Dev 2, Chap 4

4. Economic Analysis
4.1 Rationale for Social Cost–Benefit Analysis (SCBA) in
Projects
In SCBA, the focus is on the social costs and benefits of the project. These often differ
from the monetary costs and benefits of the project sponsors.

Principal sources of discrepancy between social and private (monetary) measures

1. Market imperfections
2. Externalities
3. Taxes
4. Concern for saving
5. Concern for redistribution
6. Merit wants

4.1.1 Market Imperfection

Key idea: Market prices—which form the basis for computing monetary costs and
benefits from the project‐sponsor’s viewpoint—reflect social values only under
conditions of perfect competition, a condition rarely met in developing countries.
When imperfections exist, market prices do not reflect true social values.

Common market imperfections in developing countries

1. Rationing of commodities
Government or administrative control over the price, quantity and distribution of
key goods.
2. Prescription of minimum‐wage rates
Legally mandated wage floors.
Wages paid under such legislation typically exceed the wages that would prevail in a
competitive market free of wage controls.
3. Foreign exchange regulations
Official exchange‐rate controls.
The official rate of foreign exchange in many developing countries is set below the
market‐clearing rate, leading to a premium in unofficial (black‐market) transactions.
 Implication:
– Minimum‐wage laws distort true labor costs.
– Exchange‐rate controls distort the real cost of foreign currency.

4.1.2 Externalities
Definition: A project may generate non‐market (external) effects that impact third
parties.
Positive (beneficial) externalities: E.g., technological spillovers, improved public
health or infrastructure benefits enjoyed by others.
Negative (harmful) externalities: E.g., environmental pollution, noise, congestion.
Treatment in SCBA:
Positive externalities are included in the benefit stream even though project
sponsors receive no direct payment from beneficiaries.
Negative externalities (like pollution) are included as social costs, despite
sponsors not bearing the monetary cost.

Why externalities matter in SCBA:

They represent real social gains or losses that are ignored in pure financial analysis
because they involve no direct monetary transaction for the sponsor.

Next steps:
We’ve now covered the rationale for SCBA and the first two discrepancy sources—market
imperfections and externalities.
When you’re ready, let me know, and we’ll proceed to the remainder of section 4.1 (taxes,
savings, redistribution and merit wants) on the next page.

Note: In SCBA, all costs and benefits are analyzed—irrespective of whom they accrue
to, or whether they involve actual monetary payments.

4.1.3 Taxes and Subsidies

Private viewpoint:
Taxes = monetary costs
Subsidies = monetary gains
Social viewpoint:
Both taxes and subsidies are treated as transfer payments (i.e., redistribution
within society)
 Hence: they are regarded as irrelevant for measuring net social costs or benefits

4.1.4 Concern for Savings

Private firm:
Does not distinguish between consumption and savings when valuing benefits
Social perspective:
Division of benefits into consumption vs. saving (investment) matters
In capital-scarce developing countries, one birr saved (and invested) is deemed
more valuable than one birr consumed
SCBA adjustment: assigns a higher shadow price to saved/invested funds and a
lower shadow price to consumption

4.1.5 Concern for Redistribution

Private firm:
Ignores who ultimately benefits from its projects
Society:
Cares about the distribution of benefits across socio-economic groups
A birr of benefit accruing to a poor household is valued more highly than a birr
going to an affluent household

4.1.6 Merit Wants

Definition: Goals or goods not determined by market demand, but deemed desirable
by policymakers for broader social welfare
Examples:
Adult education programs
Balanced-nutrition initiatives for schoolchildren
Treatment:
Private analysis: Ignores merit wants
SCBA: Includes them as social benefits, even though consumers wouldn’t
necessarily demand them
UNIDO’s Five-Stage SCBA Appraisal Method
(I.M.D. Little & J.A. Mirrlees, 1974; Prasanna Chandra, 1995)
A. Financial profitability at market prices
B. Net social benefits measured in economic (“efficiency”) prices
C. Adjustment for the project’s impact on savings & investment
D. Adjustment for the project’s impact on income distribution
E. Adjustment for the project’s impact on merit & demerit goods whose social values differ
from market values

Annex 4.1 – Compounding

(Details of compounding social costs and benefits over time appear in the annex on the next
page.)

— Let me know when you’re ready to move on to the Annex and the next page!

