The Process of Economic Analysis

Economic analysis is an iterative process that normally begins with a “without the project” situation, which is the baseline against which all alternatives are compared. Through a process of successive approximations, the analyst defines alternatives, drops poor project components, includes new components, examines the alternatives from financial and economic points of view, compares them with the baseline and with each other, and modifies them until a suitable and optimal project design emerges.

For each alternative, the analyst needs to identify the financial and economic streams of costs and benefits, then price them correctly. Next explains the main adjustments needed to go from financial to economic analysis. In general terms, analysts need to remove all subsidies and taxes from the financial flows and include the project’s most significant externalities. Analysts must keep careful track of who pays for or receives the costs and benefits of projects in order to assess financial and fiscal sustainability.

Once the financial and economic flows have been correctly identified, analysts need to adjust the prices to reflect economic opportunity costs. Next deals with this subject. The main price adjustments include using border prices for all tradable goods and services and a shadow exchange rate to convert foreign to domestic currency. If nontradables are a sizable part of project costs, their prices should be adjusted to reflect opportunity costs to society. As the discusses, labor is one of the most important nontradables. This blog suggests that analysts use sensitivity analysis to determine whether the project’s NPV turns negative when using an upper boundary for the shadow price of labor, which is usually the market price. If the NPV is positive, then you do not need further analysis. Information about the sources of divergence between border and market prices and between shadow and market exchange rates helps identify the groups that benefit from, and pay for, the differences. For transport, health, and education projects, analysts usually need to use indirect measures of the value of these goods and services.

The final price adjustments affect nontradables. In many cases, especially in health and education projects, volunteer labor is an important component. To assess project costs and sustainability correctly, such contributions need to be priced at their opportunity costs.

Next, the analyst needs to put this information together, identify gainers and losers, and undertake a risk analysis. The sources of divergence between economic and financial prices and economic and financial flows convey extremely useful information that enables analysts to answer three important questions:

• By identifying the groups that enjoy the benefits and pay for the costs of the project, this comparison shows the impact of the project on the main stakeholders and gives an indication of its sustainability. In particular, because taxes and subsidies are usually important sources of difference, this step essentially assesses the project’s fiscal impact.

• By identifying the causes of the differences between the financial and the economic evaluations, the analyst can tell whether the differences are market induced or policy induced. If they are policy induced, the analyst must consider the costs and benefits of policy changes that would bring the economic and financial assessments closer to each other. In short, the analyst needs to consider whether the project is timely, or whether it might be preferable to convince the authorities to change their policies.

• The comparison finally sheds light on the size and incidence of the environmental externalities that can be evaluated in monetary terms.