ECONOMIC VALUATION IN CLOSED

ECONOMY THE HARBERGER APPROACH

THE ESSENTIAL ELEMENTS OF AN ECONOMIC ANALYSIS
Financial Analysis Economic Analysis
Adjustments:
Deduction of transfer payment within the economy from project cash flow
Common features:
Discounted cash flow
Sensitivity or probability analysis
Deduction of transfer payment within the economy from project cash flow
Inclusion of any net change in CS in net benefits and the exclusion of any
change in PS from cost
Estimation of economic or shadow price for project output and produced
input to correct for any distortion in the market
The estimation of economic price from non-produced project inputs
(labor, natural resource) to correct for any distortion in the market
The valuation and inclusion of any externalities
The valuation and inclusion of public goods
The estimation and use of an appropriate social discount rate
ECONOMIC OR SHADOW PRICE
Shadow Price = Economic Price = Accounting Price
It corrects for any divergence between market and
economic price due to market failure, government
intervention, externalities, public goods, CS and PS,
and distributional consideration and distributional consideration
Economic pricing Harberger Equation Approach
Shadow
price
increase in
social
welfare
well-defined
social
welfare
function
real income
per capita
TRANSFER PAYMENT
TP can be defined as payments that are made
without receiving any good or service in return.
YES NO
Taxes (personal and company income tax,
value added tax and other indirect taxes)
Sales tax, externality or
pollution tax, bad-goods tax
Subsidies including those given via price
support scheme
Subsidies including those given via price
support scheme
Tariffs on import an export subsidies and taxes Tariffs to protect infant
industry
Producer surplus (gain received by an existing
supplier of a factor as a result of an increase in
the price of that factor)
Credit transaction between domestic
borrowers and lenders
Foreign loan receipt and
repayments
CUSTOMER SURPLUS
CS measure the differences between the amount
consumer would be WTP for a good and service
and what they actually have to pay for it
Project is relatively
Downward sloping
in D curve of the
Fall in equilibrium Project is relatively
large supplier
in D curve of the
projects output
Fall in equilibrium
price
Additional CS after
project
In Economic Analysis, any
change in CS as a result of
the project should be
included in projects
economic cash flow
because these changes
represent real effect on
peoples welfare
Price (cent/kg) S
D
Sp
20
15
peoples welfare
Gain in CS:
7.5 cents (CS) + 15 cents
(actual payment) = 22.5
cents
What about public good?
(Ex. free hospital service)
15
1 2 Quantity of rice (kg)
Gain in CS from reduction in the price of rice
PRODUCER SURPLUS
PS measure the differences between the amount
that suppliers on an input would be WTA
(willingness to accept) to supply this input and the
amount that they actually received for supplying it.
PS is not an economic cost, but just a rent that PS is not an economic cost, but just a rent that
transferfed from consumer to producer
Electricity for almunium
smelting
When tariff rises from P2 to
P3, Q2 increases to Q3. Total
amount for newly supply
Q2Q3CF; just Q2Q3CB will be
true economic cost.
At Q3: actual cost QoQ3CP3;
actual resource QoQ3CPo;
thus PoCP3 represents the
amount WTA (PS)
User who are un-WTP at P3
Electricity
Tariff S
P3 E F C
User who are un-WTP at P3
will loss their welfare QpQ2BE
In total: Financial cost
QpQ3CE; economic cost
QpQ3CBE. So, in economic
analysis PS (EBC) must be
deducted from financial
analysis
P2 B
Dp
D
Po
Qo Qp Q2 Q3 Quantity (MWh)
MEASURING ECONOMIC BENEFITS OF PROJECT OUTPUTS IN
CLOSED ECONOMY WITH NO DISTROTION THE
HARBERGER APPROACH
Harberger Approach (Harberger,1971; Jenkins and
Harberger,1991) measures the economic benefits and
costs of project outputs and inputs in term of their
demand and supply price and elasticity, and therefore demand and supply price and elasticity, and therefore
automatically includes any change in CS and PS
It is used to shadow price non-traded and traded goods
as well as foreign exchange rate and capital
The measurement of the economic benefit generated
by a project depends on whether the output produced
meets new demand, or merely substitutes for an
existing source of supply for that good and service
1. Economic Benefits If
Projects Output Meet New
Demand (Railway)
If a project increases total
supply of a good and service
available in a closed economy,
its economics benefit will be
measured in term of the extra
benefit (marginal social
benefit, MCB), which people
derive from consuming this
increased output.
