value. Hence no profit or gain is expected from its liquidation. Therefore, the net
recovery of working capital margin is equaled with the working capital margin provided at the
outset.
2.6. Investment Profitability Analysis
Once the Stream of costs and benefits for a project is defined in the form of cash flows, the
attention shifts to the issue of project worthwhile ness. A wide variety of project appraisal
criteria (or evaluation methods) have been suggested to judge the worthwhile ness of capital
projects. Some are general and applicable to a wide range of investments; others are specialized
and suitable for certain types of investments. The more important and popular of these can be
classified into two broad categories:
2.6.1. Non-discounted measures of project worth
Projects, which are powerful means of development, have to be appraised by multiple criteria. In
order to appraise a project idea we need operational criteria applicable in evaluating alternatives.
Technical criteria are used to compare the merits of alternative technical solutions. It should be
noted that there might be no one best technique for estimating project worth although some may
be better than others. We should also note that these are only tools to improve decision-making.
There are other non-quantifiable and non-economic criteria for making project decisions. The
tools are only used to improve the decision making process. Before we discuss the discounted
project appraisal criteria we need to consider some common undiscounted measures.

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 1. Ranking by Inspection

It is possible, in certain cases, to determine by mere inspection which of two or more investment
projects is more desirable. There are two cases under which this might be true.
(a) two investments have identical cash flows each year up to the final year of the short-lived
investment, but one continues to earn cash proceed (financial results or profits) in subsequent
years. The investment with the longer life would be more desirable.
Example: Consider the following hypothetical projects (Table 2.1)
Investment (project) Initial cost Year I Year II
A 10,000 10,000 -
B 10,000 10,000 1,100
C 10,000 5,762 7,762
D 10,000 7762 5,762
Accordingly project B is better than investment A, since all things are equal except that B
continues to earn proceeds after A has been retired. More analysis is required to decide between
C & D,
(b) Two investments have the same initial out lay (the total net value of incremental production
may be the same), the same earning life and earn the same total proceeds (profits) but one project
has more of the flow earlier in the time sequence, we choose the one for which the total proceeds
is greater than the total proceeds for the other investment earlier. Thus investment D is more
profitable than investment C, Since D earns 2000 more in year 1 than investment C, which does
not make up the difference until year 2.
2. The payback period.

The payback period also called the pay off period is one of the simplest and apparently one of the
most frequently used methods of measuring the economic value of an investment. The payback
period is the length of time required to recover the initial cash out lay on the project.
Example: If a project requires an original out lay of birr 300 and is expected to produce a stream
of cash proceeds of birr 100 per year for 5 years, the pay back period would be
300  3 years
100
Note: If the expected proceeds are not constant from year to year, then the payback period must
be calculated by adding up the proceeds expected in successive years until the total is equal to
the original out lay.
As observed in table 2.1 above, investment A and B are both ranked as 1, since they both have
shorter pay back periods than any of the other investments, namely 1 year. But investment B
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which has the same rank as A will not only earn 10,000 birr in the first year but also 1, 100 birr a
year later. Thus, investment "B" is superior to "A". But a ranking procedure such as the payback
period fails to disclose this fact. Thus, it has two important limitations:
(i) It fails to give any considerations to cash proceeds earned after the pay back date. It simply
emphasizes quick financial returns
ii) It fails to take into account differences in the timing of receipts and earned proceeds prior to
the payback date. For instance, if we have two projects with the same capital cost and if they
have the same pay back period then they are equally ranked. Yet we know by the inspection
method the project with more earlier benefits should be desirable and should be preferred since
the earlier a benefits is received the earlier it can be reinvested or consumed.
3. Proceeds per unit of outlay

Under this method, investments are ranked according to their total proceeds divided by the
amount of the corresponding investments.
Example: consider the following hypothetical example
Investment Total proceeds Investment Proceeds per Ranking
Unit of outlay
A 10,000 10,000 1.00 4
B 11,100 10,000 1.11 5
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1

Accordingly project C and D must be implemented. However, both projects are given the same
rank. Although we know by inspection method that project D is superior because D generates
birr 2000 of proceeds in year 1. This method is a gain deficient because it still fails to consider
the timing of proceeds
4. Out put capital Ratio

It is defined as the averages (un discounted) value added produced per unit of capital expenditure.
Under this criterion we select the project with the highest out put capital ratio or the lowest
capital out put ratio.
2.6.2. Discounted measures of project worth
The undiscounted measures discussed so far share common Weakness. They fail to take into
account adequately the timing of benefits. Thus, it is an accepted principle in economics that
inter-temporal variations of costs and benefits influence their values and a time adjustment is

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necessary before aggregation. Therefore a time dimension should be included in our evaluation.
That means we need to express costs and benefits in terms of value by discounting all items in
the cash flows back to year 0. The need for such a procedure will be apparent if one considers the
following simple argument.
Suppose one is offered the choice between receiving birr 100 today and receiving the same
amount in a year's time. It will be rational to prefer to receive the money today for several
reasons.
a) One may expect inflation to reduce the real value of birr 100 in a year's time
b) If there were no inflationary effect, it would still be preferable to take the money today
and invest it at some rate of interest, r, hence receiving a total of birr 100 (1+r) at the end
of the year.
c) Even if no investment opportunities are available, one might reason that birr 100 today
would still be preferable on the grounds that there is a finite risk to collect the money
next year.
d) Even where inflation, investment opportunities and risk are ignored, there is pure time
preference, which would lead one to prefer the immediate offer.

For all these reasons we say there is a positive rate of discount, which leads us to place a lower
present value on a given sum of money the further in the future one expects it to accrue. The
accepted method for this adjustment amounts to bringing them to a common time denominator.
This principle is called discounting.
Discounting is a technique or a process by which one can reduce future benefits and costs to
their present worth or present value. This is the method used to revalue future cost and benefits
are discounted by a factor that reflects the rate at which today's value of a monetary unit
decreases with the passage of every time unit.
Any costs and benefits of a project that are received in future periods are discounted, or deflated
by some factor, r, to reflect their lower value to the individual (society) than currently available
income. The factor used to discounted future costs and benefits is called the discount rate and is
usually expressed as a percentage. Hence, discounting is very important for project analysis. The
discount rate is usually determined by the central authorities.
Note that in order to clearly understand the principles of discounting it will be helpful to have a
clear understanding of the principle of compounding. Compounding is the technique of

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calculating the future worth (F) of a present amount (P) at the end of some period T at a given
interest rate. On the other hand finding the present worth of a future Stream of value is called
discounting. Hence, if there is an initial amount p at present, then if this investment was
borrowed from the bank at an interest rate of "r" birr then after one period it becomes:
P + Pr = P (1+r) - since the borrower must also repay the principal
After two periods the amount becomes:
P + Pr +r (p + pr)
P + Pr +Pr + pr2
P + 2Pr + pr2
P (1+ 2r +r2
P [ (1+r) (1+r)] = P (1+r)2
In general, the amount accumulated after t periods would be A = P (1+r) t
Now given that future value accumulated after t periods as above, if we want to know the present
value of this amount we would be taking about discounting. Hence the present value would be:
A amount .. accumulated at some future date
P t
  A (1 r ) t
(1 r ) (1 r )t
A. The Net present value (NPV)
The most widely used and straightforward discounted measure of project worth is the net present
value (NPV). This value is obtained when a stream of cost and benefits accruing over a period of
time are discounted to the present is called the present value of the stream. The NPV is defined
as the difference between the present value of benefits and the present value of costs. The NPV
can be obtained by discounting separately for each year, the difference of all cash outflows and
inflows accruing through out the life of project at a fixed, pre determined interstate rate.
The net present value formula is:
B0  C0 B1  C1 B2  C2 Bn  Cn n ( Bt  Ct )
NPV     . . . 
(1  r ) 0 (1  r )1 (1  r ) 2 (1  r ) n t  0 (1  r )t

Where Bt are the project benefits in period t.

Ct is the project costs in period t.
r is the appropriate financial or economic discount rate
n is the number of years for which the project will operate
The discounted rate should be equal either to the actual rate of interest on long term loans in the
capital market or to the interest rate paid by the borrower. However, since capital market do not
usually exist in developing countries, the discount rate should reflect the opportunity cost of
capital i.e. the possible return of capital invested elsewhere. This is the minimum rate of return
below which the planner considers that is does not pay for him to invest.

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The discounting period should normally be equal to the life of the project. This period is the
economic life of the project and varies from project to project.
Having set the discount rate, an investment project is deemed acceptable if the discounted net
benefits (benefits minus costs) are positive. The economic criterion of project appraisal is to
accept all projects that show positive NPV at the predetermined discount rate and reject all
projects that show Negative NPV. Thus, the decision is to accept if NPV > 0. We can also
discount benefits and costs separately, and if B>C then NPV >0.
Example: consider the following discounted cash flow for the hypothetical project in million birr.
Year Cash flow Discounted factors Discounted cash flow Discounted factor Discounted
for (10%) for 20% cash flow
10 % (20%)
0 -20 1.00 -20.0 1.00 -20.0
1 4 0.909 3.64 0.833 3.33
2 4 0.826 3.30 0.694 2.78
3 4 0.751 3.00 0.579 2.32
4 4 0.683 2.73 0.482 1.92
5 4 0.621 2.48 0.402 1.61
6 4 0.564 2.26 0.335 1.34
7 4 0.513 2.05 0.279 1.12
8 4 0.467 1.87 0.233 0.93
9 4 0.424 1.70 0.194 0.78
10 4 0.386 1.54 0.162 0.65
NPV 4.57 -3.21

Since discounting the cash flow at 10 percent produces a positive NPV of 4.57 million birr. We
conclude that the project should be under taken. Suppose now that cost of capital was to be
raised to 20 percent, the project produces a negative NPV of 3.21 million birr. In this event the
project would have to be rejected.
Decision rule for Mutually Exclusive projects
A mutually exclusive project is defined as a project of that can only be implemented at the
expense of an alternative project as they are in some sense substitutes for each other. The
decision rule for such projects is to accept the project with the highest NPV.
Example: Consider two hypothetical dams, which may be proposed for one prime site in a
locality in a fast flowing river (in million birr).
Years
Dam A 1 2 3 4 5 6 7 8 9 10
Cost 3
Benefits 0 1 1 1 1 1 0.5 1
Net benefits -3 1 1 1 1 1 0.5
NPV = 1 million

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 Years
Dam B 1 2 3 4 5 6 7 8 9 10
Cost 500
Benefits 0 100 100 100 100 100 100 100 100 100
Net benefits -500 100 100 100 100 100 100 100 100 100
NPV = 33 million
If the two projects were independent and there was no budget constraint, the country could there
fore construct both, and then it should do so as they both have positive NPVS. However, Since
the projects are mutually exclusive the dam with the higher NPV should be selected, that is dam
B.
Practical application for the present value method.
The practical application of the present value criterion as a means of evaluating investment
proposals for project planning implies the following assumptions.
a) Annual out lays and receipts from each investment are known for the entire life of the
project
b) That the project life span is known
c) That there is a rate of discount, which can be applied to every proposal and for every time
period.
However, the information required (the assumptions) made above is not always available for
every project. That means the NPV criterion may be applicable only to a limited number of
project proposals on which relevant data as indicated above could be computed or imputed.
Advantages of NPV method
Conceptually sound, the net present value selection criteria has considerable merits:
 It is simple to use and does not rely on complex conventions about where costs and
benefits are netted out.
 It is the only selection criteria that can correctly be used to choose between mutually
exclusive projects, with out further manipulation
 It takes in to account the time value of money
 The net present value of various projects, measured as they are in today's birr, can be
added. For example, the net present value of a package consisting of two projects, A and
B, will simply be the sum of the net present value of this projects individually:
NPV (A+ B)=NPV (A)+NPV (B)
Limitations of the Net present value method
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 Some projects could be deferred from implementation although they show positive NPV, due
to scarcity of funds. Thus passing the NPV test may be a necessary condition but not a
sufficient condition
 If some projects were mutually exclusive then the implementation of one would naturally
exclude the execution of the other. This will lead both the central authorities and the
sponsoring agency in to a dilemma which project should be implemented. If funds are
unlimited then both could be implemented, but this is not always the case
 The selection of an appropriate discount rate is another limitation
 It does not show the exact profitability rate of the project.
B. The Internal Rate of Return of a project (IRR)
The internal rate of return of a project is the discount rate, which makes its net present value
equal to zero. The method utilizes present value concept but seek to avoid the arbitrary choice of
a discount rate. Hence an attempt is made to find that discount rate which just makes the net
present value of the cash flow equal to zero. It is possible to think a level of interest rate that
could result in NPV of zero. This rate of interest rate is termed as the Internal rate of return
(IRR). The IRR is the rate of discount, which makes the present value of the benefits exactly
equal to the present value of the costs.
( Bt  Ct
NPV  0  
(1 r )t
For financial analysis it would be the maximum interest rate that the project could afford to pay
on its funds and still recover all its investment and operating costs. While calculating the NPV
we have used a pre determined discount rate and a table. But the calculation of the IRR amounts
to Searching for the discount rate that gives a zero NPV. This is achieved through trial and error
using the standard discounting table.
To illustrate the calculation of internal rate of return, consider the cash flows of a project:
Year Cash flow
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
The internal rate of return is the value of r, which satisfies the following equation

130
  100,000 30,000 30,000 40, 000 45,000
0    
(1 r ) 0 (1 r )1 (1 r ) 2 (1  r )3 (1 r ) 4
30,000 30,000 40, 000 45,000
100, 000    
(1  r )1 (1  r ) 2 (1  r )3 (1  r ) 4
We try different values of r till we find that the right-hand side of the above equation is equal to
100,000. Let us, to begin with, r = 12 percent.
30,000 30,000 40, 000 45,000
    107,773
(1.12)1 (1.12) 2 (1.12)3 (1.12) 4
Since this is more than 100,000, we have to try a higher value of r. (In general, a higher r lowers
the right-hand side value and a lower r increases the right-hand side value.) Let r = 14%
30,000 30,000 40, 000 45,000
    103,046
(1.14)1 (1.14) 2 (1.14)3 (1.14) 4
Since this value is higher than the target value of 100,000, we have to try a still higher value of r.
Let r = 15%
30,000 30,000 40, 000 45,000
    100,802
(1.15)1 (1.15) 2 (1.15)3 (1.15) 4
This value is a shade higher than our target value, 100,000. So we increase the value of r from
15% to 16%. The right-hand side becomes:
30,000 30,000 40, 000 45,000
    98,641
(1.16)1 (1.16) 2 (1.16)3 (1.16) 4
Since this value is now less than 100,000, we conclude the at the value of r lies between 15
percent and 16 percent
At 15 percent, the present value is 100,802
At --? Percent, the present value is 100,000
At 16 percent, the present value is 98,641
1 percent difference (between 15 percent and 16 percent) corresponds to difference of 2, 161=
(100802-98641). The difference between 100,802 (present value at 15 percent) and 100,000
(target present value) is 802. This difference will correspond to a percentage difference of:
802
x100  0.37 percnet
2161
Adding this number to 15 percent, we get the interpolated value as 15.37 percent.

