Economic Analysis Concepts

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Economic Analysis Concepts
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Questions Decisions (1)

• Is the project justified ?- Are benefits greater
  than costs?
• Which is the best investment if we have a set of
  mutually exclusive alternatives?
• If funds are limited, how should different
  schemes be ranked?
• When should the road be built or upgraded?

3
Questions Decisions (2)

• What standard of construction should be used?
• What standard and frequency of road maintenance
  is optimal?
• Should staged construction be used?
• Are complementary investments required?

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Appraisal Framework

• All appraisals need a framework or model for
• a) Forecasting changes
• b) Evaluating those changes

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Components of Economic Analysis (1)

• Costs and benefits are measured in money terms
• Road construction and maintenance costs are
  compared with estimates of the direct primary
  benefits going to road users and road agency
• Secondary benefits are usually ignored
• Economic prices are used in constant terms

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Components of Economic Analysis (2)

• Costs and Benefits are forecast over the planning
  time horizon (usually between 10 and 20 years)
• Future Benefits are valued less as time
  progresses using the planning discount rate
• Costs and Benefits are compared using decision
  criteria such as NPV, IRR, etc.

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Economic and Financial Prices
The cost to the economy of road rehabilitation
and maintenance may differ from the financial
cost because of

• taxes and duties
• shortage of foreign exchange
• under-employment

The Government will usually be concerned with
ECONOMIC costs. Contractors will usually be
concerned with FINANCIAL costs.
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Use of Economic Prices
In an Economic Appraisal we use ECONOMIC (or
SHADOW) prices NOT FINANCIAL prices

• Adjust financial prices as follows
• Exclude all taxes and duties and subsidies
• Use the planning discount rate not financial
  market rate
• If overvalued exchange rate then value imports
  and
• exports more highly
• Use the opportunity cost of labor
• Standard Conversion Factors are now widely used
  for
• road construction costs

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Benefits from Road Investment

• Changes in transport costs occur because of
• Lower road roughness
• Shorter trip distance
• Faster speeds
• Reduced chance of impassability
• Reduced traffickability problems
• Change in mode

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Project Costs

• Management (including design and supervision)
• Labor
• Equipment
• Materials
• Land, Resettlement, Environment

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Primary Effects (1)

• Reduced vehicle operating costs (VOC)
• fuel and lubricants
• vehicle maintenance
• depreciation and interest
• Tire wear
• Crew time
• overheads
• Reduced journey time
• drivers, passengers and goods

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Primary Effects (2)

• Changes in road maintenance costs
• Changes in accident rates
• Increased travel
• Environmental effects
• Change in value of goods moved

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Secondary Effects

• Changes in agricultural output
• Changes in services
• Changes in industrial output
• Changes in consumers behavior
• Changes in land values
• Changes in income

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Consumers Surplus Approach

• Captures primary benefits
• Advantages Simple, cost based, traffic approach
  dependent on predicting changes in traffic
• Disadvantages May not address critical factors
  promoting either rural development or social
  access

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Normal and Generated Traffic Benefits
Transport cost savings to Normal traffic and
growth

Cost

Additional benefits to Generated traffic
C1
C2
Demand Curve (Price Elasticity of Demand)
T1
T2
Traffic
Normal
Generated
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Generated Traffic Benefits

• Traffic induced by the road investment are
  traditionally valued at
• Half the difference in transport costs
• Hence total generated transport cost benefits
• Generated Traffic Volume x Change in
  Transport Costs per km x Distance x 1/2

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Producers Surplus Approach

• Captures secondary benefits
• Advantages Draws attention to changes in
  agricultural output (key economic activity in
  rural areas)
• Disadvantages No reliable way of predicting
  response
• - impact studies give widely different answers
• - it could be based on agricultural supply
  price
• elasticities but this is almost never done
  it requires very careful examination to use.
• For most projects benefits are just invented !

