Economic Valuation in Closed Economy

8/3/2019 Economic Valuation in Closed Economy

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ECONOMIC VALUATION IN CLOSED

ECONOMY THE HARBERGER APPROACH


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THE ESSENTIAL ELEMENTS OF AN ECONOMIC ANALYSIS

Financial Analysis Economic Analysis

Adjustments:

Common features:

Discounted cash flow

Sensitivity or probability analysis

Deduction of transfer payment within the economy from project cash flow

Inclusion of any net change in CS in net benefits and the exclusion of any

change in PS from cost

Estimation of economic or shadow price for project output and produced

input to correct for any distortion in the market

The estimation of economic price from non-produced project inputs

(labor, natural resource) to correct for any distortion in the market

The valuation and inclusion of any externalities

The valuation and inclusion of public goods

The estimation and use of an appropriate social discount rate


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ECONOMIC OR SHADOW PRICE

Shadow Price = Economic Price = Accounting Price It corrects for any divergence between market and

economic price due to market failure, government

intervention, externalities, public goods, CS and PS,

and distributional consideration

Economic pricing Harberger Equation Approach

Shadowprice

increase insocial

welfare

well-definedsocial

welfarefunction

real incomeper capita


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TRANSFER PAYMENT

TP can be defined as payments that are made

without receiving any good or service in return.

YES NO

Taxes (personal and company income tax,

value added tax and other indirect taxes)

Sales tax, externality or

pollution tax, bad-goods tax

Subsidies including those given via price

support scheme

Tariffs on import an export subsidies and taxes Tariffs to protect infant

industry

Producer surplus (gain received by an existing

supplier of a factor as a result of an increase in

the price of that factor)

Credit transaction between domestic

borrowers and lenders

Foreign loan receipt and

repayments


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CUSTOMER SURPLUS

CS measure the differences between the amountconsumer would be WTP for a good and service

and what they actually have to pay for it

Pro ect is relativel

Downward sloping

Fall in e uilibrium large suppliern curve o eprojects output

price

Additional CS afterproject


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In Economic Analysis, any

change in CS as a result of

the project should be

included in projects

economic cash flow

because these changes

represent real effect on

Price (cent/kg) S

D

Sp

20

peoples welfare

Gain in CS:

7.5 cents (CS) + 15 cents

(actual payment) = 22.5

cents What about public good?

(Ex. free hospital service)

15

1 2 Quantity of rice (kg)

Gain in CS from reduction in the price of rice


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PRODUCER SURPLUS

PS measure the differences between the amountthat suppliers on an input would be WTA

(willingness to accept) to supply this input and the

amount that they actually received for supplying it.

PS is not an economic cost, but just a rent that

transferfed from consumer to producer


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Electricity for almuniumsmelting

When tariff rises from P2 toP3, Q2 increases to Q3. Totalamount for newly supply

Q2Q3CF; just Q2Q3CB will betrue economic cost.

At Q3: actual cost QoQ3CP3;actual resource QoQ3CPo;thus PoCP3 represents theamount WTA (PS)

Electricity

Tariff S

P3 E F C

User who are un-WTP at P3will loss their welfare QpQ2BE

In total: Financial costQpQ3CE; economic costQpQ3CBE. So, in economic

analysis PS (EBC) must bededucted from financialanalysis

P2 B

Dp

D

Po

Qo Qp Q2 Q3 Quantity (MWh)


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MEASURING ECONOMIC BENEFITS OF PROJECT OUTPUTS IN

CLOSED ECONOMY WITH NO DISTROTION THE

HARBERGER APPROACH

Harberger Approach (Harberger,1971; Jenkins and

Harberger,1991) measures the economic benefits and

costs of project outputs and inputs in term of their

demand and supply price and elasticity, and thereforeautomatically includes any change in CS and PS

It is used to shadow price non-traded and traded goods

as well as foreign exchange rate and capital

The measurement of the economic benefit generated

by a project depends on whether the output producedmeets new demand, or merely substitutes for an

existing source of supply for that good and service


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1. Economic Benefits IfProjects Output Meet NewDemand (Railway)

If a project increases total

supply of a good and serviceavailable in a closed economy,its economics benefit will bemeasured in term of the extrabenefit (marginal socialbenefit, MCB), which peoplederive from consuming this

increased output.