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Source: Written by Berhanu G/Mariam, Senior Assistant Professor

Annex 4.1 – Compounding

1. Interest as the “price” of capital
Capital (money) is a factor of production with a price called interest.
Lender receives interest; borrower pays interest.
2. Compounding defined
When you convert present money into future money, the future amount must be
larger.
How much larger? Depends on:
The interest rate (price of capital)
The investment period
3. Numerical illustration
1 Birr deposited at 10 % p.a. grows to 1.10 Birr after Year 1.
If left another year at 10 %, it grows to 1.21 Birr (1.10 + 0.11) at end of Year 2.
This growth process is compounding; its multiplier is the compounding factor.
Year 1 factor at 10 % = 1.10
Year 2 factor at 10 % = 1.21
 Reference tables: J. Prince Gittinger (1982), Compounding and Discounting Tables
for Project Evaluation, Johns Hopkins Univ. Press.
4. Compounding formula

F = Future value of a present amount

P = Present (initial) amount
i = Interest rate (decimal form)
n = Number of compounding periods (years)
5. Worked examples

Scenario Initial P Rate i n Factor Future F

(Birr) (%) (years) (1+i)n(1+i)^n (Birr)
a) 1 000 8 10 2.159 2 159
b) 5 000 10 8 2.144 10 720
c) 500 12 5 1.762 881
d) 4 500 15 15 Try yourself Try yourself
e) 26 000 12 5 Try yourself Try yourself

Annex 4.2 – Discounting

1. Discounting = inverse of compounding
Used to compute the present worth of future costs or benefits.
2. Discounting formula

P = Present value of a future amount F

F = Future amount
i = Discount rate (decimal)
n = Number of periods until payment or receipt

Let me know when you’re ready for the next page!

Thought for a couple of seconds

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Source: Written by Berhanu G/Mariam, Senior Assistant Professor

Annex 4.2 – Discounting Examples

Sum Future Rate of Discount Factor Present Value (P

Receivable Period (n Interest (i 1(1+i)n\tfrac{1} = F × Discount
(F) years) %) {(1+i)^n} Factor)
16 405 6 8 0.630 10 335
46 500 8 10 0.467 21 716
5 000 7 12 0.452 2 260
148 000 10 11 Try yourself Try yourself
35 465 12 15 Try yourself Try yourself
15 048 5 9 Try yourself Try yourself

4.2 Differences between Economic Analysis and

Financial Analysis
1. Perspective
Financial analysis: Evaluates a project from the viewpoint of the individual entity
participating in it.
Economic analysis: Evaluates from the perspective of the nation as a whole.
2. Pricing of inputs and outputs
Financial: Uses market prices.
Economic: Uses shadow (economic) prices to reflect true social costs and
benefits.
3. Treatment of externalities
Financial: Excludes external costs and benefits arising outside the entity (e.g.,
environmental impacts).
Economic: Includes externalities as part of social cost–benefit analysis.
4. Transfer payments
Financial: Includes taxes, duties, subsidies, interest, etc., as they affect the firm’s
cash flows.
 Economic: Excludes transfer payments, treating them as neutral redistributions
within society.

4.3 Projects Requiring Economic Analysis

Economic analysis should be undertaken when its cost is justified by the benefits of
improved decision-making. Conduct SCBA especially if:

Project size justifies the expense of performing the analysis.

There is a strong possibility that a project’s outcome—when valued at economic
prices—will differ significantly from an analysis conducted at market prices.

Let me know when you’d like to proceed to page 113!

4.3.1 When Economic Analysis Is Less Likely Needed

Economic (social cost–benefit) analysis may be unnecessary when:

Project scale is small, unless it’s a pilot likely to be replicated.

Financially viable & export-oriented: The project sells mainly for export, with no
significant negative externalities and no heavy use of undervalued local resources.
Financially viable & local-market: The project serves the domestic market, but isn’t
protected by subsidies/tariffs, generates no major externalities, and uses few
undervalued resources.
Social-sector projects with hard-to-value benefits: Where benefit valuation is
impractical, cost-effectiveness isn’t an issue, and alternative ways to achieve the same
objectives are difficult to identify (even though methods exist, consensus on valuation is
hard to reach).