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Producers Surplus
Price Costs per Unit of Output
IncreasedFarmgate Price
P2
P1
Lower Input Costs
Output
O1
O2
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Coverage and Double Counting

• Any economic analysis should be designed to give
  maximum coverage of benefits
• But we must avoid double counting. Do not add
  primary and secondary benefits (e.g. changes in
  land values added to changes in transport costs)
• In a competitive economy the consumers surplus
  approach (used in HDM) should be adequate

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Economic Comparisons

• Economic analysis involves a comparison of
  With and Without project cases
• Forecasts are made of traffic, road condition,
  VOC and road maintenance effects for BOTH
  scenarios
• An unrealistic Without case (i.e. with little
  maintenance) can give a false result
• A range of With investment cases should be
  analyzed to find the best solution

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Traffic Categories

• Normal traffic Existing traffic and growth that
  would occur on road, with and without the
  investment
• Diverted traffic Traffic diverted from another
  road with same origin and destination to as the
  project road as a result of the investment
• Generated traffic Traffic associated with
  existing users of the road driving more
  frequently or driving further than before
• Induced traffic Traffic attracted to the project
  road due to increased economic activity in the
  roads zone of influence brought about by the
  project

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Benefits from Road Investment
Transport cost savings for existing (or normal)
traffic Normal Traffic Volume x Change in
Transport Costs per km x Distance Main changes
in cost from a) change in transport MODE b)
reduced journey TIME c) reduced VOCs
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Benefits of Upgrading to a Motorable Track
Headloading
C1
Track
Costs
Improved
road
C2
C3
T1
T2
T3
Traffic
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Cost Effectiveness Against Standard of Road
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Development Benefits

• Development benefits arise from a combination of
  increased traffic and reduced transport costs.
• Benefits may also include
• Increased agricultural production
• Increased service provision
• Increased industrial activity

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Estimating Benefits

• Normal traffic benefits tripsN d1 (VOC1-
  VOC2)
• Diverted traffic benefits tripsD ((d1
  VOC1)-(d2VOC2))
• Generated and Induced traffic benefits tripsG
  d2 (VOC1- VOC2)/2
• d1 existing road length d2 new road
  length
• VOC1 vehicle operating costs per km without
  investment
• VOC2 vehicle operating costs per km with
  investment
• VOC data relates to each road section and its
  condition at the time

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Economic Decision Criteria (1)

• Net Present Value
• NPV (B1- C1)/(1 r) (B2- C2)/ (1 r)2
  (Bn- Cn)/(1 r )n
• Internal Rate of Return
• To calculate IRR, solve for r, such that NPV 0
• B1, B2Bn Benefits in years 1, 2 n
• C1, C2Cn Costs in years 1, 2 . n r
  Planning discount rate n Planning time
  horizon

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Economic Decision Criteria (2)

• Net Present Value/ Investment Cost
• NPV/ C NPV/Ci
• First Year Rate of Return
• FYRR (B1- C1) / Ci
• B1 , C1 Benefits and Costs in year 1 after
  construction
• Ci Road investment costs
• Payback Period

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Economic Decision Criteria (3)

• NPV IRR3 NPV/C FYRR
• Project economic validity V.Good V.Good V.Good Poo
  r
• Mutually exclusive projects V.Good Poor Good Poor
• Project timing Fair Poor Poor Good
• Project screening 1 Poor V.Good Good Poor
• Under budget constraint 2 Fair Poor V.Good Poor
• Notes
• 1. check for robustness to changes in key
  variables (sensitivity analysis)
• . with incremental analysis
• . IRR may be indeterminate with NONE or MANY
  solutions.