Rail fare

S Sp

MCB itself can be measuredby what are WTP for it,assuming societys incomedistribution is optimal.

In freely operating marketwith no externalities or CS,

the amount that people areWTP for a good will be equalits competitive demand price(Pd).

Pd D

Economic benefit =

WTP for new output

Q Qd Quantity of rail service


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2. Economic Benefits If

Projects Output Substitutes

for Existing Supply (Bakery)

Since the output was

already available, the value

of the project is not WTP

(demand price), but the

labor, capital, foreign

exchange and raw material

resources saved by the

Price

D S

Sp

Pos B

displaced supplier (supply

price)

Demand is inelastic, so the

increased supply will only

drive the price down and

force some existing

producers out of the

business

P1s C

Economic Benefit =

resources saved

by displaced supplier

Qs Qd Quantity


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3. Economic Benefits IfProjects Output PartiallyMeet New Demand and

Partially Substitutes forExisting Supply (ShoeFactory)

With establishment of newfactory, supply curve moveout from So to Sp. The benefit

of the project that the fall inprice:

encourage an increase indemand and the economicbenefit: QoQ1CA (financialbenefit =QoQ1CD + CS = ADC)

Price

D So

S orce o some ex s ngproducers out of the industry,cutting the amount supplied(Qo to Qe). The economicbenefit: QeQoAB

Total economic benefit =

QeQ1CAB :(amount actuallypaid by consumer = QeQ1CB)+ (CS = PoP1CA) (loss in PS =PoP1BA)

Po = 20 E A

P1 = 15 B C

D

Qe Qo Q1 Quantity good

180 200 280


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THE HARBERGER EQUATION FOR MEASURING

ECONOMIC BENEFIT (1)

The projects total economic benefits can bemeasured by the weighted average of demand and

supply price of its output, where the weight are the

quantity of output that meet new demand and

(1) Benefit:

(2) Benefit per unit output:

Where: AvP is the average price of output before and after theproject = (P1+Po)/2; Qs is the quantity of output substituting forexisting supply (Qo-Qe); Qd is the quantity of output meeting

new demand (Q1-Qo)

QdxAvPdQsxAvPs

QdQs

QdxAvPdQsxAvPs


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Economic Benefits If

Projects Output Partially

Meet New Demand and

Partially Substitutes forExisting Supply

AvP = (20+15)/2 = 17.5

Total Economic Benefit :

= AvPs x Qs + AvPdx Qd= (17.5 x 20) + (17.5 x 80)

= 1,750

Economic benefit per output:

= 1,750/100

Price

D So

Sp

= 17.5Po = 20 E A

P1 = 15 B C

D


180 200 280


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THE HARBERGER EQUATION FOR MEASURING

ECONOMIC BENEFIT (2)

The economic benefit per unit output (i) can also beexpressed in term the price elasticity of demand and supply

(the slope of its demand and supply) for the projects output

This may be useful in a situation where the analyst has

estimates of the elasticities of demand and supply for the

goo to e pro uce rat er t an pr ce ata o ow muc t eplanned production will meet new demand and substitutes

for existing supply.


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(3) Benefit per unit of output:

(4) Ws is the weighted on the supply price =

(5) Wd is the weighted on the demand price =

didsis WPWP

is

ididis

is

Q

Q

id

Q

where: is is the price elasticity of supply; id is the priceelasticity of demand; Pid is the average demand price; Pis isthe average supply price; Qis is the quantity supplied; and Qid

is the quantity demanded for output i

is

ididis

is

id

Q

Q

Q


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Value alternatives of economic benefit

is

ididis

is

idididisis

Q

QQ

QPP

Meet New Demand Substitutes

id infinity Zero

Wd (5) Unity Zero

Ws (4) Zero UnityEconomic benefit

mesurement (3)

Pd Ps


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Economic Benefits If

Projects Output Partially

Meet New Demand and

Partially Substitutes forExisting Supply

Price

D So

Sp

1

6.120020

580

4.0200

20

5

20

is

id

id

is

Q

Q

xQdPdx

PQd

xQs

Psx

P

Qs

Po = 20 E A

P1 = 15 B C

D


180 200 280

5.17)6.14.0(

)5.176.15.174.0(

xx

u st tut ng toEconomic benefits per unit of output:

Total economics benefits:= (17.5x20) + (17.5x80)

= 1.750


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MEASURING ECONOMIC COSTS OF PROJECT INPUTS IN

CLOSED ECONOMY WITH NO DISTORTION THE

HARBERGER APPROACH In economic analysis, the cost of a projects inputs are

valued in term of their opportunity cost that indicate thevalue in the next best alternative uses

In freely operating market, if the projects requirements for

,cost will be the marginal social cost of the increasedproduction. The economic cost of the inputs will equalsupply price (Ps) because of completely elastic in supplycurve

If the projects demand for input must be met by displacingexisting users of these inputs, the economic cost will be theamount that these displaced counsumers were WTP for theinputs or their demand price (Pd)


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Economic Costs If Projects

Input Partially Supplied fromNew Production and Met byDisplacing ExistingConsumers (Steel Products)

The rise in price because ofdemand increases affects:

Force some of the existing

consumers to lower consumption(Qo to Qd). The economic cost isthe utility lost by the displaceconsumers = QdQoFE (WTP)

Encourage an increase in supply(Qo to Q1). The economic cost is

Price

S

producers to increase output =QoQ1GF

Total economic cost (QdQ1GFE) =financial cost (QdQ1GE) thegain in PS (PoP1FGP1) + loss in CS(PoFEP1)

PS (EFG) is substracted because itjust transfer from consumers toproducers

P1 = 550 E G

Po = 500 H

F

Dp

D

Qd Qo Q1 Quantity

17 20 22


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The economic cost calculation

(7) Cost: (8) Cost per unit output:

Where: AvP is the average price of input; Qs is the quantity ofinput met by new supplier (Q1-Qo); Qd is the quantity of input

QdxAvPdQsxAvPs

QdQs

QdxAvPdQsAvPs

met y spac ng ex st ng consumers o-


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(9) Cost per unit of output:

(10) Ws is the weighted on the supply price of input (j) =

(11) Wd is the weighted on the demand price of input (j)=

djdsjs WPWP

js

jd

jdjs

js

Q

Q

jd

Q

where: js is the price elasticity of supply; s is the priceelasticity of demand; P d is the average demand price; Pjs theaverage supply price; Q s is the quantity supplied; and Qjd is

the quantity demanded for input j

js

jd

idis

js

jd

Q

Q

Q


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js

jd

jdjs

js

jd

jdjdjsjs

Q

Q

Q

QPP

Meet by New Displacing Other

Supply Consumers

js infinity Zero

Ws (10) Unity Zero

Wd (11) Zero Unity

Economic cost

measurement (12)

Pjs Pjd


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Price

S

P1 = 550 E G

Po = 500 H

F

Dp

D

Using Eq (7), the total cost:

= {(22-20) x [(500+550)/2] } +

{(20-17)x[(500+550)/2]}

= 2,625Cost per unit = 525

1

5.120500

503

120

500

50

2

js

jd

jd

js

Q

Q

xQdPdx

PQd

xQs

Psx

P

Qs

525)5.11(

)5255.15251(

xx

Economic benefits per unit of output:

Total economics benefits:

= 525 x 5

= 2,625

Qd Qo Q1 Quantity

17 20 22


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MEASURING ECONOMIC BENEFITS OF NON-TRADED OUTPUT IN MARKETS

WITH DISTORTION (1) SALES TAX ON THE PROJECT OUTPUT

From the producers point of

view, the imposition of the tax

will cause a downward shift in

demand curve

The demand price including

sales tax P1d

Price

P1d S

sales

Pom tax

P1s

The supply price paid to

producer will be P1s

The new market equilibrium

price

will rise to P1d if market prices

are quoted inclusive of sales tax

Will fall to P1s if market prices

are quoted exclusive of sales tax

D

Dst

Qost Qom Quantity


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WITH DISTORTION

Sales Tax on The Project

Output (Shoes) Establishment of the project

will cause a shift in the supply

curve (S to Sp), supply price

falls (P1s to P2s).