Rail fare
S Sp
increased output.
MCB itself can be measured
by what are WTP for it,
assuming societys income
distribution is optimal.
In freely operating market
with no externalities or CS,
the amount that people are
WTP for a good will be equal
its competitive demand price
(Pd).
Pd D
Economic benefit =
WTP for new output
Q Qd Quantity of rail service
2. Economic Benefits If
Projects Output Substitutes
for Existing Supply (Bakery)
Since the output was
already available, the value
of the project is not WTP
(demand price), but the
labor, capital, foreign
exchange and raw material
resources saved by the
displaced supplier (supply
Price
D S
Sp
Pos B
displaced supplier (supply
price)
Demand is inelastic, so the
increased supply will only
drive the price down and
force some existing
producers out of the
business
P1s C
Economic Benefit =
resources saved
by displaced supplier
Qs Qd Quantity
3. Economic Benefits If
Projects Output Partially
Meet New Demand and
Partially Substitutes for
Existing Supply (Shoe
Factory)
With establishment of new
factory, supply curve move
out from So to Sp. The benefit
of the project that the fall in
price:
encourage an increase in
demand and the economic
benefit: QoQ1CA (financial
benefit =QoQ1CD + CS = ADC)
Force of some existing
Price
D So
Sp
Force of some existing
producers out of the industry,
cutting the amount supplied
(Qo to Qe). The economic
benefit: QeQoAB
Total economic benefit =
QeQ1CAB :(amount actually
paid by consumer = QeQ1CB)
+ (CS = PoP1CA) (loss in PS =
PoP1BA)
Sp
Po = 20 E A
P1 = 15 B C
D
Qe Qo Q1 Quantity good
180 200 280
THE HARBERGER EQUATION FOR MEASURING
ECONOMIC BENEFIT (1)
The projects total economic benefits can be
measured by the weighted average of demand and
supply price of its output, where the weight are the
quantity of output that meet new demand and
substitutes for existing supply: substitutes for existing supply:
(1) Benefit:
(2) Benefit per unit output:
Where: AvP is the average price of output before and after the
project = (P1+Po)/2; Qs is the quantity of output substituting for
existing supply (Qo-Qe); Qd is the quantity of output meeting
new demand (Q1-Qo)
Qd x AvPd Qs x AvPs +
Qd Qs
Qd x AvPd Qs x AvPs
+
+
Economic Benefits If
Projects Output Partially
Meet New Demand and
Partially Substitutes for
Existing Supply
AvP = (20+15)/2 = 17.5
Total Economic Benefit :
= AvPs x Qs + AvPdx Qd
= (17.5 x 20) + (17.5 x 80)
= 1,750
Economic benefit per output:
= 1,750/100
Price
D So
Sp = 1,750/100
= 17.5
Sp
Po = 20 E A
P1 = 15 B C
D
Qe Qo Q1 Quantity good
180 200 280
THE HARBERGER EQUATION FOR MEASURING
ECONOMIC BENEFIT (2)
The economic benefit per unit output (i) can also be
expressed in term the price elasticity of demand and supply
(the slope of its demand and supply) for the projects output
This may be useful in a situation where the analyst has
estimates of the elasticities of demand and supply for the
good to be produced rather than price data of how much the good to be produced rather than price data of how much the
planned production will meet new demand and substitutes
for existing supply.