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Present Value Calculation
Period Flow
A0
PV(A0) A0
0
1
2
3
4
A5
PV(A5) A5 / (1 i ) 5
5
6
7
PV(Aj) Aj / (1 i ) j
PV(Aj) Present Value of Aj
Aj Amount at year j
i Discount rate
j Year
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Present Value at 12.0 Discount Rate
1.00
1.00 in
Year 1

in Year 1
Year 2
0.89
Year 3
0.80
Year 4
0.71
0.64
in Year 1
1.00 in
Year 5

0.57
Year 6
0.51
Year 7
0.45
Year 8
0.40
Year 9
Year 1 0
0.36
1.00 in

in Year 1
in Year 1
1.00 in

0.20
Year 15
0.12
Year 20
in Year 1
1.00 in

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Discount Rate

• The discount rate is opportunity cost of capital
  in the public sector, ie the rate of return on
  marginal public sector investments
• The discount rate to be used will be given by the
  planning authority responsible for the project
• The World Bank traditionally has not calculated a
  discount rate for each project but has used 10 to
  15 percent as a notional opportunity cost of
  capital in developing countries

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Discount Rate Versus Interest Rate
US discount rate around 4
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NPV and IRR

• The Net Present Value (NPV) of a project
  alternative relative to the without project
  alternative is the sum of the discounted annual
  net benefits.
• The Internal Rate of Return (IRR) is the discount
  rate at which the NPV is zero.

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NPV Decision Rule

• 1. If the NPV is positive, for the chosen
  discount rate, then the alternative is
  acceptable.
• 2. If the NPV is negative, for the chosen
  discount rate, then the alternative is
  unacceptable.
• 3. If the NPV is zero, for the chosen discount
  rate, then the alternative is indifferent to the
  without project alternative.

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NPV and IRR Calculation (1)
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NPV and IRR Calculation (2)
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NPV Versus IRR
- The IRR and NPV will not necessarily rank the
alternatives by the same order- Always use NPV
to compare project alternatives
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Multiples Rates of Return
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No Rate of Return
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Same Rate of Return
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Incremental Rate of Return
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IRR Reinvestment Assumption
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Modified Internal Rate of Return
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Benefits X Cost
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Net Benefits X Costs (Efficiency Frontier)
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Comparison of Alternatives

• When comparing project-alternatives, the Net
  Present Value (NPV) is used to select the optimal
  project-alternative (alternative with highest
  NPV)
• The Internal Rate of Return (IRR) or the B/C
  ratio are not recommended to compare alternatives
  of a given project

Alternatives NPV0.03.76.75.5
Project
Optimal AlternativeHighest NPV
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Ranking Projects

• When comparing the economic priority of different
  projects, a recommended economic indicator is the
  NPV per Investment ratio

Selected Alternative OverlayReseal Overlay
NPV/Investment 8.45.2 2.1
PRIORITY
Projects
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Budget Constraints Simple Methodology
Selected Alternative OverlayReseal Overlay
Reseal Overlay
NPV perInvestment 8.45.2 4.0 1.5 0.5
NPV 16.815.6 20.0 3.0 5.0
Investment 2.03.0 5.0 2.0 10.0
Projects
PRIORITY
Available Budget
Budget Constraint Cut Off
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Budget Constraints Optimization
NPV0.03.76.75.50.02.01.03.50.05.42.1
3.2
Projects Alternatives
Evaluates all possible combinations of
project-alternatives to find the combination that
maximizes the NPV of the overall network for the
given budget constraint. P Number of projects A
Number of alternatives C Number of possible
combinations C A P
Available Budget
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HDM-4 Optimization Example (1)
Section 1
Option
NPV
Cost
2
A
4
5
B
7
7
8
C
Section 2
Option
NPV
Cost
1
3
A
3
6
B
5
C
8
What is the recommended program for a budget of 5?
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HDM-4 Optimization Example (2)
dNPV/dCost
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HDM-4 Optimization Example (3)
Combination of project alternatives that
maximizes the NPV of the network
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Appraisals Post Evaluations (1)

• An Appraisal is carried out before an investment
  is made. Everything is uncertain.
• A Post evaluation may be made say 5 years after
  the investment. The investment is known and 5yrs
  of with case are known.
• The without case is unknown as is the
  remainder of the with case.