Total amount supplied by the

project Q1s-Q1st

Price

P1d D S

Sp

P2d C

Part will meet new demand

(Q1st-Qost). The Economic

benefit is QostQ1stCD, part of

this (AECD) is sales tax paid to

government

Part will substitute for existingsupplier (Q1s-Qost). The

economic benefit is Q1sQostAB

(saving in real resource)

P1s

A

P2s

B E D

Dst

Q1s Qost Q1st Quantity


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Benefit

Where: Qd is the change in the quantity Demanded; Qs isthe change in the quantity supplied by existing supplier;

(P2d+P1d)/2 is the average demand price, including the sales

2)(

2)( 1212

11

sss

ddd

ostsostst

PPxQPPxQ

ABQQCDQQ

ax, e ore an a er pro ec ; s s s e average supp yprice after the sales tax imposed. Before and after the project.

Benefit per unit of output

is

ididis

is

idstimidisis

Q

Q

Q

QtPP

)1(

where Pim is pre-tax market price


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Meet New Demand Substitutes

id Infinity(usually for small project) Zero

Economic benefit Pd = Pim(1+tst) Ps (the pre-tax

market price)


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WITH DISTORTION

Production Subsidies on

Projects Output (Rice)

The price falls will cause

Some of higher cost existing

producer go out the business,

releasing resource

Q1sQ0subBA. Part of that is

paid for subsidy ECBA

Price

S

Pos B Ssub

new supply Q1subQosubDC

Economics benefits per output

Pis = P1m/(1-S) A subsidi, S

Pod=Pom C Ssub+proj

P1d=P1m E D

D

Q1s Q0sub Q1sub Quantity

is

ididis

is

ididid

imis

Q

Q

Q

QP

S

P

)1(


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If both subsidy and tax are imposed, economic benefit

per unit of output can be formulated:

ididis

is

idstimid

imis

Q

Q

QtP

S

P

)1()1(

is


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WITH DISTORTION

Price Control on Projects

Output

At the artificial low price,

there is excess demand of

seat (Qod-Qos)

The total amount that people

would have been WTP (Pd)

for the limited seat (Qos) is

Pmax

Pd A S

Sp

0QosAPmax

The project will expand the

service at fixed price to Qod.

The economic benefit is

QosQ1sBA, there will no drop

in real fare and no displaced

alternative producer

Pe B

Pf D

E

D

Qos Q1s Qod Passanger

kilometers


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MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS WITH

DISTORTION

Sales Tax on Projects

Input (Steel)

As the project push out the

demand curve (Dst to Dpst)

Increase new production (Q1st-

Qost). Market price is

(P2s+P1s)/2 and the economic

cost is QostQ1stCD

Displacing existing consumers

Price

P2d A

P1d B

- .Market price is (P2d+P1d)/2 and

the economic cost is

Q1dQostCD

Economic cost per output:

Po

P2m=P2s D

P1m=P1s

C D

Dpst

Dst

Q1d QuantityQost Q1st Qo

is

idjdjs

is

idstjmjdjsjs

Q

Q

QQtPP

)1(


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MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN

MARKETS WITH DISTORTION - SUBSIDY ON PROJECTS INPUT

Supply Price :

Economic cost per output (subsidy)=

)1( S

P

Pjm

js

js

jd

jdjs

js

jd

jdjd

jmjs

Q

Q

Q

QP

S

P

)1(

If both subsidy and tax are imposed, economic cost per unit

of output can be formulated:

js

jd

jdjs

js

jd

stjmjd

jmjs

Q

Q

Q

QtP

S

P

)1()1(


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MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS

WITH DISTORTION PRICE CONTROL ON PROJECT INPUT

Minimum Wages for

Unskilled Labor

The increase demand for labor

as the result of the project will

cause the reduction on excess

supply

Price

S

Wf

The true of cost workers ofsupplying Qdl is 0QdlAWs

If the project increase the

demand for labor, economic cost

will be measured by the supply

cost of labor (QdlQdpAB), therewill be no change and no

displaced employer

B

A

Ws Dp

D

0 Qdl Qdp Qsl Quantity


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MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS

WITH DISTORTION PRICE CONTROL ON PROJECT INPUT

Price Controlled Input (Coal)

The project cause the excess

demand increase

The economic cost is the

amount that displaced

consumers would have been

Price

E

S

C

WTP (QrdQosCE).

Pf

S D Dp

0 Qdr Qos Qod Q1d Quantity

Economic Valuation in Closed Economy

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