Identifying
costs and benefits is the first and 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. Identifying the costs
and benefits
of a project is one of the most important steps in economic
analysis. A
second important step is to quantify them. The final step is to
value them
in monetary terms.
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. First, we need to include or exclude some costs and
benefits.
Second, we need to revalue inputs and outputs at their economic
opportunity
costs. 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
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.
Economic and
financial costs are always closely intertwined, but they
rarely
coincide. The divergence between financial and economic prices
and flows
shows the extent to which someone in society, other than the
project
entity, enjoys a benefit or pays a cost of the project. Sometimes
such
payments are in the form of explicit taxes and subsidies, as in a
sales tax;
sometimes they are implicit, as in price controls. The magnitudes
and
incidence of transfers are important pieces of information that
shed light
on the project’s fiscal impact, on the distribution of its costs
and
benefits, and, hence, on its likely opponents and supporters. By identifying
the groups
benefiting from the project and the groups paying for
its costs,
the analyst can extract valuable information about incentives
for these
groups to implement the project as designed, or to support it
or
oppose it.
A thorough
evaluation should summarize all the relevant information
about the
project. To look at the project from society’s and the implementing
agency’s
viewpoint, to identify gainers and losers, and ultimately to
decide
whether the project can be implemented and sustained, it is necessary
to integrate
the financial, fiscal, and economic analyses and identify
the
sources of the differences.
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