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Appraisals Post Evaluations (2)

• In Both Cases forecasting and evaluation models
  are required to come to an answer.
• Hence we can never be certain about the viability
  of an investment !

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Sensitivity Analysis

• Consequences of changes on inputs
• Investment Costs (e.g. 15)
• Traffic Growth Rate (e.g. zero)
• Generate Traffic (e.g. zero)
• Value of Time (e.g. zero)
• A Investment Costs Increase (e.g. 15)
• B Road User Benefits Decrease (e.g. -15)
• C A and B together

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Switching Values Analysis

• Inputs that yield a NPV equal to zero
• Investments Costs
• Normal Traffic
• Traffic Growth Rate
• Generate Traffic
• Investment Cost
• Road User Benefits

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Risk Analysis

• Inputs vary at the same time following some
  defined distributions

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Rural Transport Infrastructure
Tracks
Roads
Highways
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Rural Transport Infrastructure
Focus on social evaluation (cost effectiveness
indices, community priorities and multi-criteria
analysis)
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Social Benefits Why the Concern ?

• There is unease with conventional appraisal based
  primarily on transport cost savings to traffic
• There is a strong desire at community and
  national levels for better access and mobility
  which is frequently not matched by standard
  measured economic benefits
• The rich world governments subsidise rural
  transport. Should the same happen for developing
  countries ?
• Isolation is a recognised characteristic of
  poverty
• There is a feeling that a minimum degree of
  access and mobility is a basic human right
• Development has moved away from a narrow
  definition of economic development towards
  concern with livelihoods and meeting
  Millennium Development Goals
• The issue is particularly important when roads
  are impassable to motor traffic

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Economic Social Benefits

• Consumers and producers surplus approaches are
  very economic in orientation. Yet roads provide
  social benefits including improved access to
  health and education facilities and improved
  social mobility that cannot be easily translated
  into conventional economic benefits. Although
  they may have important long term economic
  consequences. Improved health and education and
  more secure social networks increase long term
  earning capabilities but so far the economic
  forecasting framework does not include this.
• When roads are impassable to motorized traffic we
  know that the quality of health care and
  schooling falls. Drug supply and supervision
  drops. Likewise no NGO, government agency or
  commercial enterprise will establish or support a
  service which cannot guarantee all year round
  access.

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Indices and Ranking

• Widely used for feeder road planning there are
  many different approaches
• e.g. i) cost of improvement /
  population
• ii) estimated trips / cost
• Advantages Speed , simplicity, transparency,
  many factors can be incorporated
• Disadvantages How do we value widely different
  factors ? (adding up apples and pears)
  weightings are not stable cannot easily address
  questions of road standards, timing etc,
  possible double counting

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Example of Two Indices

• i) Andhra Pradesh (India)
• cost effectiveness cost of upgrading/
  population served
• But no measure of condition change and no
  importance to traffic
• ii) Airey Taylor
• 1st for impassable roads
• rank cost per head of
  establishing basic access
• 2nd when access is there
• 
  estimated trips x access change
• prioritization index
  --------------------------------------------
• 
  rehabilitation cost per km

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Community Priorities

• Community priorities now often form an important
  part of feeder road appraisal. It is possible
  just to ask communities to rank the investments
  they prefer- both within the road sector or
  between roads and other investments.
• Advantages Community acceptability, use of
  community knowledge
• Disadvantages Sectional interest groups may
  dominate voting, community knowledge of area or
  road impact may be poor

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Cost Effectiveness Analysis (CEA)

