Analytical Tools and Practical Applications

The assumption would underestimate the returns to university education if earnings differentials do widen over time, as the evidence from the United suggests is currently happening.

Where cross-sectional data are unavailable, the evaluator can still attempt to estimate the economic value of education by spot-checking what employers currently pay people with different educational qualification. Evaluators of the World Bank-financed Mauritius Higher Education Project took this approach; the underlying assumption is that the gap in earnings between workers in different education groups is the same at all ages, and that the gap remains stable over time.

Incorporating the Value of Externalities

Unlike earnings, some out-of-school benefits from education accrue mostly to society as a whole rather than to individuals. Economists use various terms to refer to such benefits: public goods, spillover effects, or externalities. One study lists 20 types of benefits associated with education, including crime reduction, social cohesion, technological change, income distribution, charitable giving, and possibly fertility reduction  In more recent work  the authors show that large social gains also accrue via the effect of parental education on children. Ensuring that parents have a high school education reduces the probability that their children will drop out of school and that their daughters will bear children as unmarried teenage mothers by 50 percent. It also reduces their children’s probability of being economically inactive as young adults by 26 percent. Most of the social benefits associated with education have not been quantified. Thus, given the current state of knowledge I n the field, it may prove difficult to incorporate these benefits in project evaluation. Summers illustrates how progress is nonetheless possible in a practical way. He estimates the value of the reduction in child and maternal mortality and in fertility associated with investment in an extra year of schooling for girls by asking how much society would have to spend to achieve the same results using other means. Summers concludes that the benefit of giving 1,000 Pakistani girls an extra year of education amounts to US$88,500, and that the present value of the benefits amounts to US$42,000, compared with a cost of US$30,000 in education

Economic Evaluation of Health Projects

The same three basic techniques used to assess education projects can be used for health projects, namely, cost-effectiveness analysis, weighted costeffectiveness analysis , and cost-benefit analysis, in increasing order of complexity. Cost-benefit analysis is the most difficult technique, because it requires estimating the monetary value of benefits. Analysts should use the simplest technique possible to address the problem at hand: cost-effectiveness where possible and weighted cost-effectiveness and cost-benefit analysis only where needed for intersect oral comparisons or for assessing projects with several measurable objectives, such as gains from economic efficiency in one component and gains in health status in another.

The Steps of Economic Analysis

For health projects, as for any other kind of project, the analyst needs to define the objectives of the analysis and the alternatives to be evaluated. This includes the without project alternative. For each alternative, the analyst identifies the incremental opportunity costs of the project. These should include capital costs, such as expenditures for plant, equipment, and training; recurrent expenditures, including the incremental costs of administrators, doctors, nurses, laboratory technicians, unskilled support, and other staff; and indirect costs such as patients’ time and travel. The analyst should include an imputed annual capital cost or rent for existing equipment and buildings whose use will be diverted to the project. Client costs should include the opportunity cost of travel and waiting time and out-of-pocket expenditures for food, supplies, and travel.

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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.

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Risk Analysis of Economic Analysis

The approach also goes beyond sensitivity analysis and switching values for assessing risk. The former estimates how sensitive project outcomes are to changes in the values of critical variables. In a transportation project, for example, sensitivity analysis would indicate to analysts what the effect of a 10 percent decline in traffic on the net present value of the project would be. Switching value analysis identifies the value that a critical variable must assume for the project to become unacceptable. In the transportation example, it would identify the volume of traffic at which the project’s net present value would go to zero. While both techniques are useful in project design, they do not take probabilities or correlations into account, which limits their usefulness. Switching value analysis may tell us that a project will fail if a given variable departs by more than 25 percent from its posited value, but if we do not know the likelihood of this event, the information is of limited use. The major shortcoming of both types of analyses, however, is the disregard for correlation. When one thing goes wrong, something else is likely to go wrong: correlations can be devastating. For example, if projected traffic along a given corridor falters because the expected economic growth failed to materialize, fiscal receipts may also fall short. Consequently, counterpart funds may also be in short supply. Analyzing the impact of one variable at a time may mislead us into believing that risky projects are in fact robust.

Monte Carlo analysis takes into account probabilities and correlations and identifies the likely impact of each variable on project outcomes. It can also take into account delays and other events that may impinge on project outcomes. More important, it helps assess the expected net present value of the project, the probability distribution of the outcome, and the probability of project failure. By ranking the variables in terms of their impact on project outcomes and probability of occurrence, Monte Carlo simulation helps analysts design better projects and identify the variables worth tracking during project performance. Until recently, Monte Carlo simulations were time-consuming, expensive, and difficult. With the advent of personal computers and readily available risk analysis programs, Monte Carlo techniques are as convenient to use as spreadsheets.

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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.

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