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Note: If the positive and negative NPVs are close to zero, a precise and less time consuming way
to arrive at the IRR uses the following interpolation formula
Pv ( I1  I 2 )
IRR  I1 
Pv  Nv
Where: I1 = the lower discount rate
I2 = the upper discount rate
Pv=NPV (positive) at the lower discount rate of I1
NV = NPV (negative) at the higher discount rate of I2
Note: I1 and I2 should not differ by more than one or two percent.
802 (16  15) 802
IRR 15   15   15.37%
802 1359 2161
Another approximate solution to IRR is to plot the NPVs corresponding to several discount rates
to give what we call the NPV curve. The present values are plotted on the Y - axis and the
discount rates on the x-axis. A curve is then drawn to connect the various points on the graph.
The point at which the curve cuts the x-axis represents the rate at which the present value of the
investment is equal to zero.
Example: By experimenting with discount rates between 10 and 20 in our hypothetical project,
the IRR for the project is fractionally above 15%.
Decision rule for independent projects
According to the IRR Version of economic criterion we implement all projects that show an IRR
greater than the predetermined discount rate (opportunity cost of capital), i.e. accept all
independent projects having an IRR greater than the opportunity cost of capital (cut off rate). The
reference discount rate, which is also called the target rate, is predetermined by the central bank.
Once the IRR is identified, the decision rule is accept the project if the IRR is greater than the
cost of capital, say Y. Note also that:
When NPV > 0 then IRR > r
NPV = 0 then IRR = r
NPV < 0 then IRR < r
All projects with an internal rate of return greater than some target rate of return r, should be
accepted. The target rate is usually the same rate used as the financial or social discount rate
employed in the computation of the projects net present value.
The IRR and mutually Exclusive projects
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While the IRR cannot be directly used to choose between mutually exclusive projects it can be
employed for further manipulation. This manipulation entails the subtracting the cash flow of the
smaller project from the cash flow of the larger one and calculating the internal rate of return of
the residual cash flow. It the residual cash flow's internal rate of return exceeds the target
discount rate, which could only occur if the larger project has a higher NPV, then the larger
project should be under taken.
Comparison of the NPV and IRR
Form the foregoing discussions it is clear that both the NPV and the IRR methods can and do
rank investment projects in more rational manner than the other methods previously considered.
Thus it is advisable to calculate these measures so that easily understandable information is
provided to the authorities. In general it can be said that the NPV method is simpler, easier, and
more direct and more reliable.
In some situations both the NPV and the IR criteria give the same accept- reject decision.
However, there are two probable reasons why all acceptable projects cannot be under taken. One
is that inventible funds (capital funds) may be limited. The second real problem is that the
discount rate has not been set correctly.
When the capital requirements of all acceptable projects exceed the available funds, the central
authorities should raise the discount rate up to that level where the projects passing the test are
just enough to exhaust the available funds. But if too few projects are acceptable then the
discount rate should be reduced. Hence as long as capital funds are "unlimited" it is argued that
NPV should be the relevant criterion. But the function of the discount rate is to ration capital in
such a manner, as eventually to pass just sufficient projects as well use up available investment
resources. Hence the argument is not whether NPV or IRR should be preferred as a criterion, but
whether planners have set the discount rate correctly.
The IRR and NPV might suggest different projects for similar level of discount rate.
Example: cash flows for a hypothetical project.
Cash flows
Year Project A Project B Project C
0 -20 -40 -20
1 4 8 14
2 4 8 14
3 4 8 -
4 4 8 -

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 5 4 8 -
6 4 8 -
7 4 8 -
8 4 8 -
9 4 8 -
10 4 8 -
NPV at 10% 4.57 6.08 4.36
IRR 15.1% 13.7% 25.8%
As it can be observed from the table above the three projects by their NPVs (at 10% discount rate)
results in project B heading the list, while ranking them according to their IRRs would lead the
planners to prefer C. 25.8% is better because a project with 25.8% economic rate of return is
likely to a better investment than with a project with 15% economic rate of return. That is, it
contributes more to the national income relative to the resources used.
There are two possible reasons for not to undertake all the above projects.
The first is there may not be enough capital funds the second problem is related to the fact that
two or more projects could be mutually exclusive. If there is enough budget resources, both NPV
and IRR give the same accept-reject decision. However, ranking the projects using the two
methods will lead to the choice of different projects: project B on NPV basis and project C on the
IRR basis.
Note however, that 10% is not an appropriate discount rate because it passes all the three projects
more than can be accommodate by the given capital. Hence we have to set the discount rate
correctly up to the level where the project passing the test are just enough to exhaust the
available funds as shown below.
Project A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39
In general if funds are unlimited and the projects are not mutually excusive, the NPV is the
relevant criteria. All projects with positive NPV should go a head. But, the function of the
discount rate is to ration capital in such a way that eventually to pass just sufficient projects that
will exhaustively use up available inevitable funds. Thus, the important question is not whether
NPV or IRR is to be preferred, but whether planners have set the discount rate correctly or not.
Example:
Assume that the total investment budget is birr 80 million. The projects above are all projects in
the economy. In this case planners can implement all projects. If the budget is birr 40 million
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however can implement all projects. If the budget is birr 40 million however, the planner has to
make the choice of carrying B alone or A and C together. Since the combine NPV of A and C is
larger B is the least choice at 10 discount rate.
Advantages of the IRR
1. The IRR is used in many projects
2. It is the only measure of project worth that takes account of the time profile of a project but
can be calculated with out reference to a predetermined discount rare.
3. It is a measure that could be understood by non-economists since it is closely related to the
concept of the return on investment
4. It is a pure number and hence allows projects of different size to be directly compared.

Problems with the IRR

1. The IRR is inappropriate to use for mutually exclusive projects and independent projects
when there is a single period budget constraint.
2. A project must have at least one negative cash flow period before it is possible to calculate its
internal rate of return. This is because the NPV will always be positive to matter how high
the discount rate used to discount it, unless the project has at least one negative cash flow
period.
3. Certain cash flows can generate NPV = 0 at two different discount rates. If a project has more
than one IRR, then neither can be reliably used and another decision rule such as the NPV
must be used rather than the IRR.

. The following cash flows generates NPV = 0 at both (-50% & 15.2%)
Co C1 C2 C3 C4 C5 C6
-1000 + 800 + 150 + 150 + 150 + 150 - 150
C. The Net Benefit Investment Ration (NBIR)
It is the ratio of the present value of the projects benefits, net of operating costs, to the present
value of its investment costs. This is given by,
n
( Bt  OCt
NBIR 
t
  0 (! r )
t

ICt
 (1 r ) t

135
Where OC is operating costs in period t; IC is investment costs in period t; r the appropriate
discount rate, and B the benefits in period t. The NBIR shows the value of the projects
discounted benefits, net of operating costs, per unit of investment.
The decision rule using NBIR is to accept the project if its value is greater than 1. This criterion
is especially important for ranking investments that shows the benefit per unit of investment.
When we have a single period budget constraint projects with the highest NBIR should be
selected up to the point where the budget exhausted.
The main advantage of the NBIR is its capacity to determine the group of priority projects if
there is a single period budget and investment constraint. Its limitation is how ever, that it is not
suitable for choosing between mutually exclusive projects, for the same reason that the IRR
cannot be used for this purpose. That is a project with highest NBIR could have the lowest
absolute net present value. The other disadvantage of NBIR is that the convention used for
dividing costs in to operating and investment may vary from institution to institution and may
render problems of comparability.
D. The Domestic Resource cost Ratio (DRCR)
In its simple form the DRCR is an discounted measure of project worth calculated for a single
typical year of project operation. It is given as
n
(Ct1  Bt 1)

t  0 (1  r )
t
(birr )
DRCR  n
Ct f  Bt f )

t 0 (1  r )t

Where Bt1 are the benefits of the project obtained in local currency
Ct1 are the costs of the project incurred in local currency
Btf are the benefits of the project obtained in foreign exchange
Ctf are the costs of the project incurred in foreign exchange.
The decision rule for DRCR
When undertaking a financial appraisal a project should be accepted if its DRCR is less than or
equal to the official exchange rate, OER. This means a project should proceed if it uses less
domestic resources, measured in local prices, to earn 1 unit of foreign exchange than is the norm
for the whole economy (the norm here being represented by the official exchange rate.) The
modified DRCE (Modified because it is discounted which traditionally was not the case) is some
times referred as the internal exchange rate approach to emphasize the fact that the computation
of DRCR is independent of any predetermined exchange rate as that of IRR, which do not
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immediately, require a discount rate. It produces own internal exchange rate, which is internal to
the project.
Example. Estimation of the domestic resource costs ratio, special economic zone project -foreign
exchange component (denominator) million us dollar.
Year
1 2 3 4 5 6 7 30
Local costs
Investment 40 60 30 10
Production 0 50 75 90 100 100 100 100
Total local costs 40 110 105 100 100 100 100 100
Local Sales 0 0 20 25 25 25 25 25
Net local costs 40 110 85 75 75 75 75 75
PV of net local costs Birr 711.6
Year
1 2 3 4 5 6 7 30
Foreign exchanger earnings
Exported output 0 3 20 30 30 30 30 30
Foreign exchange costs 2
Imported investment goods 20 40 12 8 10 10 10 10
Other imported items 0 5 7
Net foreign exchange earnings -20 -42 1 20 20 20 20 20
(expert-imports)
PV of net foreign exchange Us $ 86.7
earnings

DRCR = Pv net local costs / PV of net foreign earnings = Birr 711.6 / US $ 86.7 = 8.21 birr per
US $
The main advantage of this approach is that non-economists can readily understand its decision
rule. More substantially in economics with serious balance of payment problem the DRCR
clearly show the potential of a project to earn foreign exchange. However, its disadvantages
includes, like that of IRR it cannot be used to rank projects. It cannot also be used to choose
between mutually exclusive projects if both use less domestic resource to earn a unit of foreign
exchange. This is because it does not show which of the two, or more, mutually exclusive
projects will generate the greatest net benefits for the country.
E. The Benefit cost Ration (BCR)
The BCR is defined as the ratio of the sum of the project's discounted benefits to the sum of its
discounted investment and operating costs. This is given as

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 n
Bt
 (1  r )
t 0
t
BCR  n
Ct
 (1  r )
t 0
t

The Decision rule for BCR

A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its discounted benefits
exceed its discounted cost)
2.7.Sensitivity analysis
Sensitivity analysis shows how the value of the efficiency criterion Net present value, Net
national value added or any other criterion changes with variations in the value of any variable
(sales volume, selling price per unit,cost per unit etc).
It may be expressed as the absolute change in the efficiency criterion divided by a given
percentage or absolute change in a variable or set of variables. Thus, one may say cutting in half
the selling price of the output will make the value added zero. If the value added is sensitive to
the variables, the project is sensitive to uncertainties and special care should be devoted to
making precise estimates, particularly of those variables the estimated values of which may
contain significant errors.
Sensitivity analysis may be used in early stages of project preparation to identify the variables in
the estimation of which special care should be taken. In practice it is not necessary to analyze the
variations of all possible variables. It is sufficient to confine the analysis to the key variables
affecting the project the most, are expected to vary considerably below or above the most likely
magnitude. If value added is insensitive to the value of a particular input or output, the project is
said to be insensitive to uncertainties and there is little point in trying to estimate this variable
with great precision. Sensitivity analysis provides a better understanding of which variable is in
fact crucial to the project's appraisal. Such analysis will also be helpful for those in charge of
managing the project later. It will indicate critical areas requiring close managerial attention in
order to ensure the commercial success of a project.

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 Chapter Three: Economic Analysis of Projects

3.1 An overview of economic analysis

In financial analysis, the analyst is concerned with the profitability of the project from an
individual point of view (firm’s profitability). The main objective here is to maximize the
income of the firm or to analyze the budgetary impacts. In financial analysis the analysis is done
by applying market prices. Given the prevailing market prices the financial analysis will tell the
project analyst whether a project will be financially profitable.

Thus, governments and individuals can pursue only limited objectives when they choose projects
on the basis of financial appraisal. From the standpoint of the economy as a whole, however, the
objective is to maximize national income no matter who receives it. But financial analysis will
rarely measure a project’s contribution to the community’s welfare. Only in very unlikely
conditions of perfect competition and absence of externalities, government interventions, taxes
and other market distortions, will financial analysis of a project indicate whether or not a project
will make a positive contribution to society’s welfare. In the absence of these conditions, a
financial analysis will only tell us whether a project is profitable or not. Thus the project analyst
must not only be sure that a proposed project will be profitable enough to attract investment but
also that the project will contribute sufficiently to the growth of national income. Making that
assessment is the task of economic analysis.

What is the starting point for this analysis? The starting point for the economic analysis would be
the financial prices. They are adjusted as needed to reflect the value to the society as a whole of
both the inputs and outputs of the project.

The objective of any legitimate government should be the promotion of social/community/

welfare. They will be more concerned with their public work programs to promote community
welfare than they merely maximize financial profits at distorted local prices.

The basic question here is whether it is possible to use market prices to assess the economic
worth of projects. The answer is obviously no. Prices could be distorted because of many factors.
So governments must choose projects on the basis of an economic analysis if they wish to
promote the community’s welfare.

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It is useful to have a fuller understanding of the areas where government intervention and market
failure result in serious distortion in market prices. This will help in understanding the process of
correcting for these distortions when economic prices are used.

The major conditions under which it is impossible to use market prices to assess the economic
worth of projects can be grouped under the following major headings:

1. Intervention in and failures of goods markets including the markets for internationally
traded goods.
2. Intervention in and failure of factor markets including the market for labor, capital, and
foreign exchange.
3. The existence of externalities, public goods and consumer and producers surplus.
4. Imperfect knowledge, which the neoclassical model assumes that consumers and
producers have full knowledge of about all aspects of the economy relevant to their
choice of operations. This is unrealistic because of poor transport and communication and
low education levels.

Social Cost Benefit Analysis/Economic analysis is done because of the following reasons:

1. Inflation: When high degree of inflation prevails in any economy, the project's inputs
and outputs do not reflect their real value.

 Therefore, the price of these inputs and outputs should be adjusted

2. Currency over valuation: when the foreign currency is over valued (eg, dollar), it does
not reflect the situation prevailed in the market

3. Existence of income/wealth inequality: due to this inequality price may not reflect the
social equalities. As a result project analysts shift to apply social pricing techniques (that
is shadow pricing techniques).

4. Externalities: are costs and benefits to the economy as a whole. Since they are not paid
for by a particular firm, financial analysts ignore them. But someone has covered their
cost (government), thus their value should be included in the economic pricing technique.

5. Existence of tariffs, customs and duties: existence of these restrictions and impositions
by the government may increase the price of commodities.

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 6. This cost needs to be excluded in the economic analysis because it does not reflect the
commitment of real resources.

7. Existence of under employment: Unskilled and semi-skilled labor market is highly

affected because workers are paid less and

8. the payment of employees not the same for all doing the same job. Therefore, for
economic analysis purpose this distortion should be adjusted.

9. The existence of the above mentioned factors demands economic analysis so that the
value of inputs and outputs of a project can reflect its real value.

Common features of Financial and Economic Analysis

The economic analysis of a project has many features in common with a financial analysis.

1. Both involve the estimation of a project’s cost and benefits over the life of the project for
inclusion in the project’s cash flow.
2. In both the cash flow is discounted to determine the project’s net present value, or other
measures of project worth

Both may also use sensitivity or probability analysis to assess the impact of uncertainty on the
project’s NPV.
Distinction Between Financial and Economic Analysis

Financial analysis looks at the project from the perspective of the implementing agency. It
identifies the project's net money flows to the implementing entity and assesses the entity's
ability to meet its financial obligations and to finance future investments. Economic analysis, by
contrast, looks at a project from the perspective of the entire country, or society, and measures
the effects of the project on the economy as a whole. These different points of view require that
analysts take different items into consideration when looking at the costs of a project, use
different valuations for the items considered, and in some cases, even use different rates to
discount the streams of costs and benefits.

Financial analysis assesses items that entail monetary outlays. Economic analysis assesses the
opportunity costs for the country. Just because the project entity does not pay for the use of a
resource, does not mean that the resource is a free good. If a project diverts resources from other
activities that produce goods or services, the value of what is given up represents an opportunity

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cost of the project to society. Many projects involve economic costs that do not necessarily
involve a corresponding money flow from the project's financial account.

For example, an adverse environmental effect not reflected in the project accounts may represent
major economic costs. Likewise, a money payment made by the project entity--say the payment
of a tax--is a financial but not an economic cost. It does not involve the use of resources, only a
transfer from the project entity to the government.