• Compares the cost of interventions with its
  predicted impacts and it is used where the
  benefits cannot be measured in monetary terms, or
  where the measurement is difficult
• It includes provisions that (a) the objectives of
  the intervention are indicated and are clearly
  part of a ampler program of objectives (such as
  reduction of the poverty) and (b) the
  intervention represents the smaller cost
  alternative of obtaining the indicated objectives
• It produces effectiveness indicators, such as
  Total Beneficiary Population per Investment or
  Investment per Beneficiary Population

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CEA Comparison of Alternatives

• To compare project-alternatives, the investment
  cost is used to select the optimal alternative
• The selected alternative is the one with the
  lowest investment cost that will achieve the
  objective of the program

Alternatives Investment 2.03.71.75.5
Project
Optimal AlternativeLower Investment
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Projects Eligibility with CEA

• To assess if a project is eligible, an acceptable
  effectiveness indicator threshold is defined

Investment perPopulation(U/person)
50150 500
EffectivenessIndicatorThresholdExample
Projects
Eligible
Not Eligible
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Effectiveness Indicator Threshold
Evaluate Universe of Projects and Available Budget
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Possible CEA Indicators

• Investment Cost per Total Beneficiary Population
• 100 US per person
• Total Beneficiary Population per Investment Cost
• 0.01 persons per US
• Total Beneficiary Population per Investment Cost
  in thousands of dollars
• 10 persons per 1,000 US
• Etc.

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Options for Beneficiary Population

• Rural beneficiary population
• Effectiveness (rural beneficiary population) /
  Investment
• Poor beneficiary population
• Effectiveness (poor beneficiary population) /
  Investment
• Mixed beneficiary population
• Effectiveness (poor persons 0.3 non poor
  persons) / Investment
• Etc.

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Total Beneficiary Population (1)

• Total Beneficiary Population Directly Benefited
  Population Indirectly Benefited Population
• The Directly Benefited Population is the one that
  lives next on the road, defined for example to
  2.0 km at each side of the road, and the
  population in the ends of the road, depending on
  its characteristics and the use of the road
• The Indirectly Benefited Population is the
  population that lives in other roads near the
  road in consideration, who use the project road
  to arrive at the main population center of the
  region or at a main road

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Total Beneficiary Population (2)
For example, for the road section B-CDirectly
Benefited Population Population along section
B-C plus on towns B and CIndirectly Benefited
Population Population along section A-B plus on
town A
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Multi Criteria Analysis (MCA) (1)

• It adopts criteria such as traffic, proximity to
  educative, health, and economic centers, etc.
• To each section, a number of the points is
  assigned to each criteria that correspond to the
  fulfillment of the criteria
• The added number of the points that each section
  receives is computed simply adding the points
  assigned for each criteria, or with the use of a
  more complex formula, for example, weighting the
  criteria by their perceived importance

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Multi Criteria Analysis (2)

• It produces a priority indicator
• The indicators used in a MCA reflect implicit
  economic and subjective evaluations
• If the weights and the points are decided and
  assigned on a participative way, the MCA has the
  potential to be a good participative method for
  planning based on implicit a socioeconomic
  estimates
• Nevertheless, it tends to be applied by planning
  consultants or in isolation without the
  consultation with the users and communities
  affected by the project

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Multi Criteria Analysis (3)

• The result of the MCA, is often, unfortunately,
  not transparent, specially if many factors are
  considered and a complicated formula is also
  applied
• Therefore, if it is adopted, this method must be
  used very carefully and to be maintained simple,
  transparent, and participative

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Multi Criteria Analysis Example (1)

• Level of poverty of the influence area (Low,
  Medium, High)
• Potential for economic development of the
  influence area (Low, Medium, High)
• Importance of the road given by local
  consultation process (Low, Medium, High)
• Provision of access of social services of the
  road (Low, Medium, High)
• Problems of transitability of the road (Low,
  Medium, High)
• Functional classification level of the road (Low,
  Medium, High)
• Existence of public transport (Low, Medium, High)

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Multi Criteria Analysis Example (2)
Factor Value / Maximum Value