Social Cost-Benefit Analysis

The following points highlight the top four things to know about Social Cost-Benefit Analysis. The things are: 1. Criteria for Social Cost-Benefit Analysis 2. Identifying Benefits and Costs 3. Valuation of Costs and Benefits 4. Social Rate of Discount.

Social Cost-Benefit Analysis: Thing # 1. Criteria for Social Cost-Benefit Analysis:

The objective function of CBA is the establishment of net social benefit (NSB) which can be expressed as NSB = Benefits – Costs.

There are four benefit-cost criteria. They are ‘В — С/I’, ‘∆В /∆С’, ‘В — С’ and ‘B/C’, where В and С refer to benefits and costs respectively, I relates to direct investment and Δ is incremental or marginal.

Of these, the formula В – C/1 is “for determining the total annual returns on a particular investment to the economy as a whole irrespective of to whom these accrue.” Here I does not include the private investment that may have to be incurred by the beneficiaries of the project, such as the cultivators from an irrigation project.

If the private investment happens to be very large, even a high value of В – С/I may be less beneficial to the economy. Thus this criterion would not give satisfactory results.

The criterion of ∆В/∆С = 1 is meant to determine the size of a project that has already been selected and is not for selecting a project. The adoption of the В – C. criterion would always favour a large project, and make small and medium size projects less beneficial. Thus this criterion can only help in determining the scale of the project on the basis of the maximisation of the difference between В and C.

But the best and the most reliable criterion for project evaluation is B/C. In this criterion, the benefit-costs ratio is the measure for the evaluation of a project. If B/C = 1, the project is marginal. It is just covering its costs. If B/C > 1, the benefits are more than costs and it is beneficial to undertake the project.

If B/C < 1, the benefits is less than costs and the project cannot be undertaken. The higher the benefit-cost ratio, the higher will be the priority attached to a project.

Social Cost-Benefit Analysis: Thing # 2. Identifying Benefits and Costs:

Identifying benefits and costs is essential for the evaluation of benefits and costs of a project:

(a) Identifying Benefits:

A project is evaluated on the basis of the benefits accruing from it. Benefits refer to the addition to the flow of income accruing from a project. A project is beneficial to the extent it tends to increase the income of the people, increase in income being measured by the actual increase in production and consumption. Benefits may be real or nominal and direct or indirect.

Real or Nominal Benefits:

In CBA, we are concerned with the real benefits rather than with the nominal benefits flowing from a project. A river valley project may increase irrigational facilities to the cultivators. But if at the same time the state leaves heavy betterment levy on them, the benefit is nominal. For, whatever benefit accrues from the project it goes to the treasury. But if the same project, besides increasing irrigational facilities, raises the productivity of land per acre and leads to a number of other external economies whereby, the level of real income of the farmers raises then it leads of real benefits.

Direct and Indirect Benefits:

Direct benefits are those benefits which are immediately and directly obtainable from a project. They are the values of the immediate products and services for which direct costs are incurred. A number of direct and immediate benefits flow from a multipurpose river valley project such as flood control, irrigation, and navigation facilities, the development of fisheries, power, etc. A project may also lead to certain indirect or external benefits. These are the benefits to the non-users of the project.

For instance, the construction of the Bhakra Nangal Project has led to the construction of a new railway line connecting Nangal township and the Bhakra Dam with the rest of the country. New roads have been laid. A new town, Nangal, has come up.

A fertilizer factory has been started there which is the harbinger of more factories. The Bhakra-Nangal Dam has been developed into a tourist resort, thereby augmenting income. Usually external benefits are non­monetary, but sometimes they may result in direct financial benefits.

Tangible and Intangible Benefits:

A project may also lead to tangible or intangible benefits. Tangible benefits are those which can be computed and measured in terms of money while intangible benefits cannot be measured in monetary terms. For example, benefits flowing from the Bhakra-Nangal Project are tangible and can be computed.

Intangible benefits enter into individual evaluations for which there is neither a market nor a price. They may be positive or negative. The former are the scenic beauty and recreational value of the Bhakra Dam while the latter refer to the uprooting of the people as a result of the Dam.

Identifying Costs:

Just as there are various forms of benefits, so there are various types of costs

Project Costs:

They are the value of the resources used in constructing, maintaining and operating the project. They relate to the cost of labour, capital, intermediate goods, natural resources, foreign exchange, etc., including allowance for induced adverse effects.

Indirect or Secondary Costs:

They are the value of goods and services incurred to provide indirect benefits of a project, viz., houses, school, hospital, etc., or the people working at the project site. They also include the costs of processing the immediate products of the project.

Real and Nominal or Pecuniary Costs:

Costs may be real or nominal. If a Block Samiti borrows from the people of the area for digging a canal, it is a case of nominal costs. For no real sacrifice is involved on the part of the people, money having been transferred to the Block Samiti from the people. But if the people of the block are asked to dig the canal themselves, it would be real cost for them.

Primary or Direct Costs:

In cost-benefit analysis, we are concerned more with primary or direct costs. These are costs properly incurred for the construction, maintenance and execution of a project.

External Costs:

There are of two types:

(i) Monetary Costs:

That relate to the loss of profits to competitors. In the case of Delhi Metro, external monetary costs would include the loss of profits to other transport operators such as three wheelers, buses, taxis, etc.

(ii) Non-monetary Costs:

These include pollution and other types of inconveniences to local residents. Construction of an airport may lead to externalities resulting from its operation, such as noise.

Conclusion:

Thus in evaluating a project, we are to identify, compute and compare its total direct benefits and total direct costs. If it is found that the benefits are expected to be more than the costs, it will be beneficial to undertake the project, otherwise not costs.

Social Cost-Benefit Analysis: Thing # 3. Valuation of Costs and Benefits:

In the valuation of social costs and benefits of a public project, the shadow prices of inputs and outputs of the project are used instead of actual market prices. Shadow prices reflect true values of goods and services, including the factors of production.

Their money values are computed on the basis of price indices in different markets, giving weights to inflationary and deflationary situations. Economists estimate three such prices: shadow wage rate, shadow interest rate and shadow exchange rate. However, for many items of social costs and benefits, there may not be any shadow price at all.

Social Cost-Benefit Analysis: Thing # 4. Social Rate of Discount:

The B/C formula usually used for evaluating social costs and benefits does not take into account the time horizon of the project. As a matter of fact, future benefits and costs cannot be treated at par with present benefits and costs. Therefore, the appraisal rule for a public project requires discounting of future benefits and costs because society prefers the present to the future.

For this purpose, economists use a social rate of discount for discounting all benefits and costs. It is a rate of discount that reflects society’s preference for present benefits over future benefits. The social discount rate is used to calculate the net present value (NPV) of a time stream of benefits and costs of a project where its NPV is calculated as

NPV = Σ_t (B_t-C_t/(1 + i)^t)

B_t is the expected gross benefit of the project at time t, C, is the expected gross cost of the project at time I, and i is the social discount rate at time t.

If the government chooses a high rate, the future net benefits will discount mere. As a result, the project with a long life will be-less beneficial than a project which yields a quick’s return. It is, therefore, advisable to choose a relatively low discount rate.