Finally, some inputs—say the services of volunteer workers--may be donated, entailing no

money flows from the project entity. Analysts must also consider such inputs in estimating the
economic cost of projects.

Another important difference between financial and economic analysis concerns the prices the
project entity uses to value the inputs and outputs. Financial analysis is based on the actual prices
that the project entity pays for inputs and receives for outputs. The prices used for economic
analysis are based on the opportunity costs to the country.

The economic values of both inputs and outputs differ from their financial values because of
market distortions created either by the government or by the private sector. Tariffs, export taxes,
and subsidies; excise and sales taxes; production subsidies; and quantitative restrictions are
common distortions created by governments. Monopolies are a market phenomenon that can
either be created by government or the private sector. Some market distortions are created by the
public nature of the good or service. The values to society of common public services, such as
clean water, transportation, road services, and electricity, are often significantly greater than the
financial prices people are required to pay for them. Such factors create divergence between the
financial and the economic prices of a project.

But an economic analysis goes beyond a financial analysis appraisal, as it will also involve
adjustments and incorporating of imputed items. Economic analysis is an iterative process that
normally begins with a "with out the project" situation, which is the baseline against which
all alternatives are compared.Through a process of successive approximations, the analyst
defines alternatives, drops poor project components, includes new components, examines the
alternatives from financial and economic points of view, compares them with the baseline and
with each other, and modifies them until a suitable and optimal project design emerges. The

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comparison finally sheds light on the size and incidence of the environmental externalities
that can be evaluated in monetary terms.

Table 3.1: difference between economic and financial analysis

Factors Financial Economic

Analysis Analysis
Pricing of inputs Domestic market Shadow prices
price
Treatment of transfer All included Excluded
payments, tax, subsidy, etc
Externalities Excluded Included

3.2.Shadow Prices and Conversion Factors

 Observed prices (used in the financial analysis) may not necessarily reflect the true
economic value of inputs and outputs.
 This may occur where:
 Prices of inputs and outputs are distorted because of inefficient markets; and
 Governments impose tariffs that are non-reflective of costs.
For example, for illustrative purposes let us assume that there is only one cement manufacturer in
a country.
 Let us also assume no price regulation in this sector.
 Let us also assume a scenario whereby the producer is able to set the price of cement at
20% higher than world markets and transport cost.
 In economic appraisal the ‘true’ cost of this production input (i.e. cement) should be
reduced by 20%.
 In practice, estimating these types of distortions is difficult and in general the market
price should be taken as the economic price.

For Which Items to Have Shadow Prices used in Economic analysis?

The inputs and outputs for which one has to have shadow prices can be categorized into five
categories, at least according to the “National Economic Parameters and Conversion Factors for
Ethiopia, Ministry of Economic Development and Finance, 1998”..

1. Primary factors. There are different categories of labour, land, natural resources,
domestic resources and foreign exchange. Land and natural resources are usually valued

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 indirectly through estimation of their productivity in their alternative uses rather than as
capital values. This is normally done through taking the ‘with-out project situation’ rather
than through adjustment of prices. For this reason there is no national parameter
calculated for land.
2. Tradable goods(alternatively referred to as traded goods): This is undertaken when there
is a significant difference between the border price and the local market price and/or
where the item concerned is likely to feature prominently as an input or an output for a
number of projects.
3. Non-tradable goods(alternatively referred to as non-traded). Where there may be a
significant difference between the local market price and the economic value and/or
where the item concerned is likely to feature prominently as an input or an output for a
number of projects.
4. Average Estimates relating to particular sectors: here cost data do not allow further
breakdown or where the sector concerned is not a high priority for further investigation.
Important average is the standard conversion factors.
5. The Discount rate– the rate at which the future streams of costs and benefits are brought
into common denominator, the present values.
3.2 Identification costs and benefits of economic analysis
Identifying costs and benefits is the firstand most important step in economic analysis. Often
project costs and benefits are difficult to identify and measure, especially if the project generates
side effects that are not reflected in the financial analysis, such as air or water pollution. A
secondimportant step is to quantify them. The final step is to value them in monetary terms.

The major steps in economic analysis can be summarized as:

1. Identification of cost and benefit items that need to be incorporated in economic analysis;
This involves the inclusion of some variables and exclusion of others from the economic
accounts.
2. Quantify both the cost and benefit items;
3. Revalue the cost and benefit items; i.e. what prices to use?

The projected financial revenues and costs are often a good starting point for identifying
economic benefits and costs, but two types of adjustments are necessary.

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  First, we need to include or exclude some costs and benefits.
 Second, we need to revalue inputs and outputs at their economic opportunity costs.

3.2.1 Sunk cost

For both financial and economic analysis, the past is the past. What matters are future costs and
future benefits? Costs incurred in the past are sunk costs that cannot be avoided. When analyzing
a proposed project, sunk costs are ignored. Economic and financial analyses consider only future
returns to future costs.

Ignoring sunk costs sometimes leads to seemingly paradoxical, but correct, results. If a
considerable amount has already been spent on a project, the future returns to the costs of
completing the project may be extremely high, even if the project should never have been
undertaken. As a ridiculous extreme, consider a bridge that needs only one dollar to be
completed in order to realize any benefits. The returns to the last dollar may be extremely high,
and the bridge should be completed even if the expected traffic is too low to justify the
investment and the bridge should never have been built in the first place. However, arguing that a
project must be completed just because much has already been spent on it is not valid. To save
resources, it is preferable to stop a project midway whenever theexpected future costs exceed the
expected future benefits.

On the other hand, although stopping a partially completed project may be more economical than
finishing it, closing a project is often costly. For example, one may have to cancel partially
completed contracts, and lenders may levy a penalty. Such costs have to be taken into account in
deciding whether or not to close the project. Similarly, the cash flow of a project should show
some liquidation value at the end of the project. This liquidation value should be counted as a
benefit. Sometimes, to focus attention on the years for which the information is more reliable, we
use the estimated liquidation value of a project as of a certain year.

3.2.2 Transfer payments, externalities and others

Transfer payments (-) :In general terms, analysts need to remove all subsidies and taxes from
the financial flows. The analyst must eliminate (deduct) transfer payments within the economy
from theproject’s cash flow.In other words the transfer is made without any exchange of goods
and services. Exclude it from economic analysis. Transfer paymentsare considered to non-
exhaustive because they do not directly absorb resources or create output. Examples:

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 Taxes-Personal and company income taxes, VAT, indirect taxes, excise and stamp duties.
 Subsidies ---- Including those given via price support schemes.
 Tariffs on imports and exports subsidies and taxes .
 Producer surplus - gains received by a supplier
 Credit transactions - loans received and repayment of Interest and principal

 EX– welfare(financial aid), social security, and subsides

Externalities (±) :A project may have a negative or positive impact on specific groups in society
without the project entity incurring a corresponding monetary cost or enjoying a monetary
benefit.For example, an irrigation project may lead to a reduced fish catch.Once the financial and
economic flows have been correctly identified, analysts need to adjust the prices to reflect
economic opportunity costs.

The main price adjustments include

 Using borderprices for all tradable goods and services and

 a shadow ex-change rate to convert foreign to domesticcurrency.

If non-tradables are a sizable part of project costs, their prices should be adjusted to
reflectopportunity costs to society. Labor is one of the most important non-tradables. It is
suggested thatanalysts use sensitivity analysis to determine whether the project's NPV turns
negative when using anupper boundary for the shadow price of labor, which is usually the
market price. If the NPV is positive,then you do not need further analysis. Information about the
sources of divergence between border andmarket prices and between shadow and market
exchange rates helps identify the groups that benefitfrom, and pay for, the differences.

For transport, health, and education projects, analysts usually needto use indirect measures of the
value of these goods and services. The final price adjustments affect non-tradables. In many
cases, especially in health and educationprojects, volunteer labor is an important component. To
assess project costs and sustainability correctly, such contributions need to be priced at their
opportunity costs.

Example: enterprises will pay workers the market wages and not in real Birr (not shadow ones)
irrespective of what is believed to be their opportunity cost from the economy’s viewpoint.
Similarly, the enterprise will collect for its exports the equivalent of local currency calculated at
the official exchange rate, even when the foreign currency is undervalued. Note that the
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estimation process should include the valuation and inclusion of any un-priced outputsor
inputs such as public goods or social services.Stakeholders analysis/Income distribution/:
Then the analyst needs to identify gainers and losers, and undertake a risk analysis.

The sources of divergence between economic and financial prices and economic and financial
flows convey extremely useful information that enables analysts to address three important
issues:

By identifying the groups that enjoy the benefits and pay for the costs of the project, this
comparison shows the impact of the project on the main stakeholders and gives an indication of
its sustainability. In particular, because taxes and subsidies are usually important sources of
difference, this step essentially assesses the project's fiscal impact.

3.3 Determining economic values

As indicated in our previous discussion, Markets are distorted for social, political, historical, and
economical reasons consequently the signals they give in the form of prevailing prices are also
distorted and do not reflect marginal productivities and marginal utilities. Divergence between
economic and market prices could be due to market failure, government interventions,
externalities, public goods and distributional considerations. Hence serious distortions exist in
the market for labor, capital and foreign exchange and efforts are necessary to replace the signals
from these markets by more appropriate measures.
Economic pricing involves making adjustments to market prices to correct for distortions and
then the adjusted price should then reflect the true opportunity cost of an input or people's
willingness to pay for it.
Under this section you will be introduced about the Shadow pricing, traded and non-traded
commodities, border parity pricing, national parameters and standard conversion factors. After
studying this section you will be able to achieve the following objectives.
3.3.1 Adjustment for transfer payments
The fires step in adjusting financial prices to economic values is to estimate direct
transferpayment. Direct transfer payments are payments that represent only the transfer of
claims toreal resources from one person in the society to another, not the use of real
resources. The most common transfer payments are taxes, direct subsidies, and credit
transactions that include (normally) loan receipts, repayments of principals, and interest

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payments. All these entries should be taken out before the financial accounts are adjusted to
reflect economic values.
3.3.2 Shadow pricing
Market prices represent shadow prices only under conditions of perfect competition, which
are almost invariably not fulfilled in developing shadow prices. Hence, there is a need for
developing shadow prices and measuring net economic benefits of goods/services in terms
of these prices to guide the allocation of resources.
The term shadow prices or accounting prices refers to a price that has been calculated with a
certain objectives in mind, such as maximizing economic growth, improving the BOP, and
enhancing employment opportunities consistent with the existing development policies and
resource endowment. The shadow price of goods and services is thus a measure of its value
to the economy as a whole in terms of the above objectives. It is also a set of prices that are
believed to reflect better the opportunity costi.e. the value in their next best alternative use
of different goods and services. These prices are used instead of domestic market prices in
guiding the allocation of resources for the latter does not reflect the opportunity cost and
therefore using market prices would lead to resource misallocation. The role of shadow
prices is thus to guide efficient resource allocation to achieve improved economic efficiency
and it ends there.
Rationale: Market prices in developing countries are generally often unreliable of the real
worth of goods and services bought and sold in the market. Markets in most countries
andparticularly those of developing countries, often do not function in such a way that the
pricesand opportunity costs are the same. As a result, operation of the market mechanism
does not lead to optimal allocation of scarce resources. A difference between market prices
andopportunity cost occurs particularly in labour markets because of statutory minimum
wages, trade union pressure, and imperfect information in markets for capital and foreign
exchange. Therefore, in order to arrive at the economic values of these inputs it is necessary
to adjust the prices to take into account of market imperfections1. This suggests the need to
developing efficiency shadow prices and measuring net economic benefits of goods/services
in terms of these prices to guide the allocation of resources.
Efficiency or Economic Shadow prices
As it is discussed, market prices are inappropriate in project selection, the question arises how
the necessary accounting prices should be estimated. Thus the economic analysis of projects
requires that inputs and outputs be valued at their contribution to the national economy, through
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efficiency or Shadow prices. From the national economic point of view it is the alternative
production foregone or the cost of alternative supplies that should be used to value project inputs
and outputs. An economic or shadow price reflects the increase in welfare resulting from one
more unit of an output or input being available.
Definition of shadow (accounting) prices
Accounting or shadow prices are simply a set of prices that are believed to better reflect the
opportunity cost i.e. the cost in their best use of goods and services. It is the value of Used in
economic analysis for a cost or benefit in a project when the market price is left to be a poor
estimate of economic value.
Efficiency shadow prices are border prices determined by international trade. The basic
assumption here is that international market is less distorted than the domestic market and thus
taking international price is more realistic to value the true cost of goods and services.
Shadow price estimates can be made at two levels:
 Economic analysis
 Social analysis
In economic analysis resource efficiency is considered. In social analysis growth and income
distribution objectives are pursued.
3.3.3 Traded and Non-Traded commodities
As we have discussed market prices are inappropriate in project selection and the question that
arises would be how the necessary accounting (shadow) prices should be estimated. The
valuation of goods and services depends on whether the good can be traded in international
market or whether it is consumed locally such as in a closed economy.
Non-Traded Goods
The non-traded goods are goods that do not enter into the international trade because of their
nature or physical characteristics. So the non-traded inputs and outputs of a project cannot be
valued directly at border or world prices. When goods do not enter in to trade by their very
nature decomposing is a pre requisite to their valuation in terms of would prices. For some non-
traded goods no reference border prices are available. Example: Teff. For other commodities the
local supply price is below the CIF (Cost, insurance and Freight) price of potential imports but
above the FOB (Free on board price) of potential exports. In both cases the non-traded inputs and
outputs of the project cannot be valued directly at border or world prices. So the valuation of
non-traded goods at world prices consists of a number of steps.
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(a) Net out taxes from the domestic market price of the commodity
(b) The net of taxes price is decomposed in to its traded and non-traded cost elements. For the
traded components a border price is available by definition and they are valued at this price. The
non-traded items are further decomposed into traded and non traded and the procedure continues
until in successive rounds the original inputs or outputs is developed in to traded components and
labor.
Example: consider the production of electricity from coal. Major cost elements are coal,
transport of coal to its site; transmission costs wages and salaries, etc.If the out put of a project is
a non-traded good for which border prices are however, known and if its domestic supply price is
below CIF but above the FOB, a convenient approximation is to value it at the average of the
two.
Traded Goods
Traded goods are defined as goods and services whose use or production causes a change in the
country's net import or export position. Traded goods produced or used by a project do not
actually need to be imported or exported themselves, but must be capable of being imported or
exported.Traded goods are either exportable or importable goods or Services. Exportable goods
are those whose domestic cost of production is below the FOB export price that local producers
can earn for the good on the international market.
3.3.4 Valuation of Traded and Non-traded commodities
3.3.4.1 Valuation of Tradable commodities
The economic benefits of producing tradable outputs and costs of using tradable inputs are
measured by the border price of these inputs and outputs. An importable border price is its CIF
import price - its price landed in the importing country before the effects of any tariffs or
quantitative restrictions have been added to its price. The landed cost of an import on the dock or
other entry point in the receiving country includes the cost of international freight and insurance
and often includes the cost of unloading on to the dock. But this excludes any changes after the
import touches the dock and excludes all domestic tariffs and other taxes or fees. The CIF price
represents the direct foreign exchange cost of the input up to the port or the border.
Similarly an exportable good should be valued at a border price or FOB export price. The FOB
price is the price that would be earned by the exporter after paying any costs to get the good to
the border, but before any export subsidies or taxes were imposed. The border price (FOB price)

