An Overview of Economic Analysis

Economic analysis helps design and selects projects that contribute to the welfare of a country. Economic analysis is most useful when used early in the project cycle to identify poor projects and poor project components. If used at the end of the project cycle, economic analysis can only help determine whether to proceed with a project or not. When used solely to calculate a single summary measure, such as the project’s net present value (NPV) or economic rate of return (ERR), economic analysis serves a limited purpose.

The tools of economic analysis can help answer various questions about the project’s impact on the entity undertaking the project, on society, and on various stakeholders. They can also help identify the project’s risks and assess its sustainability. In particular, these tools can help

• Determine whether the private or the public sector should undertake the project

• Estimate its fiscal impact

• Determine whether the arrangements for cost recovery are efficient and equitable

• Assess its potential environmental impact and contribution to poverty reduction.

This article provides a toolkit that helps answer these questions; however, it does not provide a recipe for every possible instance. The procedure set out is an iterative process that should begin early in the project cycle and be used throughout it. This procedure works best when analysts use all the information available about the project, including the financial evaluation and the sources of divergence between financial and economic prices.

The Economic Setting

A project cannot be divorced from the context in which it takes place. The relationship of the project to the broader development objectives for the sector and for the country is an integral part of its economic justification. Early in the assessment of a project, analysts should always ascertain that the project fits with the broader country and sector strategies. The key role of the policy and institutional framework must also be discussed. More important, because research indicates that environments with low distortions produce more successful projects than highly distorted environments (Kaufmann 1991), analysts should ensure that sectoral policies and macroeconomic preconditions, as well as the institutional framework, are conducive to good project performance. Also, to ensure project effectiveness, analysts must identify key distortions that should be removed prior to project implementation.

Rationale for Public Sector Involvement

Worldwide, the private sector increasingly provides goods and services that a few decades ago were deemed to be properly in the domain of the public sector. Two main reasons account for this development. First, a growing, albeit inconclusive, body of evidence indicates that the public sector is less efficient than the private sector when engaged in market oriented activities.1 Second, technological changes are making it possible to have competition in markets that have traditionally been considered natural monopolies.

What, then, is the economic justification for public provision of goods and services?

As discussed in appendix 1A, government intervention in the provision of goods and services is justifiable if the project addresses a market failure, or if it reduces poverty. In every case calling for government intervention, analysts must identify the market failure that prevents the private sector from producing the socially optimal quantity of the good or service, and they must show that society will be better-off as a result of government involvement. In short, analysts must show that the benefits of government involvement will outweigh the costs. The strength of the case for government involvement depends on institutional arrangements; legal, regulatory, and political conditions; and external circumstances, conditions that vary from country to country, and within a particular country, from year to year. In addition to economic considerations, there are also equity, political, and strategic considerations. Consequently, no hard and fast rules enable decision makers to come unmistakably to the conclusion that government involvement will make the country better off, and each case must be decided on its merits.

The tools of economic analysis developed can help Analysts

• Judge whether the project would be financially viable if done by the private sector

• Assess the magnitudes of externalities associated with the project

• Estimate the impact of policy distortions and market failures on the project’s economic and financial flows

• Identify the incidence of costs and benefits on various groups in society.

These important considerations help decide whether the project should be done by the public sector.