4.3.2 The Processes of Economic Analysis

1. Annual Statement of Costs & Benefits at Constant Market Prices
Stage 1: Compute Net Internal Benefits =

Benefits – Investment Costs – Working Capital – Operating Costs

All figures expressed at constant market prices to isolate real project performance.
 2. Externalities & Linkages
Stage 2: Adjust for non-market effects:
+ External benefits (e.g., spillover gains)
– External costs (e.g., pollution)
+ Linkage effects (e.g., input-output multiplier gains)
Result = Net Internal Benefits after externality and linkage adjustments, still at
constant market prices.
3. Applying Shadow Prices
(Details on shadow pricing appear on the next page.)

Let me know when you’re ready to continue into the shadow-pricing methodology and Stage
3!

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Source: Written by Berhanu G/Mariam, Senior Assistant Professor

Stage 3: Applying Shadow Prices

Purpose: Convert market‐prices of costs and benefits into shadow prices that reflect
true social opportunity costs.
Methods:
1. Use official conversion factors published by the Ministry of Finance & Economy
(or MEDaC).
2. Multiply each market‐price cost/benefit by its conversion factor → yields net
benefits at shadow prices.

Resource Pricing & Economic Analysis

Key requirement: Reliable estimates and robust methodologies are essential to
determine a project’s economic viability.

Two Valuation Principles

1. Little & Mirrlees (1974) “Foreign‐Exchange Opportunity Cost” Principle
Valuation base: International market prices (opportunity cost in foreign exchange),
which better indicate trade possibilities than domestically distorted prices (inflated
by tariffs, taxes, monopoly profits, overstated wages, etc.).
 Interpretation: Each unit of input or output is worth as much foreign exchange as
the international price.
Assumption: No persistent excess capacity in the economy.
2. Efficient Use of National Resources Principle
Valuation base: The project’s ability to mobilize and efficiently deploy scarce
domestic resources to generate national income.
Focus: Measuring how well the project makes use of labor, capital, materials, and
land in social terms.

Approaches to Economic Analysis in Project

Formulation
Shadow‐pricing method: Directly adjusts prices via conversion factors (focus of this
text).
“Effects” method: Estimates net social effects without explicit price adjustment.
Both methods aim to answer the same core questions and are equally valid.

4.4 The Shadow Pricing Method

Objective: Reflect resource scarcity by valuing costs and benefits in terms of their social
worth rather than private market transactions.

Three essential modifications to financial analysis:

1. Putting values on all resources (including those traded or non‐traded).

2. Valuing unpriced resources:
Assign an economic value to resources not sold in any market (e.g., household labor
on family farms, use of communal grazing land).
3. Adjusting market prices of identifiable inputs and outputs via conversion factors so
they represent shadow prices.

Ready to proceed to the detailed shadow‐pricing calculations and examples on page 115?

Continuing Stage 3: Shadow‐Pricing Procedures

1. Eliminate Transfer Payments
 Definition: Remove from analysis all payments for which no goods or services are
received (e.g., taxes, subsidies, duties, loan interest, social‐security charges).
2. Classification of Inputs & Outputs
All project items are first grouped into three categories:
1. Internationally traded: Commodities and services with world‐market prices (e.g.,
wheat, fuel oil, imported machinery, skilled foreign personnel).
2. Non-traded: Goods/services without a world price (e.g., local civil‐works
construction, electricity, land use, domestic transport).
3. Unskilled labor: Local labor without a direct market price comparable to traded
wages.

A. Traded Items
Residual (“ex‐tax/subsidy”) price is split into:
1. Border‐price component:
Imports: CIF cost (Cost + Insurance + Freight)
Exports: FOB price (Free on Board)
2. Internal‐price component:
Handling, transport, storage and processing costs from point of supply to port
(exports) or port to point of demand (imports).
Currency conversion options (choose one):
1. Convert border price into domestic currency using a shadow exchange rate
(SER).
2. Convert internal component into foreign currency using a standard conversion
factor (SCF).
Rationale:
The official exchange rate (OER) often misrepresents true purchasing power.
SER (Lyn Squire & Herman Vander Tak, 1975; Little & Mirrlees, 1974) corrects for
this misalignment.
SCF adjusts for distortions in domestic pricing of non-traded services.