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should be netted from handling, transportation and marketing expenses to arrive at the project
site place. The FOB border price is the actual foreign exchange earned from exporting the export
price minus any marketing margins and transport costs to get the good from the project site to the
border.
3.4 Border parity pricing
World prices are normally measured as border prices reflecting the value of a traded good at the
border or port of entry of a country. Border price is the unit price of a traded good at a country's
border (FOB for exports and CIF for imports.) However, values in project financial statements
will normally be at prices received by the project -ex - factory or farm gate prices or paid by the
project for inputs. To move from market to shadow price analysis, therefore, shadow prices must
in terms of prices to the project. This means that for traded goods domestic margins, relating to
transport and distribution (including port handling) will have to be added to prices at the border
to obtain values at the project level.
The decomposition of these margins is referred to as border parity pricing. A parity price or
parity economic value is the price or value of a project input that is based on a border price
adjusted for expenses between border and the project boundary.
To assess the full economic values of a traded good in a world price system requires both its
foreign exchange worth at the border, plus the value at world price of the non-traded activities of
transportation and distribution required per unit of output. Thus for goods that are traded directly
by a project the border parity price for the project out put is the FOB price minus the value of
transport and distribution. These later costs must be deducted since real resources are required
before the good can be exported.
Similarly where a project imports an input its border parity price is the CIF price plus transport
and distribution costs. If the project does not actually import or export the goods concerned but
produces that save imports (import substitutes) and uses domestic goods that could have been
exported (exportable) or could have been imported (importable) the adjustment is less straight
for word.
3.5 National parameters and standard conversion factors
3.5.1 Conversion factors
As has been stated that all project inputs and out puts should be valued at the world prices, which
are the border prices. World prices are used to measure the opportunity cost to the economy of
goods and services, which can be bought and sold on the international market. This means the

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world price reflect the terms on which it can buy and sell on the world market. However, in
practice there are significant number of commodities for which there will be no direct world
price to use as a measure of economic value. (Example Teff) of non-traded goods.
Thus some world price equivalent figure need to be derived for these non traded goods. To
estimate the efficiency (accounting prices) for all other non-traded gods, (inputs and outputs) we
use conversion factors
A conversion factor is defined as the factor by which we multiply the actual price in the domestic
market of an input or out put to arrive at its accounting price when the latter cannot be observed
or estimated directly. The more then inputs and out puts are traded the less will be the need to
use conversion factors. The conversion factor is simply the ration of the shadow price of the item
to its market prices. A conversion factor is estimated simply by taking the ratio of border prices
(world prices) to domestic market prices of the good.
National parameters:
There are some important parameters that have general applicability in the sense that they are
used in all projects. These parameters should take the same value in all projects although they
can change from time to time. In other words such parameters are national in that they apply to
all projects regardless of their sector, and they are economic because they reflect the shadow
price of the items concerned. A typical list of national economic parameters covers conversion
factors for:
 Unskilled and skilled labor
 Some of the main non-traded sectors
 Some aggregate conversion factors such as consumption conversion factor, a standard
average conversion factor, the discount rate, etc.
A project analyst can apply these parameters directly to the project under analysis. They are
called national parameters to distinguish them from the project specific shadow prices. They are
estimated by the central planners a dare taken as given by the project analyst. How many
parameters should be estimated depends upon the economic conditions of the country and the
degree of sophistication desired in project analysis. However, a minimum of three or four
national parameters should be estimated:
 The standard conversion factor
 The shadow wage rate

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  The discount rate and
 The shadow exchange rate
3.5.2 The standard conversion factor
This is an all - inclusive conversion factor used in place of commodity - or sector specific
conversion factors, either because they can not be estimated accurately, or because we believe
that they can not be estimated accurately or because they do not differ substantially from the
standard conversion factor. It is a summary measure to calculate accounting prices for non traded
commodities.
In the case of Ethiopia the standard conversion factor is interpreted as a summary and
approximate quantification of the distorted markets (domestic) as compared to the international
market. It is therefore estimated as the ratio of the value of imports and exports of a country at
border prices (CIF and FOB) to their value at domestic prices.
The formula for computing the standard conversion factor is given as:
MX
ScF 
( M  Tm  Sm)  ( X  Sx _ Tx )
Where = M and X are total imports and exports respectively at world prices converted at the
official exchange rate.
= Tm and Tx are the total trade taxes on imports and exports respectively.
= Sm and Sx are total trade subsidies on imports and exports respectively.
All values should refer to the same year or to an average over the same period. The SCF is a
summary measure to calculate accounting prices for non traded goods. This is achieved by
multiplying the net of taxes domestic prices of one commodity by the SCF.
Thus every effort must be made to decompose the, non-traded goods in to traded and non-traded
elements and apply the SCF only to the latter. The rule for the non-traded goods should be still
decomposition and the SCF should be used only when this is impossible, very difficult or is not
worth the effort. The SCF is revised from time to time by the central economic authorities and
adopted by planning bodies.
To summarize, although in general it is recommended that a different accounting price be
estimated for different non-traded goods. It is useful to have available a standard conversion
factor that can be used for non-traded goods which remain after one or two rounds of
decomposition. For this purpose, the ratio of the value of border prices of all exports and imports
to their value at domestic prices might be used. SCF / OER  1/ SER.
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 3.5.3 The Economic valuation of foreign Exchange:

As we have discussed in our previous Sections, border prices are used to value the economic
benefits and the cost of project's tradable inputs and outputs. In project appraisal the foreign
exchange earnings and costs are usually converted in to local currency so that they can be
included in the project's cash flow with its non-traded inputs and outputs. The OER (official
exchange rate) would be applied on the border price of exported commodities, X (fob price) and
to that of each of the imported inputs, M (C.i.f) to value of them domestically. This is so because
in very few countries in the world there is little or no gov't intervention and few imperfections in
the country's traded goods and foreign exchange markets. However, there are many distortions in
the market for foreign exchange and traded goods.

There are many distortions in the market for foreign exchange and traded goods.
(a) The market for foreign exchange may be strictly controlled and it may only be possible to
purchase foreign exchange for permitted purposes. These controls may be imposed because the
fixed official exchange rate is over valued. Which results in the demand for foreign exchange
greatly exceeding supply
(b) A currency is over valued if the official exchange rate understates the amount of domestic
currency that residents of the country would be willing to pay for a unit of foreign currency if
they could freely spend it on duty free goods -goods sold at their border prices. Trade distortions
such as import tariffs and quotas; result in a country's currency being over valued. After studying
this unit you will achieve the following objectives.
 Understand and explain the premium on foreign exchange
 Explain shadow exchange rate
 Describe foreign exchange premium and valuation of traded goods.
1. The Foreign Exchange Premium

In the official exchange rate, OER, expressed in terms of units of local currency needed to buy
one unit of foreign exchange is fixed below their equilibrium level it is said to be over valued.
This means that an unrealistically high value is placed on the local currency in terms of how
much foreign exchange can be bought with a unit of currency. Countries that have an over
valued exchange rate or to have a foreign exchange premium (FEP). A FEP measures the extent
to which the OER under states the true amount of local currency that residents would be willing
to pay for a unit of foreign exchange, or its true opportunity cost to the economy. It is defined as
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the proportion by which the OER overstates the real value of local currency or of non-traded
goods and services relative to traded goods and services. It is used to calculate the shadow
exchange rate and the standard conversion factor for economic analysis.
The FEP can be measured by the ratio of the value of total trade, imports plus exports, values in
domestic prices and there fore including the effect of tariffs and other distortions, to the value of
trade in border prices, minus one, as given below.
 M (1 t )  X (1  d  s ) 
FEP     x 100 percent
 Mx 
Where: t = tariffs, or tariff equivalents of non - tariff barriers, imposed on imports.
d = are the export tax equivalent on any restrains and taxes imposed on exports
s = are the export subsidy equivalent to any support given to encourage exports
M = is the value of imports in border prices, C. i.f
X = is the value of exports in border prices, fob.
The numerator measures the total amount in local currency that residents are actually paying to
consume imports (including tariffs and taxes) plus the amount they are actually accepting for
exports (excluding export taxes and including export subsidies). It there fore measures the true
values placed on traded goods produced and consumed in the country.
The denominator shows the actual foreign exchange value of these traded goods. They are
measured at their border prices, converted in local currency at the OER. The ratio of the
domestic value to the border price value, there fore, shows the true value on traded goods,
relative to apparent economic values at the official exchange rate. FEP is usually expressed as %
(that is why we subtract 1 and multiply it by 100). The result show the extra % that consumers
are willing to pay over and above the OER if we were able to buy currency freely and spent it on
duty free goods.
If both traded and non-traded commodities are used or produced in a project, they need to be
valued in comparable prices before they can be used together in net cash flow of a project.
2. The Shadow Exchange Rate

One way to correct for an over valued exchange rate in project appraisal is to use a shadow
exchange rate, rather than the official exchange rate to value all foreign exchange earned and
used by the project.

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The SER is that rate of exchange which accurately reflects the consumption worth of an extra
dollar (or other convertible foreign currencies) in terms of one's own currency. Thus the SER is
the shadow price of foreign exchange and reflects the foreign exchange premium. Thus one-way
to adjust for the over valuation of local currency is to increase the OER by the foreign exchange
premium to obtain a shadow exchange rate. In order to make it more clear, see the following
example. Example: If consumers in an economy would be willing to pay 20 percent more than
the OER to obtain foreign goods, then the foreign exchange premium is 20 percent and the OER
would be increased by 20 percent to obtain the SER. Thus if the OER were birr 10 = 1$US, then
the SER would be birr 12 = $ US1.
Thus the input which is traded a cross international borders and is found in the project account it
would be valued not at the OER but at the SER. This will make imports more expensive and
there by encourage the use of plentiful domestic resources rather than use foreign exchange. A
simple definition of a country's SER involves addition of the percentage FEP to the OER, or
more precisely, multiplication of the OER by one plus the FEP divided by 100.
 FEP 
SER  OER   1
 100 
Example: If FEP is 100 percent and if the OER is 1 us dollar is equivalent to birr 10, then the
shadow exchange rate can be estimated by:
 100 
SER  Birr 10 / us $   1  birr 20 / 1 us $
 100 
The Shadow exchange rate would therefore, be birr 20 per 1US $. Thus foreign exchange infract
has twice the value indicated by the official exchange rate.
The SER can also be derived from the definition of the FEP.
 Value of trade in domestic prices 
SER  OER  
 Value of trade in border prices 

 M (1  t )  x (1  d  s ) 
 OER  
 M x 
Where: x, M, t, d, and S are defined as before the value of export (FOB), value of import (CIF),
tariffs imposed on imports, and export subsidy.
3. Foreign Exchange premium and valuation of traded goods

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There are two main approaches for correcting for any premium placed on foreign exchange when
valuing traded and non-traded goods in project appraisal. The first is the approach proposed in
the Guidelines for project Evaluation (UNIDO, 1972) and the second approach is that developed
by Little and Mirrlees in project Appraisal (The border price (BP) Approach.)
The UNIDO Guide lines or the Domestic price Approach.
The most simple and widely used formula in estimation of shadow exchange rate (SER) is the
one developed by UNID 1972. It attempts to measure, in local domestic prices, the increase in
welfare in an economy that will be generated from one additional unit of foreign exchange.
The UNIDO SER formula is the weighted average of the ratio of the domestic prices to border
prices (C.i.f or fob) of all goods traded by the country, where the weights reflect how the next
dollar of foreign export (FX) would be spent.
n  Pad  h  Pbd 
SER   fa     Xb   x OER
 a 1  Pacif  b 1  Pbfob 
Where:
fa = is the fractional increase in each of the country's n imports as a result of a one local currency
(birr) increases in the availability of foreign exchange
Xb = is the fractional fall in each of a country's h exports in response to a 1 birr increase in the
availability of foreign exchange
Pad and Pbd = are the domestic market clearing prices of ath importable goods and the bth
exportable good, respectively.
Pacif = is the C.i.f price of ath importable good, measured in birr, converted at the official
exchange rate.
Note: the Pad diverges from Pacif because of tariffs and non-tariff prices; while the Pbd diverges
from Pb fob because of export taxes and subsidies.
Example: Assume that 1 birr of addition FE becomes available as a result of the project. Of this
85% is spent on increase imports of wheat (M) and 15% on purchasing rice, which would other
wise have been exported (X). The C.i.f price of M at the OER is birr 3/kg and its market clearing
domestic price is birr 4/kg due to tariff and non-tariff barriers with a tariff equivalent of 50%.
The fob price of exportable price is birr 3kg while its domestic market-clearing price is birr 2/kg,
due to an export tax of 33%. The SER in this simple two-good economy would be: SER=0.85x
(4.5/3) +0.15x(2/3)=1.374xOER

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Since the OER in this economy is birr. 10/$ US1,
SER  birr 13.74 / $ US 1.
The UNIDO approach values all traded and non-traded goods and services in terms of domestic
price equivalent. Domestic prices are used as the numeraire or the common unit of account in
terms of which all project inputs and outputs are valued. A project's non-traded inputs and
outputs are simply valued in domestic prices. Since they are, thus valued at comparable prices it
will be legitimates to add them in the projects cash flow for this reason this approach called the
domestic price approach.

The project's traded goods inputs are firstly valued in their FOB and CIF border price. They are
then converted from foreign currency to local currency using a shadow exchange rate, SER,
rather than the official exchange rate, OER. This is done to better reflect the true economic value
of foreign exchange to the economy.
The domestic price approach corrects for the FEP by inflating the border price values of traded
goods, using the economy's estimated SER, until these values correctly reflect the goods relative
worth compared with the domestic prices of non-traded goods.
In sum this approach values
Traded goods Non-traded goods
@ Border price x SER @ Domestic prices
→ Domestic price Equivalent
Numeraire: Domestic prices or Domestic consumption
Note: In a situation where the local currency is over valued and the foreign exchange premium is
positive, the ratio of the SER to OER will be greater than one when both are expressed in terms
of local currency per dollar or foreign exchange. Use of a shadow exchange rate to convert the
border prices of traded goods in to local prices will have the effect of inflating these border
prices until they equal the amount that people are willing to pay, or receive, for traded goods. As
these traded goods will now be values in domestic price equivalent they will be directly
comparable with the project's non-traded inputs and out puts valued in domestic prices.
Practical Example: Valuation at domestic price
(a) Valuation of Imported inputs
In the Table below it has been estimated the country has a foreign exchange premium of 30%
and the shadow exchange rate is there fore (1+0.30) x OER. All tariffs and taxes are deducted

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from the domestic retail price and their tradable (FX) component is inflated by the SE to obtain
the domestic price equivalent of the C.i.f import price. The economic cost of domestic transport
and handling is then added.

Valuation of imported inputs using the domestic price approach.