(3) Benefit per unit of output:
(4) Ws is the weighted on the supply price =
(5) Wd is the weighted on the demand price =
d id s is
W P W P +
(

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is
id
id is
is
Q
Q
q c
c
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id
Q
q
where: cis is the price elasticity of supply; qid is the price
elasticity of demand; Pid is the average demand price; Pis is
the average supply price; Qis is the quantity supplied; and Qid
is the quantity demanded for output i
(

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is
id
id is
is
id
id
Q
Q
Q
q c
q
(6) Benefit per unit of output:
Value alternatives of economic benefit
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is
id
id is
is
id
id id is is
Q
Q
Q
Q
P P
q c
q c
Value alternatives of economic benefit
Meet New Demand Substitutes
qid
infinity Zero
Wd (5) Unity Zero
Ws (4) Zero Unity
Economic benefit
mesurement (3)
Pd Ps
Economic Benefits If
Projects Output Partially
Meet New Demand and
Partially Substitutes for
Existing Supply
Price
D So
Sp
1
6 . 1
200
20
5
80
4 . 0
200
20
5
20
=
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= = =
= = =
is
id
id
is
Q
Q
x
Qd
Pd
x
P
Qd
x
Qs
Ps
x
P
Qs
o
o
q
o
o
c
Substituting to (6)
Sp
Po = 20 E A
P1 = 15 B C
D
Qe Qo Q1 Quantity good
180 200 280
5 . 17
) 6 . 1 4 . 0 (
) 5 . 17 6 . 1 5 . 17 4 . 0 (
=
+
+ x x
Substituting to (6)
Economic benefits per unit of output:
Total economics benefits:
= (17.5x20) + (17.5x80)
= 1.750
MEASURING ECONOMIC COSTS OF PROJECT INPUTS IN
CLOSED ECONOMY WITH NO DISTORTION THE
HARBERGER APPROACH
In economic analysis, the cost of a projects inputs are
valued in term of their opportunity cost that indicate the
value in the next best alternative uses
In freely operating market, if the projects requirements for
inputs are met from increased production, the opportunity inputs are met from increased production, the opportunity
cost will be the marginal social cost of the increased
production. The economic cost of the inputs will equal
supply price (Ps) because of completely elastic in supply
curve
If the projects demand for input must be met by displacing
existing users of these inputs, the economic cost will be the
amount that these displaced counsumers were WTP for the
inputs or their demand price (Pd)
Economic Costs If Projects
Input Partially Supplied from
New Production and Met by
Displacing Existing
Consumers (Steel Products)
The rise in price because of
demand increases affects:
Force some of the existing
consumers to lower consumption
(Qo to Qd). The economic cost is
the utility lost by the displace
consumers = QdQoFE (WTP)
Encourage an increase in supply
(Qo to Q1). The economic cost is
the real resource used to by
Price
S
the real resource used to by
producers to increase output =
QoQ1GF
Total economic cost (QdQ1GFE) =
financial cost (QdQ1GE) the
gain in PS (PoP1FGP1) + loss in CS
(PoFEP1)
PS (EFG) is substracted because it
just transfer from consumers to
producers
P1 = 550 E G
Po = 500 H
F
Dp
D
Qd Qo Q1 Quantity
17 20 22
The economic cost calculation
(7) Cost:
(8) Cost per unit output:
Where: AvP is the average price of input; Qs is the quantity of
input met by new supplier (Q1-Qo); Qd is the quantity of input
met by dispacing existing consumers (Qo-Qd)
Qd x AvPd Qs x AvPs +
Qd Qs
Qd x AvPd Qs x AvPs
+
+
met by dispacing existing consumers (Qo-Qd)
(9) Cost per unit of output:
(10) Ws is the weighted on the supply price of input (j) =