B. Non-Traded Items
Two treatment options:

1. Decomposition approach
Break the item down into:
A “traded” portion (e.g., inputs imported or exported)
 Unskilled labor component
2. Single-factor approach
Value at domestic price and then:
Either leave at that price (procedure i)
Or multiply by the SCF (procedure ii)

C. Unskilled Labor
Shadow Wage Rate (SWR):
The opportunity cost of labor—i.e., the net value workers would generate in their
next‐best alternative employment.
Typically lower than the market wage, since market rates include non-labor costs
(e.g., payroll taxes, fringe benefits, union premiums).

This completes the shadow-pricing methodology for traded, non-traded items, and labor. Let
me know when you’d like to move on to the worked examples and numerical illustrations on
page 116!

Thought for 4 seconds

Page 116
Source: Written by Berhanu G/Mariam, Senior Assistant Professor

4.4.2 Basis for Valuation of Economic Analysis – Elaboration

Objective: Ensure all prices used in SCBA reflect the true scarcity (opportunity‐cost)
value of resources.
Reality check: Perfectly competitive markets seldom exist; market prices must be
adjusted to reveal real or opportunity costs.
Conversion‐factor approach:
1. Express all project costs and benefits at world (border) prices, excluding taxes,
duties, and subsidies.
2. Convert foreign‐currency components at an appropriate exchange rate (often a
shadow exchange rate).
3. Estimate world‐price equivalents for non‐traded items when direct market prices are
unavailable.
 Key requirement: The accuracy of SCBA critically depends on correctly estimating
these adjusted prices.

Traded Items: Import & Export Parity Prices

Whether or not the project actually imports or exports a good, use:
Import‐parity price for items “as if” imported
Export‐parity price for items “as if” exported
See Tables 5.1 & 5.2 for general parity formulas; below is a concrete example.

Table 5.5 Export Parity Price for Haricot Bean (Birr / Ton)

S.N. Item Financial Economic

1 F.O.B. price at Assab port 3,361.50 3,361.50
2 Insurance –71.50 –64.35
3 Bank charges (0.5 % of FOB + 5 Birr) –21.81 –19.63
4 Impurities & spoilage (0.05 % of FOB) –1.68 –1.51
5 MTSC commission –7.92 –7.13
6 Port charges –11.81 –10.63
7 Port handling –49.61 –44.65
Net Export Parity Price 3,198.17 3,213.60

Notes:
– “Financial” column uses actual rates/fees.
– “Economic” column applies shadow-exchange rates or conversion factors to each
component.
– The resulting net prices feed into the SCBA as shadow-priced benefits of exporting.

Let me know when you’d like to proceed to Table 5.6 (Import-Parity Prices) or further
examples!

Continued Export-Parity Pricing (Table 5.1, cont’d)

 S.N. Item Financial (Birr) Economic (Birr)
8 Loading / Unloading / Storage – 6.75 – 6.08
9 Bagging and Assembly – 50.00 – 45.00
10 Overhead – 26.00 – 23.40
11 Transport cost from project area to Assab – 300.00 – 270.00
12 Net Export Parity Price at the Project 2 814.50 2 869.50

Interpretation:
After stripping out taxes, duties and other transfer payments, we split export
proceeds into “border‐price” (CIF/FOB) and “internal‐cost” components, then adjust
each by the shadow‐exchange rate or SCF as appropriate.
The resulting net export‐parity prices (2 814.5 Birr financial vs. 2 869.5 Birr
economic) feed directly into the SCBA as the social value of one ton of Haricot bean
exports.

Export vs. Import Parity Prices

If a project exports a commodity (e.g. Haricot bean), use export-parity prices (Table
5.1).
Example: Haricot bean → 2 814.5 Birr/ton (financial) vs. 2 869.5 Birr/ton
(economic).
If a project imports an input (e.g. fertilizer DAP), use import-parity prices (Table 5.2).
Example: DAP → 2 526.5 Birr/ton (financial) vs. 2 462.6 Birr/ton (economic).