Financial cost Economic cost
(in million birr)
CIF import price @ OER 250 -
(@SER = 1.3x OER) - 325
Import tariff (40%) 100 0
Handling & distribution 50 20
Internal transport 50 50
Total 450 395
Ratio of Economic value: financial value = 395/450 = 0.88
60% of these costs represent rents earned from privileged access to foreign exchange, and
therefore not included in the economic costs of handling and distribution.
(b) Valuation of exported output
The table below shows valuation of a project's exported out put, using the domestic price (DP)
approach. The country has 30% of FEP. The Foreign export (FX) earnings are inflated by the
SER and all export subsidies are deducted from the fob export price to obtain the domestic price
equivalent of the border price.
Valuation of exported out put using the domestic price approach.
Financial value Economic value
FOB out putvalue @ OER 1200 -
(@SER = 1.3x OER) 1560
Export tax (10%) -120 0
Transport to the port including 25% -40 -30
fuel tax)
Total 1040 1530

Ratio of economic value: financial value = 1530/1040 = 1.47

The market price of transport includes a 50% fuel tax. Since fuel equals has of total transport
costs, its economic value = 40 - (40x 0.5 x 0.5) = 30

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 3.5.4 valuation of non-traded goods
The valuation of the non-tradable goods is done straight forward since they are given at domestic
price. If this non -tradable goods supply can increase, its economic value can be measured by its
domestic market supply price (after adjustment for market imperfection such as taxes, subsidy,
price fixing etc has been made.) If the project uses a non-tradable goods (such as electricity)
diverted from exiting consumers, then it should be valued at the price that people were willing to
pay for it, its demand price.
The Little - Mirrlees (LM) Approach or The Border price (BP) Approach
Like that of UNIDO, it also values trade goods at their border prices. However, these border
prices are converted into local currency at the official exchange rate (OER), rather than SER. In
this approach the projects traded good inputs and outputs are effectively kept in their border
price. However if there is a FEP in the country, the price of non-tradable goods will have risen to
match the tariff inclusive price of tradable. The price of non - tradable goods therefore over
states the good's true value to consumers, relative to the border price of traded goods.
The border price (LM) approach therefore re-values these non-tradable goods in border price
equivalents using commodity specific conversion factors. A conversion factor is the ratio of the
border price equivalent of non-tradable goods to its domestic price.
Multiplying the domestic price value of non-traded good by its conversion factor has the effect
of converting the goods domestic price into its border price equivalent. Both non-traded and
traded goods are then valued in the same numeraire, border price, so it is legitimate to add them
in the computation of the projects cash flow. This is the reason why it can be called the border
price approach.
The border price approach values
Traded goods Non-traded goods
@ border price X OER @ domestic price i X CFi
→ border price equivalent
Numeraire: border prices
border price quivalent i
CFi: = conversion factor of good i =
domestic price i
Simply written it can be depicted as
NB  OER ( x)  OER ( M ) D or NB  OER ( x  M ) D
Where  a conversion factor defined as OER / SER.
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Example:
Valuation of imported inputs using the border price approach
Financial value Economic value
CIF import price @ OER 250 250
Import tariff (40%) 100 0
Internal transport 50 40
Handling and distribution 50 14
Total 450 304
Ratio of economic value : financial value = 304/450 = 0.68
The conversion factor for transport, which puts the domestic price of transport into its border
price = 0.8, hence the transport's economic value = 50 x 0.8 = 40
The conversion factor for handling = 0.7. Hence economic value = (financial value x 0.4) x Cfi
= 20 x 0.7 = 14.
60% of items represent rents earned from privileged access to foreignexchange.
Valuation of exports outputs using the border price approach
Financial value Economic value
FOB out put price @ OER 1200 1200
Export tax (10%) -120 0
Transport -40 -24
total 1040 1176
Ratio of economic value: financial value = (176/1040) = 1.13
The 50% fuel tax is deducted (fuel - half transport tax), and the conversion factor (CF) = 0.8,
hence the transport's economic value N [ 40. (40 x 0.5 x 0.5) ] x 0.8 = 24
Finally the non-traded goods, which are given in domestic price will be converted using the
commodity specific conversion factor (CFi).
 There are two types of numeraire, border price and domestic price
 Computed border parity prices, we used the OER to convert border prices and then applied
conversion factors on non-traded goods
 There are two main approaches for correcting for any premium placed on foreign exchange
when valued traded and non-traded goods in project appraisal.
 the UNIDO approach or the domestic price approach
 The Little -Mirrlee (LM) or the border price (BP) approach

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Comparing the two Approaches
Suppose a project, an oil refinery, produced petrol for export, worth X in border prices and uses
imported crude oil, worth M in border prices, and a non-traded input, construction services,
worth N in domestic prices. The out put of the Non-tradable input can be expanded to meet the
projects requirements.
(a) Using the domestic price (DP) approach, we can value it as
B1 = [(SER) x X) - [(SER) x M) - aN ...................(1)
Where a is the factor that corrects for domestic distortions and converts the market price of
construction services N, 10 its true economic value measured in domestic prices. It corrects for
taxes, subsidies etc.
(b) Using the border price (LM) approach we will have:
B2 = ((OER x X ) - ((OER) x M) - CN ....................(2)
Where:
C is the supply price conversion factor that converts the domestic supply price of
construction, N, into border price equivalent.
The two approaches lead to an identical result if:
C = ax (OER/SER) ................................................(3)
Substituting C in the Second equation above gives,
B2 = (OER) x X - (OER) x M - (OER/SER) x N ........................... (4)
Multiplying both sides of the above equation, (4), by (SER/OER) gives,
SER  SER   SER 
B2 x B2 x  (OER ) x   x X  (OER ) x   x M  aN
OER  OER   OER 
 ( SER) x X  ( SER) x M  a N
=B1
This implies that there is a constant relationship between the NB of a project measured by the
two approaches la positive NPV in one implies a positive NPV in the other approach. The ratio
OER/SER in equation (3) is called the standard conversion factor (SCF) and is an average
conversion factor for the whole economy. It is different from C, which is a commodity specific
conversion factor for the non-traded goods.

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 3.5.5 The valuation of primary factors of production: (Land, Labor, and
Natural Resources)
As you know in other economic courses, the most important factors of production are land, labor,
capital and entrepreneurship. In Economic Analysis of projects, valuation of primary factors of
production is quite essential because it is difficult to accept or reject the project without having
the value of projects.
1. Distortions in the Labor Market
For most types of labor services it is not possible to directly establish a border price merely
because most people cannot travel freely between countries to sell their labor. Labor services are
there fore, a form of non-traded primary factor and can be valued in mush the same way as non-
traded goods and services. However, labor cannot be treated just like other factor of production
and should be treated uniquely.
Distortions in the labor market for unskilled and skilled labor may result in the wages of such
labor exceeding their marginal revenue product, valued in economic prices. Examples of labor
market distortions are minimum wage legislation. Centralized wage fixing and restrictive union
practices. These distortions are usually more common in urban areas because government control
and union activity are stronger there.
Nevertheless, it is believed that distortions exist only in the market for unskilled labor. The
market for skilled labor is taken to be relatively competitive and there may not be the need for
special shadow salaries for skilled personnel. It is assumed that the market for skilled labor
reflect marginal productivities subject to the overall distortions of the economy as expressed by
the standard conversion factor (SCF).
2. The valuation of unskilled labor
The total number of unskilled workers available in an economy cannot normally be expanded in
response to market demand unless there is substantial immigration program in the country
concerned. Labor service can there fore be treated as a non-traded primary factor, which is in
elastic supply.
Since unskilled labor is generally in fixed supply when a project uses labor it will have to draw it
away from other employment some where in the economy. This labor may actually come from
another sector such as agriculture. If anon-traded factor is removed away from other users, its
economic cost is what they were willing to pay for it.

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If labor markets were generally efficient and there is no government intervention in the form of
minimum wages, wage fixing, hiring constraints or income taxes, the market wage rate paid for
this labor should reflect the contribution the marginal worker makes to the total revenue of the
employer. The market wage rate received by the labor in its previous employment will therefore,
reflect its forgone out put. In these circumstances the market wage could be used directly to
determine the economic cost of labor. However, in market distortions it would be necessary to
determine the true cost of the project labor requirements to the economy by calculating the
shadow wage rate (SWR) or the marginal social cost of labor. The basis for the derivation of the
SWR is the forgone output or labor's marginal contribution to the revenue earned in the
occupation from which it has been drawn.
Thus even when the project worker is recruited among the urban unemployed as long as he is
replaced by another unemployed coming from the rural area, it is the opportunity cost of the
latter that we should take into account in estimating the shadow wage rate.
As it has been discussed there are two approaches to value the non-traded inputs. The UNIDO
approach or the LM approach. If we use the border prices as the unit of account and thus all out
put forgone must be valued at border prices, then the general expression for the shadow wage
rage (SWR) is given as:
SWR  a : M : .CF :
Where: M: is the output foregone in alternative employment at domestic market prices.
CF: is the conversion factor required to convert this out put to world/ border prices
ai is the proportion of new worker of type i coming from activity i.
Thus the conversion factor for labor i is given as:
CFI - SWR/MWR
Where MWR is the market wage rate and CFL is the labor conversion factor.
The above approach does not mean that international wage rates are used instead of domestic
ones, but that the physical units of out put forgone are valued at border prices rather than
domestic prices.
If the domestic price system (UNIDO approach) is used then the treatment of labor is directly
comparable in a domestic and a border price system. Again labor's shadow wage is the output
forgone, but in a domestic system this measured in domestic rather than border price units. The

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general expression of the shadow wage rate will be relevant again except now there will be a
new set of CFs for the different commodities foregone so that.

DPSWR  aim DPCFi

Where: DPSWR is the SWR in domestic prices and DPCF is the domestic price conversion
factor for good i.
3. The Valuation of Skilled Labor:
The economic cots of skilled labor are in principle estimated in exactly the same way for
unskilled labor. The significance difference though, is that there is more general agreement that
skilled labor’s wage reflect its marginal product reasonably accurately. Two reasons are often
presented to support this argument:
1. Skilled labor is more specific, often being highly mobile in nature and wages tend to be
competitive and full employment is the rule.
2. The supply of skilled labor is increasingly equated to its present and future demand by the Use
of manpower planning techniques, which has the virtue of missing discrepancies between supply
and demand and hence relieving the price mechanism of part of the burden of adjustment.
4. The valuation of Land

The term land covers not merely land parcels but other material resources such as forests, fishery
reserves, mineral deposits, etc. Thus it is important to examine economic valuation of land. In
principle, the capital value of land is the discounted value of the stream of future earnings which
it can command net of the cost of purchased inputs and labor. I.e.,, it is the capitalized rental
element. Where there is competitive land market prices would equal the expected future gain
from the purchase or rental of an additional unit of land. But it is not obvious that existing land
markets are sufficiently competitive for price to be an adequate guide to productivity.
Example: Where land for a factory site was previously unused its direct opportunity cost will be
zero, since no out put would be cost by building the factory on the land, and only land clearing
costs can be properly attributed to the project. If an agricultural land is to be used, its economic
cost will be the sum of the discounted agricultural out put value cost over the life of the project,
net of the cost of other inputs, valued either in border prices or in domestic prices.
5. The Shadow price of Natural Resources

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If the natural resources (mineral deposits, oil, natural gas deposit, etc.) Use in the project are
traded they should be valued at their FOB or CIF prices, depending on whether they impact on
exports or imports at the margin.
Example: if imported mineral is used it should be valued at CIF border price. If exported mineral
is used it should be valued at the FOB border price.
If the project uses a non traded natural resource input whoseout put can be expanded this input
should be valued at its supply price, its marginal cost of production. Its supply price will be equal
to the economic valued of the resource that is used to produce it. If the project uses a non-traded
natural resource that is in relatively fixed supply, it should be valued at its demand price. If
natural resource required by the project is in short supply it is likely to earn a scarcity rent.

3.6 Social cost benefit analysis

In essence, project analysis assesses the benefits and costs of a project and reduces them to a
common denominator. If benefits exceed costs both expressed in terms of this common
denominator-the project is acceptable: if not, the project should be rejected.
Economic analysis of projects is similar inform to financial analysis in that both assess the
profit of an investment. The concept of financial profit, however, is not the same as the social
profit of economic analysis.
The purpose of Social Cost-Benefit Analysis
When under taking financial and economic project appraisal it is implicitly assumed that
income distribution issues are beyond the concern of the project analyst or that the
distribution of income in the country is considered appropriate. A financial objective is
narrow one for a public agency to pursue and for public decisions. But in most countries
governments are not only interested in increasing efficiency but also in promoting greater
equity.
When one project is chosen rather than another the choice has consequences for employment,
output, consumption, savings, foreign exchange earnings, income distribution and other
things of relevance to national objectives. The purpose of social cost-benefit analysis is to see
whether these consequences taken together are desirable in the light of the objectives of
national planning. Therefore, a social appraisal of projects goes beyond economic and
financial appraisal to determine which project will increase welfare once distributional
impact is considered. The project analysts will not be only concerned to determine the level
of project's benefits and costs but also receives the benefits and pays the costs. In a situation
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where a project is only marginal from the point of view of an economic analysis but has
strong positive distributional benefits, the analyst may consider a social analysis in addition
to the traditional economic analysis.
In an economic analysis of a project it is implicitly assumed that a dollar received by any
individual will increase the community's welfare by the same amount as a dollar received by
any other individual. But an extra dollar given to a very poar person will usually increase the
person's welfare by much more than would a dollar given to a rich person. A rationale in
welfare economic for the social analysis of projects is there fore, quite strong, the marginal
utility of income of a person who receives a low income is expected to be greater than the
marginal utility of income of the same person if he or she receives a high income. An
economic analysis of projects A & B would not capture those differences and would merely
indicate that both had the same positive impact on community welfare.
Difference between financial calculation and Social cost-benefit Analysis:
Financial profitability is measured in terms of the difference between the value of earnings
and costs in a certain period. Social cost-benefit analysis must go deeper and ask what is the
meaning of profit.
1. The price offered in the market is not a good guide to Social welfare for it includes the
influence of income distribution on the prices offered. One of the simpler means of income
redistribution may infact be project Selection. The choice may be between project A to be
located in a poor region or project B to be located in a rich area or between project X which
uses a large amount of poor, unskilled labor which might other wise be un employed and
project Y which uses factors of production supplied by rich people.
2. A project may have influences that work out side the market rather than through it. These
effects are called "externalities " externalities are relevant for social choice and provide a
sufficient argument for rejecting commercial profitability as a guide to public policy.
Externalities may arise in the process of production, in the process of consumption, and in
the process of Sales and distributions.
3. Even in the absence of externalities and consideration of income distribution commercial
profitability may be misleading because of consumer's surplus.
3.7 Cost-effectiveness

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Thus far we have focused on cost-benefit analysis. This technique is appropriate for projects
with benefits and costs that are measurable in monetary terms. A vast class of projects
generates benefits that are not easily measurable in monetary terms. If the project measures
its benefits in some non-monetary unit, the NPV criterion for deciding whether to implement
it cannot be used.
In such cases, economic analysis can still be a great help in project design and selection. We
use it to help select among programs that try to achieve a given result, such as choosing
among several methods to improve mathematical skills. Economic analysis is also useful to
select among methods that have multiple outcomes. For example, three methods might be
available for raising reading speed, comprehension, and word knowledge. Each method may
have a different impact on each of the three dimensions and on cost. Economic analysis
enables us to compare the costs of various options with their expected benefits as a basis for
making choices.
Two main techniques exist for comparing projects with benefits that are not readily
measurable in monetary terms: cost-effectiveness and weighted cost-effectiveness. In all
cases we measure costs as shown in the previous sections. The main difference between the
approaches is in the measurement of benefits. If the benefits are measured in some single
non-monetary units, such as number of vaccines delivered, the analysis is called cost-
effectiveness. If the benefits consist of improvements in several dimensions, for example,
morbidity and mortality, then the several dimensions of the benefits need to be weighted and
reduced to a single measure. This analysis is known as weighted cost-effectiveness.
The choice of technique depends on the nature of the task, the time constraints, and the
information available. We would use cost-effectiveness for projects with a single goal not
measurable in monetary terms, for example, to provide education to a given numberof
children. When the projects or interventions aim to achieve multiple goals not measurable in
monetary terms, we use weighted cost-effectiveness; for example, several interventions may
exist that simultaneously increase reading speed, comprehension, and vocabulary, but that are
not equally effective in achieving each of the goals. A comparison of methods to achieve
these aims requires reducing the three goals to a single measure, for which we need some
weighting scheme.
All evaluation techniques share some common steps. The analyst must identify the problem,
consider the alternatives, select the appropriate type of analysis, and decide on the most
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appropriate course of action. This topic provides the tools for identifying the costs and
benefits and assessing whether the benefits are worth the costs.
3.7.1 Cost-effectiveness Analysis
Cost effectiveness analysis is a technique closely related to cost benefit analysis .it differs in
that it asks a different question, namely given a particular objective, which is the least cost
way of achieving it? It aids choice between options but cannot answer the question whether
or not any of the options are worth doing. It is utilized when there are difficulties in
associating monetary values with the outcomes of projects but where the outcomes can be
quantified along some non-monetary dimension.
In cost-effectiveness analysis, we measure the benefits in non-monetary units, such as test
scores, number of students enrolled, or number of children immunized. As an example,
suppose we want to evaluate the cost effectiveness of four options to raise mathematics skills
(Levien 1983):
o Small remedial groups with a special instructor
o A self-instructional program supported with specially designed materials
o Computer-assisted instruction
o A program involving peer tutoring
We first estimate the effect of each intervention on mathematics skills as measured by, say, test
scores, while controlling for initial levels of learning and personal characteristics. Suppose we
find that students taught in small groups attain scores of 20 points, those undergoing the self-
instructional program score 4 points, those with computer-assisted instruction score 15 points,
and those in the peer-tutored group score 10 points (table 3.9). These results show that small
group instruction is the most effective intervention.
Now consider cost-effectiveness. Suppose that the cost per student is US$300 for small group
instruction, US$100 for the self-instructional program, US$150 for computer-assisted
instruction, and US$50 for peer tutoring. The most cost-effective intervention turns out to be
peer tutoring; it attains one-half the gain of small group instruction at only one-sixth the cost
for a cost-effectiveness ration of only 5 (see table 3.9). Cost-effectiveness analysis can also
be used to compare the efficiency of investment in different school inputs.
Table 3.9 Hypothetical cost-effectiveness ratios for interventions to improve mathematics
skills

Intervention Size of effect Cost per Cost

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 on test scores student (US$) effectiveness
ratio
Small group instruction 20 300 15
Self-instructional materials 4 100 25
Computer-assisted instruction 15 150 10
Peer tutoring 10 50 5
Source: Levin (1983)
Cost-effectiveness ratios must always be used with caution. In the above example, peer
tutoring is the most cost-effective intervention. If we have several cost-effectiveness (CE)
ratios and either the numerator or the denominator have exactly the same value in all cases,
CE ratio can be used safely for decision-making. CE ratios would be safe to use if the
benefits had differed, but the cost per student had been the same for each intervention. If,
however, both the measure of benefits – test scores in this case – and thecosts per student
vary among interventions, the analyst should use CE ratios with caution. In the example
above computer assisted instruction produces a gain of five points over peer tutoring at an
additional cost of US$100, or US$20 per point. To choose peer tutoring over computer-
assisted instruction solely on the basis of CE ratios would be tantamount to saying that the
marginal gain in test scores is not worth the marginal expense. When using CE ratios, we
advise analysts to ask the following three questions:
 Can I increase the intensity of an intervention and improve the results?
 Can I combine interventions and improve the results?
 Is the intervention’s marginal gain worth the extra cost?

Cost-effectiveness in health
We can use cost-effectiveness in evaluating interventions that aim to improve the health of a
population. Suppose that we want to design a program of immunization that would provide
the maximum improvement in health for allocated program funds. The package could include
only DPT (a combination of diphtheria, pertussis, and tetanus vaccines) for the child and T
(tetanus toxoid) for the mother, or it could also include BCG (Bacille Calmette Guerin, used
to prevent tuberculosis) for the child. We would want to examine the economic advisability
of adopting a DPTT program, a BCG program, or a combined DPTT plus BCG program
rather than continuing with the existing low level of immunization and treatment of
morbidity for diphtheria, petrtussis, and tetanus. Having mounted a DPTT program, suppose
we want to examine the advisability of adding a BCG program and vice versa.

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Table 3.10 summarizes the incremental costs and benefits of adding an expanded program of
immunization to the existing program of health services. We measure the benefits of the
project in terms of the deaths prevented, as calculated from a simple epidemiological model.
We base this model on the number of immunizations, the efficacy of the vaccines, and the
incidence and case fatality rates of the diseases involved. The most effective alternative is a
complete immunization program. A DPT only immunization program, however, is just as
cost-effective. If the budget constraint were US$115million, the most cost-effective feasible
alternative would be a program of DPT immunization.
This example starkly illustrates the limitations of CE ratios. In line 1, DPT only is just as
effective as line 3, a total immunization program. The cost per life saved for either program
is about US$480. Adding BCG to an existing program of DPTT, however, saves an
additional 29,500 lives at a cost of US$14 million, or US$475 dollars per life. Forgoing
adding the BCG program to DPT on the grounds of CE ratios alone would be tantamount to
saying that each additional life saved is not worth US$475.
Table 3.10 Cost-benefit comparison of immunization alternatives
Alternative Cost-benefit
Benefits Costs
ratio
(death prevented) (US$ millions)
DPTT only 231,900 111 478.7
BCG only 29,500 61 2,067.8
DPTT+BCG 261,400 125 478.1
Existing BCG,DPTT added 231,900 64 276.0
Existing DPTT,BCG added 29,500 14 474.6
Source: Authors
Assessing Unit Costs
We use unit costs for comparing the intervention’s efficacy within and across countries. In
education, for example, analysts often wish to know the average cost per student of a
particular intervention. Calculating the unit costs of a mature intervention that has reached a
steady state is the simplest of problems, as all the capital costs have already been incurred.
The recurrent costs and the number of students enrolled are fairly stable.
Assessing unit costs for a new intervention is more difficult. Capital costs are typically
higher in the initial years, and enrollment and graduates are typically higher once the project
is working at full capacity. Thus, comparing costs and benefits that occur at different points
in time is necessary. The tools of economic analysis are helpful in these instances as well.

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Given the cost and benefit profile of the project, the analysis can discount the benefit and
costs flows and compare them at a single point in time.
Consider Higher and Technical Education Project. One of the purposes of this project was to
increase the number of graduates coming out of the University of the country and the three
polytechnic schools. The investment costs, which would be distributed over five years,
amounted to Birr 343 million (present value discounted at 12 percent). The recurrent costs
would be proportional to the number of students and would rise from about Birr 4 million in
the initial year to about birr 21 million once full capacity had been reached. The discounted
value of the recurrent costs over the life of the project was assessed at Birr 143 million.
Enrollment, on the other hand, would rise slowly from 161 students in the initial years, to
about 3700 at full capacity. To assess the cost per student, the number of students enrolled
through out the life of the project was discounted at 12 percent. The discounted number of
students was calculated at 13,575 students and the cost per enrolled student at US$2048 at
the then prevailing market exchange rate. Similar calculations show the cost per graduate at
about US$8700.
Analysts could use the same methodology to assess the unit costs of interventions in health or
in any project where the output is not easily measured in monetary terms. For the moment,
suffice it to say that by using this procedure, analysts are discounting the project’s benefits.
The number of students enrolled is a proxy for these benefits. In this sense, the procedure is,
in principle, the same as for projects with benefits measurable in monetary terms.
3.7.2 Weighted Cost-Effectiveness

Sometimes project evaluation requires joint consideration of multiple outcomes, for example,
test scores in two subjects, and perhaps also their distribution across population groups. In
such situations, the analyst must first assess the importance of each outcome with respect to
single goal, usually a subjective judgment derived from one or many sources, including
expert opinion, policymakers’ preferences, and community views. These subjective
judgments are then translated into weights. Once the weights are estimated, the next step is to
multiply each of the outcomes by the weights to obtain asingle composite measure. The final
step is to divide the composite measure by the cost of the options being considered. The
results are called weighted cost-effectiveness ratios.
Application in Education

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Suppose that employing better-qualified teachers raises mathematics scores more than
language scores. To evaluate the two options for improving student learning, the analyst must
compare the effect of each option on mathematics and language performance. The analyst
could apply equal weights to the gains in test scores, but if mathematics is judged to be more
important than language, policy makers may prefer to weight scores differently to reflect the
relative importance of the two subjects.
Owing to the many dimensions of learning, the need for weighting may arise even when only
one subject is involved. Consider the data in table 3.11 which show the effects of two
improvement strategies for three dimensions of reading skills, as well as the weights assigned
by experts to these skills on a scale of 0-10 points. Assigning the weights is the trickiest part
of the exercise; the rest of the calculation is mechanical. Dividing the weighted scores by the
cost of the corresponding intervention gives the weighted cost-effectiveness ratio for
comparing the interventions. At a cost of US$95 per pupil for intervention A and US$105 per
pupil for intervention B, the option with the more favorable ratio is the latter.
Table 3.11 Weighting the outcomes of two interventions to improve reading skills
Category Weights Intervention Intervention
assigned by A a
Bb
expert opinion
Reading speed 7 75 60
Reading comprehension 9 40 65
Word knowledge 6 55 65
Weighted test score b
n.a 1215 1395
Cost per pupil n.a 95 105
Weighted cost-effectiveness ratio n.a 12.8 13.3
n.a. Not applicable Source: Adapted from Levin (1983)
a. the scores on each dimension of outcome are measured as percentile ranking
b. The weighted score is calculated by multiplying the score for reading speed, reading
comprehension, and word knowledge by the corresponding weight and summing up the
result. The weighted score of 1215 for intervention A equals (7x75+9x40+6x55).
Note that this procedure becomes meaningful only when the analyst scores outcomes on a
comparable scale. We could not compare, say, reading speed in words per minute with
reading comprehension in percentage of material understood. The reason is that the
composite score would then depend on the scale used to measure the individual scores. The
metric used must be the same for all dimensions being compared. One procedure is to

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express all the scores in terms of percentile rank, as in the earlier example. Applying the
appropriate weights to the scores then provides the desired composite score.
Application in health
Weighted cost-effectiveness is also useful for assessing health projects. Going back to the
immunization example considered before, the immunization interventions reduce morbidity
as well as mortality. A given intervention might have different impacts on the reduction of
these two indicators. To choose among several interventions would require weighting
morbidity and mortality to produce a single measure of benefits. It has become increasingly
common to measure and aggregate reduction in morbidity and premature mortality in terms
of years of life gained.
Table 3.12 Benefits from interventions: years of life gained from immunization program
Category Mortality Morbidity Total Gain from Gain from
DPT only BCG only
Benefits (years) 56,000 16,992,000 17,048,00 15,127,000 1,921,000
Costs (US$ millions) n.a n.a 125 111 61
Cost-effectiveness n.a n.a 7.3 7.3 31.8
ratios
n.a Not applicable Source: Levin (1983)
Table 3.12 shows the costs and benefits of three interventions with the benefits calculated in
terms of health years of life gained, which are calculated as the sum of the difference
between the expected duration of life with and without the intervention plus the expected
number of years of morbidity avoided as a result of the intervention. The analyst calculates
the years of life gained from reductions in mortality and morbidity by using thesame
epidemiological model previously applied to calculate deaths prevented by adding the
computation of cases, information on the average duration of morbidity, and years of life lost
based on a life table.
Comparing option with subjective outcomes
Sometimes no quantitative data exist that relate interventions to outcomes. Suppose that we
want to assess two options to improve performance in mathematical and reading, but have no
data on test scores. The evaluator could first ask experts to assess the probability that test
scores in the two subjects will rise by a given amount, say by one grade level, under the
interventions being considered, and then weighting these probabilities according to the
benefit of improving test scores in the two subjects. To elaborate, suppose informed experts
judge the probability of raising mathematics scores to be 0.5 with strategy A and 0.3 with
strategy B. Experts also judge the probability of raising reading scores to be 0.5 with strategy
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A and 0.8 with strategy B. The information is insufficient to choose between the strategies,
however, because neither dominates for both subjects.
The weighted cost-effectiveness approach overcomes this difficulty by asking policymakers
or other relevant audiences to assign weights to the gain in test scores. Suppose they assign a
weight of 9 on a scale from 0-10 to a gain of one grade level in mathematics and a weight of
6 to gain of one grade level in reading. The score for strategy A would then be 7.5
(0.5x6+0.5x9), and the score of strategy B would be 9.0 (0.3x6+0.8x9). If strategy A costs
US$375 and strategy A costs US$375 and strategy B costs US$400, then the cost-
effectiveness ratio would be US$50 for strategy A and US$44 for strategy B. In this case, B
could be the preferred strategy, because it is the most cost effective and generates the highest
benefits.
Some important caveats
When quantitative data on the relationship between project interventions and their outcomes
are available, and when only a single dimension of outcomes matters, cost-effectiveness
analysis offers a systematic tool for comparison. The method does not incorporate subjective
judgments. When such judgments enter into measuring project outcomes, the method is
called weighted cost effectiveness analysis. The main advantage of weighted cost-
effectiveness analysis is that we use it to compare a wide range of project alternatives
without requiring actual data.
The reliance on subjective data gives rise to important shortcomings in weighted cost-
effectiveness analysis. These shortcomings related to two questions: Who should rank the
benefits of the options being considered? How should the ranking of each person or group be
combined to obtain an overall ranking?
Choosing the right respondents is critical. An obvious group to consult comprises people who
will be affected by the interventions. However, other relevant groups include experts with
specific knowledge about the interventions and government officials responsible for
implementing the options and managing the public resources involved. Given that the choice
of respondents is itself a subjective decision, different evaluators working on the same
problem almost invariably arrive at different conclusion using weighted cost-effectiveness
analysis. The method also does not produce consistent comparisons from project to project.
Analysts must be careful when consolidating individual rankings. Preference scales indicate
ordinal, rather than cardinal, interpretations. One outcome may assign a score of eight as

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superior to one assigned a score of four, but this does not necessarily mean that the first
outcome is twice as preferable. Another problem is that the same score may not mean the
same thing to different individuals. Finally, there is the problem of combining the individual
scores. Simple summation may be appealing, but as pointed out in a seminal paper on social
choice, the procedure would not be appropriate if there were interactions among the
individuals so that their scores should really be combined in some other way (Arrow 1963).
Because of the problems associated with interpreting subjective weights in project evaluation,
weighted cost-effectiveness analysis should be used with extreme caution, and the weights be
made explicit.

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 Chapter Four: Project Implementation, Monitoring and Evaluation
4.1 Introduction: What is Monitoring and Evaluation

Throughout life we are monitored and evaluated: in school we receive grades, at work we are
given performance appraisals, and we evaluate relationships and monitor our health.Before we
use the formal definitions of monitoring and evaluation, lets use common sense definitions:
Evaluation asks the question “Are we doing the right thing” or “Do we have the right plan?” and
Monitoring checks to see if we are following our plan.
Monitoring and Evaluation is the systematic collection and analysis of information to enable
managers and key stakeholders to make informed decisions, maintain existing practices, policies
and principles and improve the performance of their projects.
Monitoring is the regular gathering analyzing and reporting of information that is needed for
evaluation and/or effective project management. Monitoring is either ongoing or periodic
observation of a project’s implementation to ensure that inputs, activities, outputs, and external
factors are proceeding according to plan. It focuses on regular collection of information to track
the project. Monitoring provides information to alert the stakeholders as to whether or not results
are being achieved. It also identifies challenges and successes and helps in identifying the source
of an implementation problem.
Evaluation is a selective and periodic exercise that attempts to objectively assess the overall
progress and worth of a project. It uses the information gathered through monitoring and other
research activities and is carried out at particular points during the lifetime of a project.
Evaluation is different from monitoring. Monitoring checks whether the project is on track;
evaluation questions whether the project is on the right track. Monitoring is concerned with the
short-term performances of the project, and evaluation looks more at long-term effects of project
goals. Frequently, evaluation is perceived as an activity, carried out by an expert or a group of
experts, designed to assess the results of a particular project. This is a common misconception. It
is vital that evaluation is carried out with the participation of all project stakeholders, including
beneficiaries. The results of a periodic evaluation are fed into the project planning process as
quickly as possible to enhance the project’s effectiveness.