Table 5.6 Import Parity Price of DAP (Birr / Ton)

S.N. Item Financial Economic

1 CIF at Assab (Birr) 1 887.9 1 887.9
2 Bank charge + 28.0 + 25.2
3 Handling and Clearing + 34.5 + 31.05
4 Inspection + 0.4 + 0.36
5 Custom duty + 0.0 + 0.00
6 Loading / Unloading + 20.0 + 18.00
7 Storage + 4.6 + 4.14
 S.N. Item Financial Economic
8 Spoilage / Wastage + 4.8 + 4.32
9 Bank interest charge + 98.3 + 88.47
10 Overhead cost + 26.0 + 23.40
— Net Import Parity Price 2 104.5 2 062.1

Note: The “economic” column adjusts each component by the SER/SCF, yielding the
shadow-priced cost of one ton of imported DAP.

That completes the exposition of export- and import-parity pricing. Ready to move on to the
next topic or page?

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Source: Written by Berhanu G/Mariam, Senior Assistant Professor

Continued Import-Parity Pricing for DAP

S.N. Item Financial (Birr) Economic (Birr)

11 Transport cost + 312.00 + 280.80
12 Mark-up (11 Birr / quintal) + 110.00 + 99.00
13 Import‐parity price at the project 2 526.50 2 462.64

Source: Adapted from Grain Market Research Project, Promoting Fertilizer Use in
Ethiopia, MIDROC, Addis Ababa, March 1997.

Valuation of Non-Traded Items

To value goods or services that lack an international price:

1. Find an appropriate market price (e.g., the prevailing local price in a competitive
segment).
2. Apply a conversion factor (SCF) to adjust that price to its equivalent world-price
(opportunity-cost) value.
 Note: If the local market is sufficiently competitive, the observed market price may itself
approximate the true opportunity cost.

4.4.3 Basic Issues in Shadow Pricing

Before applying shadow prices to specific resources, clarify these foundational concepts:

1. Choices of Numéraire
Definition: The unit of account in which all inputs and outputs are measured.
Key questions:
Should costs/benefits be expressed in domestic or foreign currency?
Use current versus constant values?
Should project returns be measured as consumption or investment?
UNIDO’s numéraire (1978):

“Net present consumption in the hands of the people at the base level of
consumption in the private sector in constant domestic-accounting Birr.”

2. Concept of Tradability
A good is tradable if it can be imported or exported—its international price then
reflects the economy’s opportunity cost.
Substitution logic:
Imports ↔ domestic production
Exports ↔ domestic consumption
The border (international) price thus represents the real social value (economic
efficiency) of a tradable commodity.

UNIDO approach: Shadow prices stem from three sources depending on how the
project affects the national economy, for example:
i. Increasing or decreasing total consumption in the economy
(Further points continue on the next page.)

Let me know when you’re ready to move on to the remaining shadow-pricing issues and
examples!

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Source: Written by Berhanu G/Mariam, Senior Assistant Professor
4.4.3 Basic Issues in Shadow Pricing (Continued)
A. Basis of Shadow Pricing by Project Impact
Depending on how a project affects the economy, different shadow‐pricing bases apply:

1. Consumption effects
Basis: Consumer willingness to pay
2. Production effects
Basis: Cost of production
3. Import–export effects
Basis: Foreign‐exchange value
4. Combined effects (e.g., decrease imports & increase exports)
Still use foreign‐exchange valuation

B. Treatment of Taxes
UNIDO guidelines on taxes in SCBA:

Include taxes when a project diverts non-traded inputs (fixed supply) away from other
producers or adds non-traded consumer goods.
Exclude taxes when a project augments domestic production by other producers.
Ignore taxes entirely for fully traded goods (taxes are transfer payments with no social
cost).

C. Consumer Willingness to Pay

If the project’s principal impact is on consumption, use willingness to pay as the

shadow price.

D. Shadow Pricing of Labor Inputs

When a project hires labor, three scenarios determine the labor shadow price:

1. Labor withdrawn from other employment

Shadow wage = what other employers would pay (marginal product of labor in its
next-best use).
2. Labor induced (new entrants)
 Social cost of creating additional workers includes:
a. Marginal product in previous (un)employment (zero if previously unemployed)
b. Leisure forgone (preservation wage)
c. Additional subsistence needs (e.g., extra food consumption)
d. Relocation costs (transportation & rehabilitation)
3. Labor imported
Shadow wage may be set by the foreign wage or prevailing SER‐adjusted cost of
bringing in workers.

Summary: The shadow wage rate (SWR) reflects the opportunity cost of labor—what
society forgoes when workers shift into the project, not simply the market wage.

Ready to proceed to the next page for further shadow‐pricing concepts and examples?

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4.4.3 (continued) – Labor Shadow‐Pricing Adjustments

e. Worker Consumption & Savings Impact

When a project pays market wages, workers’ increased consumption reduces the
pool of social savings and investment.
Training costs to upgrade worker skills must also be included as a social cost.

f. Imported Foreign Workers

The social cost of hiring foreign labor is the wage they command.
Add a premium for the foreign‐exchange remittances they send home from their
savings.

Shadow Wage Rate (SWR)

Definition: The marginal output of labor foregone elsewhere—i.e. the opportunity cost
of labor.
Determination: Estimate the wage laborers could earn “without” the project.

1. Skilled Labor
Normally in short supply.
 Use prevailing market wages as the SWR (their opportunity cost).
2. Unskilled Labor
Supply typically exceeds demand → pure opportunity cost ≈ 0.
However, “reservation wages” (the minimum wage below which individuals prefer
unemployment) imply a positive SWR.
Recommendation: Use conversion factors from the Ministry of Central Planning’s
National Economic Parameters to set the SWR.

Valuation of Partly Tradable & Partly Non‐Tradable Items

Procedure:

1. Disaggregate each item into its traded and non‐traded components.

2. For the traded portion:
Compute CIF price (Cost + Insurance + Freight) by deducting taxes, duties, tariffs.
Convert to local currency at the official exchange rate.
3. For the non‐traded portion:
Adjust its local market price by the appropriate conversion factor (SCF) to reflect
world‐price equivalence.

4.4.4 Measures of Economic Viability

Once all costs and benefits have been shadow‐priced, apply the same evaluation
techniques as in financial analysis, but using economic metrics:
Economic Rate of Return (ERR)
Economic Net Present Value (ENPV)
Economic Benefit–Cost Ratio (EBCR)

National Economic Parameters

Rationale: Market prices often misstate true social values.

Role: Provide a standardized set of efficiency prices (shadow‐price parameters) for
key goods and services, so individual analysts need not derive every single shadow
price from scratch.
Application: Use these parameters to value inputs/outputs where bespoke shadow‐
price estimation is impractical.
Let me know when you’re ready to move on to page 121’s discussion of specific National
Economic Parameters and their application!

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Page 121
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National Economic Parameters

Definition: A standardized set of conversion factors and rates with general
applicability to all public‐sector projects in the country. These parameters translate
market prices into economic (shadow) prices, ensuring consistency and comparability
across analyses. They are periodically estimated and published (typically every decade)
by the Ministry of Planning and Economic Development (or MEDaC).

Three Core Parameters

1. Shadow Exchange Rate (SER)
Purpose: Measures the scarcity value of foreign exchange by determining how
much average domestic consumption must be forgone to obtain one unit of
convertible foreign currency.
Interpretation: Often expressed in reverse as the Standard Conversion Factor
(SCF) = 1 / SER.
Use: Adjusts border‐price components of traded goods and services to reflect true
social cost or benefit in domestic terms.
2. Shadow Wage Rate (SWR)
Purpose: Captures the opportunity cost of labor—the output or leisure foregone
when one labor unit is employed by the project.
Components:
Skilled labor: Prevailing market wage (short supply).
Unskilled labor: Reservation wage adjusted by regional conversion factors
(often close to zero but above zero due to minimum subsistence/leisure values).
Use: Values labor inputs in SCBA, replacing market wages with social‐opportunity
costs.
3. Discount Rate
Purpose: The rate at which future economic costs and benefits are discounted
to their present value.
Derivation: Reflects the social time‐preference rate or opportunity cost of public
investment funds.
 Use: Employed in calculating Economic Net Present Value (ENPV), Economic Rate
of Return (ERR), and Benefit–Cost Ratios.

Parameter Categories
Beyond these core rates, national economic parameters encompass shadow‐price ratios for:

1. Primary factors (land, capital)

2. Traded goods (import/export parity factors)
3. Non-traded goods/services (sectoral conversion factors)
4. Average estimates (e.g., regional or sectoral prices where detailed data are
unavailable)
5. Discount rate

Application Note:
Project analysts must apply these nationally determined parameters rather than derive
bespoke shadow prices for every input or output—thereby ensuring comparability and
efficiency in public investment appraisal across all regions and sectors.

This completes the detailed summary through page 121. Let me know if you’d like to
proceed to page 122!