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Monitoring is useful because it tends to highlight little problems before they become big ones.
An evaluation is a systematic examination of a project to determine its efficiency, effectiveness,
impact, sustainability, and the relevance of its objectives. The dictionary defines evaluation as a
systematic investigation of the worth or merit of an activity. Traditionally, evaluation has been
the last step in the project life cycle and in the project development process. However, it does not
make sense to wait until the project is finished to ask the question “Did we do the right thing?”
Indeed, you could evaluate the effectiveness at each stage of the project life cycle.
In a project the monitoring and evaluation group decides what to monitor. By collecting data
regularly on activity inputs and outputs, processes, and results, the community can monitor the
progress toward the group’s goals and objectives (e.g., income generated by the sale of a
cookbook, how many people sold how many books over what period of time). In managing a
project indicators are indispensable management tools. They define the data needed to compare
the actual verses the planned results.
M&E can be seen as a practical management tool for reviewing performance. M&E enables
learning from experience, which can be used to improve the design and functioning of projects.
Accountability and quality assurance are integral components of M&E, which help to ensure that
project objectives are met, and key outputs and impacts are achieved.
4.2 Why monitoring and Evaluation
M&E can help an organization to extract, from past and ongoing activities, relevant information
that can be used as the basis for future planning. Without M&E how would it be possible to
judge if a project was going in the right direction, whether progress and success was being
achieved, and how future efforts might be improved?
A structured M&E approach makes information available to support the implementation of
projects and activities and will enhance the sustainability. Used effectively M&E can help to
strengthen project implementation and encourage useful partnerships with key stakeholders.
The main objectives of M&E are thus to:
• Ensure informed decision-making;
• Enhance organizational and development learning;
• Assist in policy development and improvement;
• Provide mechanisms for accountability;
• Promote partnerships with, and knowledge transfer to, key

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 • Stakeholders;
• Build capacity in M&E tools and techniques.
• M&E is about feedback from implementation.
• The ultimate purpose of M&E is change for the better.
4.3 Different Kinds of Monitoring and Evaluation

M&E can deal with many issues. It can be M&E of Projects. policy implementation, the
performance of a unit in an organization, staff performance or, for example, deliveries from a
subcontractor.This course deals with M&E related to a project. The concepts, tools, and
procedures for project M&E, as presented in this course, also helps to understand other kinds of
M&E.
4.3.1 Internal and External Project M&E
Internal Project M&E is built into the design of a project and is undertaken by the team that is
responsible for management and implementation of the project.This is done to ensure that the
project meets deadlines, stays within the budget and achieves its objectives, activities, outputs
and impacts!. A project that does not monitor its implementation is not a well-managed
project.Findings, recommendations etc of internal monitoring is usually captured in progress
reports submitted by project management.
External Project M&E is carried out by an outside team, which is not directly responsible for
the management or implementation of the project. External M&E should assess the effectiveness
of the internal M&E put in place by the project management team. External monitoring can take
place once the project has been completed, and/or during implementation of the project.
External M&E is often required by donor agencies or government organizations if, for example,
they need to know how their funds are being spent or if their policies are being adhered to. All
projects can benefit from external M&E.Findings and recommendations of external monitoring
are often documented in a review or evaluation report.External M&E also monitors and
evaluates internal M&E
Figure 4.1: Differences between Internal and External M&E

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 4.3.2 Monitoring Levels
Traditionally, M&E focused on assessing the inputs and activities of a project. Today the focus is
increasingly on measuring the outputs and impacts of a project to achieve a broader development
objective or goal.Project inputs, activities and assumptions/risks are also important, however, as
they all affect outputs. For example, if the budget (an input) is cut by 50%, this will obviously
affect the outputs of the project and will need to be taken into account when conducting the
M&E. The various monitoring levels in a project are:
Input Monitoring
Input monitoring is the monitoring of the resources that are put into the project - these include
budget, staff, skills, etc. Information on this type of monitoring comes mainly from management
reports, progress reports and accounting.For example, ways of measuring this can be the number
of days consultants are is employed, or the amount of funds spent on training and equipment.
Activity Monitoring
Activity monitoring monitors what happens during the implementation of the project and
whether those activities which were planned, were carried out. This information is often taken
from the progress report.
Output Monitoring
Output monitoring is a level between activity and impact monitoring. This type of monitoring
assesses the result or output from project inputs and activities.The measurements used for output

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monitoring will be those which show the immediate physical outputs and services from the
project.
Impact Monitoring
Impact monitoring relates to the objectives of the project. The aim of impact monitoring is to
analyze whether the broader development objectives of the project have been met.Such
monitoring should demonstrate changes that are fundamental and sustainable without continued
project support.
4.3.3 M&E and Stakeholder Participation
The participatory approach to project management seeks to enable local communities living
adjacent to projects and other local stakeholders to take part in decision-making and share the
benefits of project activities. This participatory approach should also be applied to M&E.
Participatory M&E can play an important role in ensuring that the participatory principles are put
into practice by:
• Improving the effectiveness of project management and decision-making, as the parties who
have been involved in M&E will be informed and aware of the results of the M&E procedure;
• Ensuring that accurate and reliable information is communicated to communities and
stakeholders from the M&E process;
• Ensuring that stakeholders understand the reasons for failure in achieving project outputs and
objectives and how and what to improve in the future;
• Providing mechanisms for transparency and accountability to stakeholders;
• Building community capacity in M&E tools and techniques.
Recommendations from M&E are more likely to be accepted and taken forward by stakeholders,
if they have had an active role in shaping them.
Activity: Think about a time when you were involved in an evaluation process. What kind of
evaluation was it? What was the evaluation trying to find out? Was the evaluation participatory?
Did the information gathered and reported get used?
4.4 Procedures in Monitoring and Evaluation
The M&E procedure below sets out the steps in planning and implementing external M&E. The
M&E procedure must be customized to the specific needs of each project, taking into account the
project objectives, inputs, outputs, activities, stakeholders and beneficiaries. The M&E steps will
vary from situation to situation. Seven key steps are listed in Figure 4.2 and further explained in

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the rest of this chapter.
The M&E Procedure
Step 1: Establish the Purpose and Scope of M&E
Step 2: Identify Performance Questions and Indicators
Step 3:Establish M&E Functions and Assign
Responsibilities and Financial Resources
Step 4: Gather and Organize Data
Step 5: Analyze Data and Prepare an Evaluation Report
Step 6: Disseminate Findings and Recommendations
Step 7: Learn from the M&E
Step 1: Establish the Purpose and Scope of M&E
Specifying the purpose and scope of the M&E helps to clarify what can be expected of the M&E
procedure, how comprehensive it should be and what resources and time will be needed to
implement it.When formulating the purpose of M&E, relevant stakeholders including the project
management team, should be consulted or at least made aware of and understand the purpose of
the M&E.
Example of an External M&E Purpose
To verify that the development objective and outputs of the project have been achieved within
the allocated budget.The scope of the M&E may be determined by asking some of the following
questions:
• What is the purpose of M&E?
• How much money is available for your M&E?
• What type of information is required by project management,
• donor agents or other stakeholders?
• What is the level of M&E expertise available?
• To what extent should local communities and other stakeholders, participate in the
M&E procedure?
Step 2: Identify Performance Questions and Indicators
1. Performance Questions
A performance question is used to focus on whether a project is performing as planned and if not,
why not. Performance questions will be guided by the broader development objective, the project

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objectives, the project outputs, as well as the M&E purpose. Once performance questions have
been identified, it will be easier to decide what information is needed to evaluate the project.
Table 4.1 gives examples of performance questions for the M&E of a particular project.
2. Indicators
Indicators should be guided by performance questions and linked to the purpose of the M&E.
Indicators are basically measurements that can be used to assess the performance of the
project.While performance questions help to decide what should be monitored and evaluated,
indicators provide the actual measurements for M&E and determine what data needs to be
gathered.
The project itself may have indicators by which it monitors it's own progress - these may be used
for external M&E, if relevant. Also the funding organization and other stakeholders can provide
broader indicators that may be relevant to the external M&E of the project.Indicators, and
therefore the data needed to verify them, can be qualitative or quantitative. Quantitative data is
factual while qualitative information is based on opinions and perceptions and thus may be
subject to further interpretation. During M&E, one should aim to have both qualitative and
quantitative indicators. Table 4.1 provides examples of quantitative and qualitative indicators.
Table 4.1: Examples of Quantitative and Qualitative Indicators

INDICATOR
EXAMPLES
TYPES
Quantitative .Fifty bundles of poles are harvested each month.

Indicators .Five training courses were run during the project.

The pole harvesters regard the harvesting system as being
Qualitative
sustainable
Those who attended the training courses perceived the courses to
Indicators
be meeting the demands for skills in the area.

• Relevant - The indicators should be directly linked to the project 0bjectives/ outputs.
• Technically feasible - The indicators should be capable of being verified or measured and
analyzed.
• Reliable - The indicators should be objective: i.e. conclusions based on them should be the
same if different people assess them at different times.
• Usable - People carrying out the M&E should be able to understand and use the information

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 provided by the indicators to evaluate the project.
• Participatory - Relevant stakeholders should be involved in the collection of information
generated by the indicators, the analysis of the information and possible use of the
information in the future.
Step3: Establish M&E Functions and Assign Responsibilities and Financial Resources
Establishing M&E functions and responsibilities at the beginning of the procedure can help to
avoid major communication issues, conflicts of interest, duplication of tasks and wasted efforts.
Organizing responsibilities means deciding which stakeholders will be involved and clarifying
and assigning roles to these stakeholders as well as to funding organization officials, project
management and any partner organizations. Stakeholders may need to be trained in different
aspects of the M&E procedure
M&E will require financial resources in accordance with the type of project(s) that is being
evaluated as well as the M&E purpose, performance questions and indicators. Among the items
that should be included in M&E costs are:
• Staff salaries;
• Fees and expenses for consultants;
• M&E training;
• Organizing M&E meetings and other participatory exercises.
Consultants can play an important role in enabling projects to fulfill its M&E responsibilities by
providing specialist knowledge and expertise that may not be readily available in the
organization.
Step 4: Gather and Organize Data
Data is the oxygen that gives life to M&E. However, selecting methods of data collection can be
confusing, unless it is approached in a systematic fashion. Rarely is anyone method entirely
suitable for a given situation. Instead, using multiple methods helps to validate M&E findings
and provides a more balanced and holistic view of project progress and achievements.
The performance questions and indicators will provide guidance in deciding what
data/information to gather and the methods to be used. Data can either be primary or secondary.
1. Data Sources and Data Collection Methods

Potential data sources and data collection methods are listed below:

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• Document Review: Documents and reports provide a rich source of information for M&E.
• .Interviews: Interviews can provide a rich source of data, particularly in regard to qualitative
and sensitive information that may not be readily available in official documents.
• Surveys and Questionnaires:Surveys and questionnaires provide a way of obtaining
information from a large number of people. Questions should be relevant and simple to
answer.
• Field Visits and Transect Walks Visits to the site of a project can provide valuable
information about the environment in which the project is taking place, its impact on
beneficiaries and the working methods that are being used. Transect walks are an effective
participatory method to gather this information.
• Expert Opinion Obtaining the views of experts who are knowledgeable about particular
aspects of the project's activities can in some instances provide valuable insights that may not
be revealed by other methods of data collection.
2. Organizing and Storing Data

Data needs to be captured, organized and stored so that it can be readily used for the M&E
purposes. Proper capturing, organizing and storage is particularly important when information
has been collected from different sources with different methods.
Step 5: Analyze Data and Prepare an Evaluation Report
The captured and organized data needs to be analyzed, and findings and recommendations
summarized and compiled into a report.
In this regard, the performance questions and indicators can provide important assessment tools
for the analysis. A final comparison with the outputs and impacts of the project should then be
made. In this way performance, progress and achievements of the project can be assessed.
Reporting
Feedback and reporting are key to both internal and external M&E as, in this way, information
can be meaningfully combined, explained, compared and presented. All reporting should thus be
as accurate and relevant as possible. As mentioned earlier, external M&E will frequently use the
internal project progress reports and other relevant information as part of the information
gathered to externally monitor and evaluate the project. For external M&E the report is usually
called an evaluation or review report.
Step 6: Disseminate Findings and Recommendations

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The evaluation reports, or summaries of these reports, should be widely distributed and presented
to decision-makers and key stakeholders including those who were consulted in the M&E
process.
Step 7: Learn from the M&E
Knowledge gained through M&E lies at the core of DW AF's organizational learning process.
M&E provides information and facts that, when analyzed, understood and accepted, become
knowledge that can be used to improve Project management. Besides learning about the
progress/achievements of the project outputs, etc, it is essential to learn from what works
regarding partnership strategies, project design and implementation, and to feed this knowledge
back into ongoing and future projects and policies. This information also provides a means to
regulate the sustainable management of state projects by other agencies.
Project evaluations can help to bring development partners together, and when this occurs the
learning from M&E goes beyond project to stakeholders involved in other development and
natural resource management activities.
Types of evaluation
Many types of evaluation exist, consequently evaluation methods need to be customized
according to what is being evaluated and the purpose of the evaluation. It is important to
understand the different types of evaluation that can be conducted over a program’s life-cycle
and when they should be used. The main types of evaluation are process, impact,outcome and
Summative evaluation.Before you are able to measure the effectiveness of your project, you need
to determine if the project is being run as intended and if it is reaching the intended audience.
Process evaluation is used to“measure the activities of the program, program quality and who it
is reaching” . It will help to answer questions about your program such as:
 Has the project reached the target group?
 Are participants and other key stakeholders satisfied with all aspects of the project?
 Are all activities being implemented as intended? If not why?
 What if any changes have been made to intended activities?
 Are all materials, information and presentations suitable for the target audience?
Impact evaluation is used to measure the immediate effect of the program and is aligned with
the programs objectives. It will help answer questions such as:
• How well has the project achieved its objectives (and sub-objectives)?

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 • How well have the desired short term changes been achieved?
For example, one of the objectives of Peer-project is to provide a safe space and learning
environment for young people, without fear of judgment, harassment or abuse. Impact evaluation
will assess the attitudes of young people towards the learning environment and how they
perceived it. It may also assess changes in participants’ self esteem, confidence and social
connectedness.
Outcome evaluation is concerned with the long termeffects of the program and is generally
used to measure the program goal. It measures how well the program goal has been achieved.
 Outcome evaluation will help to answer questions such as:
 Has the overall program goal been achieved?
 What, if any factors outside the program have contributed or hindered the desired
change?
In peer-based youth programs outcome evaluation may measure changes to: Mental and
physical wellbeing, Education and employment and help-seeking behaviors.
Summative evaluation: At the completion of the program it may also be valuable to conduct
summative evaluation.This considers the entire program cycle and assists in decisions such as:
o Do you continue the program?
o Is it possible to implement the program in other settings?
o How sustainable is the program?
o What elements could have helped or hindered the program?
o What recommendations have evolved out of the program?

Chapter Five: Evaluation: Some Basics of impact evaluation

5.1 Impact assessment basics

Development policies/projects are typically designed to change outcomes: for example, raise
incomes, improve wellbeing, improving learning, or reducing illness. Whether or not these
changes are actually achieved is a crucial public policy question. Impact evaluation help policy
makers decide whether projects/programs are generating intended effects. This can be called
evidence-based policy. Impact evaluations are needed to inform policy makers on a range of
decisions, from curtailing inefficient programs, to scaling up interventions that work, to adjusting
program benefits, to selecting among various program alternatives.

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Simply, an impact evaluation assesses the changes in the well-beingof individuals that can
beattributed to a particular project, program, orpolicy. This focus on attribution which is the
hallmark of impact evaluations.Correspondingly, the central challenge in carrying out effective
impactevaluations is to identify the causal relationship between the program orpolicy and the
outcomes of interest.Impact evaluations generally estimate average impacts of a program, project,
or a design innovation.

Example:

 Did a water andsanitation program increase access to safe water and improve health
outcomes?
 Did a new curriculum raise test scores amongstudents?
 Was theinnovation of including noncognitive skills as part of a youth training program
successful in fostering entrepreneurship and raising incomes?

Ineach of these cases, the impact evaluation provides information onwhether the program/project
caused the desired changes in outcomes, as contrasted with specific case studies, which can give
only partialinformation and may not be representative of overall program impacts. Inthis sense,
well-designed and well-implemented impact evaluations areable to provide convincing and
comprehensive evidence thatcan be usedto inform policy decisions, shape public opinion, and
improve programoperations.

Impact evaluations are a particular type of evaluation that seeks to answer a specific cause-and-
effect question: What is the impact (or causal effect) of a program on an outcome of interest?
This basic question incorporates an important causal dimension. The focus is only on the impact:
that is, the changes directly attributable to a program, program modality, or design innovation.
The basic evaluation question—what is the impact or causal effect of a program on an outcome
of interest?—can be applied to many contexts. For instance:

 what is the causal effect of scholarships on school attendance and academic achievement?
 What is the impact of contracting out primary care to private providers on access to
health care? If dirt floors are replaced with cement floors, what will be the impact on
children’s health?

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  Do improved roads increase access to labor markets and raise households’ income, and if
so, by how much?
 Does class size influence student achievement, and if it does, by how much?

As these examples show, the basic evaluation question can be extended to examine the impact of
a program modality or design innovation, not just a program. The focus on causality and
attribution is the hallmark of impact evaluations. All impact evaluation methods address some
form of cause-and-effect question. The approach to addressing causality determines the
methodologies that can be used. To be able to estimate the causal effect or impact of a program
on outcomes, any impact evaluation method chosen must estimate the so-called counterfactual:
that is, what the outcome
would have been for program participants if they had not participated in the program. In practice,
impact evaluation requires that the evaluation team find a comparison group to estimate what
would have happened to the program participants without the program, then make comparisons
with the treatment group that has received the program.
5.1.1 Qualitative versus quantitative impact Assessments

Most interventions have far-reaching goals such as lowering poverty or increasing

employment. Measuring the effectiveness of such interventions are often possible only
through impact evaluations based on hard evidence. Qualitative information such as
understanding the local socio-cultural & institutional context, program & participant
details, essential to a sound quantitative assessment. e.g., qualitative information can help
identify mechanisms through which programs might be having an impact. But, a
qualitative assessment on its own cannot assess outcomes against relevant alternatives or
counterfactual outcomes. That is, it cannot really indicate what might happen in the
absence of the program. A mixture of qualitative and quantitative methods (a mixed-
methods approach) might therefore be useful in gaining a comprehensive view of the
program’s effectiveness.

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5.2 Methodologies in impact evaluation

Before looking themethodologies of impact evaluation, it is necessary to discuss the

initial steps in setting up an evaluation. The steps include constructing a theory of change
that outlines how the project is supposed to achieve the intended results, developing a
results chain as a useful tool for outlining the theory of change, find a relevant
counterfactual, selection of respondents, collecting relevant data, and finally, there
should be rigorous analysis (measuring impact with appropriate methodological
approach). Since it is new for you as a Bachler student, we have discussed the first three
steps as follows.
1. Constructing a Theory of Change

A theory of change is a description of how an intervention is supposed to deliver the

desired results. It describes the causal logic of how and why a particular program, project,
or design innovation will reach its intended outcomes. A theory of change is a key
underpinning of any impact evaluation, given the cause-and-effect focus of the research.
As one of the
first steps in the evaluation design, constructing a theory of change can help
specify the research questions. Theories of change depict a sequence of events leading to

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outcomes; they explore the conditions and assumptions needed for the change to take
place, make explicit the causal logic behind the program, and map the program
interventions along logical causal pathways.
2. Developing a Results Chain

A results chain is one way of depicting a theory of change. A results chain establishes the
causal logic from the initiation of the program, beginning with resources available, to the
end, looking at long term goals. It sets out a logical, plausible outline of how a sequence
of inputs, activities, and outputs for which a program is directly responsible interacts with
behavior to establish pathways through which impacts are achieved. The result chain in a
typical program is resented as follow:

A basic results chain will map the following elements:

 Inputs. Resources at the disposal of the project, including staff and budget.
 Activities. Actions taken or work performed to convert inputs into outputs.
 Outputs. The tangible goods and services that the project activities produce;
these are directly under the control of the implementing agency.

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  Outcomes. Results likely to be achieved once the beneficiary population uses the
project outputs; these are usually achieved in the short to medium term and are
usually not directly under the control of the implementing agency.
 Finaloutcomes. The final results achieved indicating whether project goals were
met. Typically, final outcomes can be influenced by multiple factors and are
achieved over a longer period of time.
3. Finding the right Counterfactual

Counterfactual: What would have happened to the participants of an intervention had they not
received the intervention. The counterfactual can never be observed; it can only be inferred from
a control / comparison group different from the treatment group.
Control group: In an experimental design, the control group is a group from the same
population as the treatment group that, by random assignment, is not intended to receive the
intervention.
Comparison group: A group that is as similar as possible to the treatment group in order to be
able to learn about the counterfactual.
Treatment group: Group that receives the intervention.
Impact:The impact of the intervention is,therefore, estimated by measuring the differences in
outcomes between the treatment and comparison groups.
Causal Inference andCounterfactuals
CausalInference
Assessing the impact of a program on a set of outcomes is theequivalent of assessing the causal
effect of the program on those outcomes.Although cause-and-effect questions are common,
answering them accurately can be challenging. In the context of a vocational training program
(Do vocational training programs increase trainees’ incomes?), forexample, simply observing
that a trainee’s income increases after she hascompleted such a program is not sufficient
toestablish causality. The trainee’sincome might have increased even if she had not taken the
training—becauseof her own efforts, because of changing labor market conditions, or because
of many other factors that can affect income. Impact evaluations help us overcome thechallenge
of establishing causality by empirically establishing towhat extent a particular program—and
that program alone— contributed to the change in an outcome.

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To establish causality between a program and anoutcome, we use impact evaluation methods to
rule out the possibility thatany factors other than the program of interest explain the observed
impact.The answer to the basic impact evaluation question—what is the impact
or causal effect of a program (P) on an outcome of interest (Y)? —is given bythe basic impact
evaluation formula:
Δ = (Y | P = 1) - (Y | P = 0).
This formula states that the causal impact (Δ) of a program (P) on anoutcome (Y) is the
difference between the outcome (Y) with the program (inother words, when P = 1) and thesame
outcome (Y) without the program(that is, when P = 0).For example, if P denotes a vocational
training program and Y denotesincome, then the causal impact of the vocational training
program (Δ) is thedifference between a person’s income (Y) after participation in thevocational
training program (in other words, when P = 1) and the same person’sincome (Y) at the same
point in time if he or she had not participated in theprogram (in other words, when P = 0).
The Counterfactual
As discussed, we can think of the impact (Δ) of a program as the difference in outcomes (Y) for
the same unit (person, household, community, and so on) with and without participation in a
program. Yet we know that measuring the same unit in two different states at the same time is
impossible. At any given moment in time, a unit either participated in the program or did not
participate. The unit cannot be observed simultaneously in two different states (in other words,
with and without the program). This is called the counterfactual problem.
When conducting an impact evaluation, it is relatively straightforwardto obtain the first term of
the basic formula (Y | P = 1). However, we cannot directlyobserve the second term of the
formula (Y | P = 0) for the participant.We need to fill in this missing data by estimating
thecounterfactual.
Estimating the counterfactual
The key to estimating the counterfactual for program participants is to move from the individual
or unit level to the group level.Although no perfect clone exists for a single unit, we can rely on
statistical properties to generate two groups of units that are statistically indistinguishable from
each other at the group level (if their numbers are large enough).The challenge of an impact
evaluation is therefore to identify a treatment group and a comparison group that are statistically
identical, on average, in the absence of the program.If the two groups are identical, with the sole

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exception that one group participates in the program and the other does not, then we can be sure
that any difference in outcomes must be due to the program.Finding such comparison groups is
the crux (core) of any impact evaluation, regardless of what type of program is being
evaluated.Without a comparison group that yields an accurate estimate of the counterfactual, the
true impact of a program cannot be established.
• The treatment and comparison groups must be the same in at least three ways.

1. The average characteristics of the treatment group and the comparison group must be
identical in the absence of the program.For example, the average age of units in the
treatment group should be the same as in the comparison group.

2. The treatment should not affect the comparison group either directly or indirectly.In the
pocket money example, the treatment group should not transfer resources to the
comparison group (direct effect) or affect the price of candy in the local markets
(indirect effect).

3. The outcomes of units in the control group should change the same way as outcomes in
the treatment group, if both groups were given the program (or not).For example, if
incomes of people in the treatment group increased by $100 thanks to a training program,
then incomes of people in the comparison group would have also increased by $100,
had they been given training.

What if the counterfactual is not good?

An invalid comparison group is one that differs from the treatment group in some way other
than the absence of the treatment. Those additional differences can cause the estimate of
impact to be invalid or, in statistical terms, biased. Rather, it will estimate the effect of the
program mixed with those other differences.
5.2.1 Randomized evaluations

What is randomization?
Randomization involves randomly assigning a potential participant (individual, household or
village) to the treatment or control group. It gives each potential participant an equal chance of
being assigned to each group. The objective is to ensure that the only systematic difference

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 between the program participants (treatment) and non-participants (control) is the presence of
the program.
The Basic Treatment Effect Setup
Let us consider whether receiving a job training program increases wages. We compare two
people, the person in the training program and the one who is not, to determine whether their
outcomes are different. If these two people were identical, except for exposure to the program,
then the observed difference in their wages would be the treatment effect. It is abinary
treatment where a person is treated or not (ie, in a job training program, and the like).
Let Yjidenote the potential outcome of individual iin statej (unobserved):
• Y1i if individual iparticipated in the job training program
• Y0i if individual ihad not participated in the job training program

To identify the individual treatment effect, we needdi, Y1i,Y0i, (Xi and ui) for individual i. In
practice, we only observe di, Yi, (Xi). Therefore, in a given sample, the group with di=1 that
reveals (Xi,Y1i) is the treatment group and the group with di=0 that reveals (Xi,Y0i) is the
control group. Ideally we would measure the individual treatment effect for individual ias: Y1i–

Y0i , which can be rewritten as:

• Yi =diY1i + (1- di)Y0i
• Yi = diY1i + Y0i- diY0i Yi= Y0i + di(Y1i-Y0i)

But we don’t observe two potential outcomes for the same individual, only Y1i for the treated
person and Y0iif not. We do observe the difference in average outcomes (wages) for groups of
people treated (or not). So, we can measure average treatment effects:
• E(Yi|di=1) – E(Yi|di=0)

This can be rewritten in a potential outcomes framework: (Add and subtract the expected
outcome for non- participants had they participated in the program i.e., E(Y0i|di=1)
[E(Y1i|di=1) – E(Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
Average Treatment Effect Selection bias
on the Treated (ATT)
Average difference in Y0i (potential untreated
Impact of program for those alreadyin outcomes) for those who were and were not in
theprogramDifference in potential theprogram
outcomes, conditional ontreatment
Average Treatment Effect on the Treated (ATT)measures the impact of a program for those in
the program:

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 E(Y1i|di=1) – E (Y0i|di=1) = E(Y1i-Y0i |di=1)
It is the difference in the potential outcomes, conditional on treatment.The first expression is
what we observe; but the problem is the second expression. Why? Because, It is the average
wage of a person in a job training program if they had not been trained. Even if we can measure
the ATT, we also have to worry about selection bias:
[E(Y0i|di=1) – E(Y0i|di=0)]
In this selection bias equation, the second expression is what we observe; but the problem is the
first expression. Because it is the average wage of a person in a job training program had they
not been trained
To solve this problem, the researcher uses randomization: randomly assigning a potential
participant to the treatment or control group. Therefore, Randomization implies that:
E[Y0i|di=1] = E[Y0i|di=0]
This is because, if neither had received the treatment, their outcomes would have been the same
in expectation (treatment is independent of potential outcomes).Individuals assigned to the
Treatment and Control groups will be similar along all characteristics (X and u). Randomization
therefore forces the selection bias term to be zero. More specifically, look at the following
expression.
[E(Y1i|di=1) – E(Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
=[E(Y1i-Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
= [E(Y1i-Y0i|di=1)] + [E(Y0i|di=0) – E(Y0i|di=0)]
= [E(Y1i -Y0i|di=1)]
=E(Y1i -Y0i)
= E(Y1i) – E(Y0i)
So, if there is randomization, then we can calculate the Average Treatment Effect on the treated
(ATT) and also the Average Treatment Effect (ATE) by riding the selection bias to zero.The
Average Treatment Effect (ATE) is estimated as:
E(Y1-Y0) = E(Y1) - E(Y0).
This shows that, with randomization, Average Treatment Effect (ATE) is equal to the Average
Treatment Effect on the treated (ATT).
Measuring the Average Treatment Effect on the treated (ATT)

196
The treatment effect (ATT) can be measured by using two approaches:Group means comparison
and/or regression analysis. That is an unbiased estimate of the treatment effect can be identified
by simple group mean differencing like as follows:
ATT = [E(Y1i-Y0i|di=1)] = E(Y1i-Y0i) = E(Y1i) - E(Y0i)
= E(Y1|d=1) -E(Y0|d=0)
In addition to this We can also estimate the ATT under a regression framework:
Yi = γ + αdi + ui
Where, γ is the mean of the control group, α is the difference between Y1i and Y0i ,u is the random
part. this expression can be rewritens by plugging values for d and taking expectations:
E(Yi|di=1) = γ + α + E(ui|di=1) E(Yi|di=0) = γ + E(ui|di=0)
And then subtracting:

If the independence assumption holds, then the selection bias term equals zero. Then our
expression becomes: E(Yi|di=1) - E(Yi|di=0) = α. The magnitude of the treatment effect (α)
using the group means comparison or regression analysis should be equal if other explanatory
variables will not be included in the regression equation. Look at the following ttest and
regression output.

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 5.2.2 Matching Methods- Propensity score matching (PSM)

Matching methods compares the outcomes of adopters with those of matched non-adopters,
where matches are chosen on the basis of similarity on observed characteristics. That is, the
comparison group needs to be as similar as possible to the treatment group, in terms of the
observables before the start of the treatment. The method assumes there are no remaining
unobservable differences between adopters and non-adopters. Let us see the following tables
which shows exact Matching between the treated and untreated groups on four characteristics.

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 Source: Gertler et, al., 2016
Propensity score matching (PSM)
Propensity score is defined as the selection probability conditional on the confounding
variables:p(X) = p(D = 1|X). PSM constructs a statistical comparison group that is based on a
model of the probability of participating in the treatment, using observed characteristics
(Heckman et al., 1998; Smith & Todd, 2001). Participants are then matched on the basis of this
probability, or propensity score, to nonparticipants. There are two Fundamental assumptions:
1. Conditional independence (selection on observables) assumption: (Ya ,Yn) ^ D |X
2. Common support assumption: 0 <p(X) = prob(D = 1|X) <1. This ensures that trt
observations have comparison observations nearby in the propensity score distribution.

199
Different approaches are used to match participants and nonparticipants on the basis of the
propensity score. They include nearest-neighbor (NN) matching, caliper and radius matching,
stratification and interval matching, and kernel matching and local linear matching (LLM).
Regression-based methods on the sample of participants and nonparticipants, using the
propensity score as weights, can lead to more efficient estimates (Heckman, LaLonde, and Smith
1999; Shahidur et al., 2010).
Propensity score: To calculate the program treatment effect in PSM, we must first calculate the
propensity score P(X) on the basis of all observed covariates X that jointly affect participation
and the outcome of interest. The aim of matching is to find the closest comparison group from a
sample of nonparticipants to the sample of program participants (Gertler et al., 2016). Propensity
score can be estimated by using probit or logit regression. However, PSM has limitation. That is,
PSM assumes selection on observables; but selection on unobservables happens which leads to
biased result.

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American Development Bank and World Bank. doi:10.1596/978-1-4648- 0779-4. License:
Creative Commons Attribution CC BY 3.0 IGO
4. I.M.D Little and J.A. Mirrlees, project Appraisal and planning for developing countries.,
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5. Prasanna chandra, projects planning analysis, selection, implementation and review, New
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