Page 122
Source: MEDaC & FDRE (1998), pp. 32–34; Written by Berhanu G/Mariam

4.5 National Economic Parameters for Ethiopia (1998

Estimates)
Context:
These parameters were published by the Ministry of Economic Development and
Cooperation (MEDaC) of the Federal Democratic Republic of Ethiopia in 1998 to guide
public-sector project appraisal. They include the social discount rate and a suite of
conversion factors—both aggregate and sector-specific—to translate market prices
into economic (shadow) prices.

4.5.1 Primary-Factor Conversion Factors

(World-price numéraires for key resource categories)

Resource Category Conversion Factor

Domestic resources 0.90
Unskilled labor, urban formal 0.73
Unskilled labor, rural formal 0.60
Unskilled labor, rural informal 0.98
Skilled labor 0.81

Interpretation: A factor of 0.73 for urban unskilled labor, for example, implies that 1 Birr
of observed wage in that category has a social opportunity-cost value of 0.73 Birr.

4.5.2 Aggregate Conversion Factors

(Average sector-level conversion factors)

Sector Conversion Factor

Manufacturing 0.81
Agriculture 0.98
Utilities 1.30
Transport 0.88
Construction 0.76
Standard Conversion Factor 0.90

Standard Conversion Factor (SCF) of 0.90 is the economy-wide average used for
items lacking more specific sectoral factors.

4.5.3 Sector- and Sub-Sector Factors

(Conversion factors for key tradable and non-tradable goods)

Commodity / Sub-Sector Conversion Factor

Coffee 1.12
Chat (khat) 1.52
 Commodity / Sub-Sector Conversion Factor
Wheat 0.83
Non-traded agriculture 0.90
Cattle 1.11
Sheep & goats 1.09
Pulses 1.02
Oil seeds 1.02

Note: A factor > 1 (e.g., 1.52 for chat) indicates that each Birr of market price
understates the true social value by 52 %.

Up next: These parameters feed directly into shadow-price calculations—multiplying

observed costs or benefits by the appropriate factor yields their economic price. Let me
know when you’d like to proceed to the section on the social discount rate and its
application!

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4.5.4 Additional Sector-Specific Conversion Factors

(World-price numéraires for key inputs & materials, MEDaC 1998)

Item Conversion Factor

Fertilizer 0.99
Fuel oil 0.79
Cement & other building material 0.69
Imported machinery 0.90
Imported vehicles 0.75
Imported raw materials 0.86
Construction—buildings 0.74
Construction—dams 0.77
Construction—roads 0.76
 Note: Apply these factors to each observed market cost to derive its economic
(shadow) price.

4.4.5 Practical Considerations During SCBA

1. Treatment of Transfer Payments
Definition: Taxes, duties, subsidies, interest charges, etc.
Guideline: Do not include these in economic analysis—they merely redistribute
existing resources and do not affect the economy’s aggregate resource availability.
2. Replacement Cost
For project assets whose economic life is shorter than the project horizon:
Exclude depreciation in SCBA.
Include the full replacement cost in the year when the asset must be replaced.
Include any residual (salvage) value at project end.
3. Sunk Cost
Definition: Costs of pre-existing facilities acquired by the project.
Guideline:
Omit sunk costs if the facilities have no alternative use—they are not
incremental to the project.
Include sunk costs only when valuing a rehabilitation (e.g., abandoned
irrigation)—to capture the true net benefit of improvement plus rehabilitation,
rather than only the incremental investment.
4. Physical & Price Contingencies
Risks:
Underestimating quantities of materials or labor.
Changes in the scope of physical works.
Underestimating prices of inputs at appraisal time.
Recommendation:
Include a contingency allowance of 5–10 % of base‐cost estimates.
Show this allowance separately to maintain transparency in cost projections.

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4.5 Issues in Project Analysis
A. Residual Value

Definition: The remaining value of investment items that are not fully consumed by the
end of the project period.
Treatment in SCBA:
Include the residual value as a terminal‐year benefit to reflect any salvage or
continuing productive value of assets.

B. Externalities (Revisited)

Definition: Non‐market costs or benefits imposed on third parties without direct

compensation.
Examples:
Positive: Reduced vehicle operating costs and accident savings from road
improvements; improved health and education outcomes in subsidized services.
Negative: Pollution of air or water supplies from industrial projects.
SCBA Principle:
Measure and, where possible, monetize external effects so they can be included
in the project’s cost–benefit framework (i.e., internalize externalities).

4.5.1 Depreciation
Guideline: Do not treat depreciation as an explicit cost in SCBA.
Rationale:
The incremental net‐benefit stream already embodies the return to capital,
encompassing both recovery of capital and returns (profits, dividends).
Depreciation is a bookkeeping allocation, not a resource cost; thus, it does not
appear in the numerator of the Benefit–Cost Ratio.
Residual value at project end (see above) ensures full capital recovery is captured.

4.5.2 Length of the Project Period

General rule: Choose an analysis period roughly equal to the project’s economic life—
the period over which the asset generates net benefits.
Considerations:
 Technical life of assets (e.g., tube wells, orchards) may exceed their economic
life due to technology obsolescence or declining efficiency.
Economic obsolescence: Assets may become uneconomic before they physically
wear out, particularly in fast-moving industrial or transport sectors.
Approach:
Use the expected economic life rather than the technical or physical lifespan to
define the SCBA horizon.

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4.5.3 Replacement Costs & Residual Value

Replacement Costs
For assets whose useful life is shorter than the project horizon (e.g., pumps,
machinery), include a replacement‐cost allowance in the year the asset must be
renewed.
Treat each replacement as a fresh capital expenditure in the cash‐flow schedule.
Residual (Terminal) Value
If an asset retains any undepreciated value at the end of the analysis period,
include that value as a positive benefit in the terminal year.
This ensures full recovery of capital is captured in the SCBA.

How Far to Carry Out Computation for Discounted

Measures
NPV
Report to the nearest thousand (or million) currency units; for small projects,
nearest unit may suffice.
IRR
Round to the nearest whole percentage point.
Benefit–Cost Ratio (B/C) & Net‐Benefit‐Cost Ratio (N/K)
Report to the nearest hundredth (e.g., 1.43 rather than 1.434).
4.6 Treatment of Uncertainty (Sensitivity Analysis)
“One of the real advantages of careful economic and financial project analysis is that it
may be used to test what happens to the earning capacity of the project if events differ
from guesses made during planning.”

Purpose: Assess how sensitive key performance indicators (NPV, FRR, ERR, B/C, N/K)
are to changes in underlying assumptions.
Typical variables to test:
Sale prices of outputs
Input costs (especially construction costs)
Implementation period (schedule delays)
Currency‐exchange rates or shadow‐price assumptions
Procedure:
1. Rework the base‐case analysis, holding all other factors constant except the one
under test.
2. Quantify the impact on economic metrics when the variable increases or decreases
by a specified percentage.
3. Identify critical “break‐even” values (minimum prices, maximum costs) at which the
project just meets acceptability criteria (e.g., NPV = 0, ERR = discount rate).

4.6.1 Prices & Cost Overrun

Price risk: Examine what happens if the project’s product fetches a lower (or higher)
market price than forecast.
Cost‐overrun risk: Projects—especially in construction—are prone to underestimating
costs.
Action: Model alternative scenarios with, for example, +10 %, +20 % cost
increases.
Outcome: Determine how cost overruns affect NPV, ERR, and B/C, and whether
the project remains viable under adverse conditions.

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Page 126
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4.6.2 Delay in Implementation & Output

Adoption lag:
Farmers or users may take longer than expected to adopt new practices or master
techniques—experimental trial results often overstate real‐world yields.
Equipment & administrative delays:
Procurement, shipping, or bureaucratic holdups can push back project
schedules.
Sensitivity tests:
Examine the impact of time delays on key criteria (NPV, IRR, N/K).
Test the effects of lower-than‐expected output or yields to gauge the need for
stronger extension services and realistic production forecasts.

Techniques of Sensitivity Analysis

Purpose: Assess project robustness by re‐calculating performance metrics under
alternative assumptions.
Approaches:
1. Adjust one variable at a time (e.g., increase costs or decrease yields) while holding
others constant.
2. Determine break‐even points—the percentage fall in benefits that drives NPV to
zero or B/C to one.
Note:
While sophisticated methods (e.g., Monte Carlo) exist, simple “what‐if” analyses
often suffice for non‐high‐investment projects.

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