(11) Wd is the weighted on the demand price of input (j)=
d jd s js
W P W P +
(
(

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js
jd
jd js
js
Q
Q
q c
c
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jd
jd
Q
q
where: cjs is the price elasticity of supply; qjs is the price
elasticity of demand; Pjd is the average demand price; Pjs the
average supply price; Qjs is the quantity supplied; and Qjd is
the quantity demanded for input j
(
(

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js
jd
id is
js
jd
Q
Q
Q
q c
q
(12) Benefit per unit of output:
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js
jd
jd js
js
jd
jd jd js js
Q
Q
Q
Q
P P
q c
q c
Meet by New
Supply
Displacing Other
Consumers Supply Consumers
c
js
infinity Zero
Ws (10) Unity Zero
Wd (11) Zero Unity
Economic cost
measurement (12)
Pjs Pjd
Price
S
P1 = 550 E G
Po = 500 H
F
Dp
D
Using Eq (7), the total cost:
= {(22-20) x [(500+550)/2] } +
{(20-17)x[(500+550)/2]}
= 2,625
Cost per unit = 525
1
5 . 1
20
500
50
3
1
20
500
50
2
=
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= = =
= = =
js
jd
jd
js
Q
Q
x
Qd
Pd
x
P
Qd
x
Qs
Ps
x
P
Qs
o
o
q
o
o
c
525
) 5 . 1 1 (
) 525 5 . 1 525 1 (
=
+
+ x x
Economic benefits per unit of output:
Total economics benefits:
= 525 x 5
= 2,625
Qd Qo Q1 Quantity
17 20 22
MEASURING ECONOMIC BENEFITS OF NON-TRADED OUTPUT IN MARKETS
WITH DISTORTION (1) SALES TAX ON THE PROJECT OUTPUT
From the producers point of
view, the imposition of the tax
will cause a downward shift in
demand curve
The demand price including
sales tax P1d
The supply price paid to
Price
P1d S
sales
Pom tax
P1s
The supply price paid to
producer will be P1s
The new market equilibrium
price
will rise to P1d if market prices
are quoted inclusive of sales tax
Will fall to P1s if market prices
are quoted exclusive of sales tax
D
Dst
Qost Qom Quantity
MEASURING ECONOMIC BENEFITS OF NON-TRADED OUTPUT IN MARKETS
WITH DISTORTION
Sales Tax on The Project
Output (Shoes)
Establishment of the project
will cause a shift in the supply
curve (S to Sp), supply price
falls (P1s to P2s).
Total amount supplied by the
project Q1s-Q1st
Price
P1d D S
Sp
P2d C
P1s
project Q1s-Q1st
Part will meet new demand
(Q1st-Qost). The Economic
benefit is QostQ1stCD, part of
this (AECD) is sales tax paid to
government
Part will substitute for existing
supplier (Q1s-Qost). The
economic benefit is Q1sQostAB
(saving in real resource)
P1s
A
P2s
B E D
Dst
Q1s Qost Q1st Quantity
Benefit
Where: Qd is the change in the quantity Demanded; Qs is
the change in the quantity supplied by existing supplier;
(P2d+P1d)/2 is the average demand price, including the sales
tax, before and after project; (P2s+P1s)/2 is the average supply
2
) (
2
) (
1 2 1 2
1 1
s s
s
d d
d
ost s ost st
P P
x Q
P P
x Q
AB Q Q CD Q Q
+
A +
+
A =
+ =
tax, before and after project; (P2s+P1s)/2 is the average supply
price after the sales tax imposed. Before and after the project.
Benefit per unit of output
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+
is
id
id is
is
id
st im id is is
Q
Q
Q
Q
t P P
q c
q c ) 1 (
where Pim is pre-tax market price
Meet New Demand Substitutes
qid
Infinity
(usually for small project)
Zero
Economic benefit Pd = Pim(1+tst) Ps (the pre-tax
market price)
MEASURING ECONOMIC BENEFITS OF NON-TRADED OUTPUT IN MARKETS
WITH DISTORTION
Production Subsidies on
Projects Output (Rice)
The price falls will cause
Some of higher cost existing
producer go out the business,
releasing resource
Q1sQ0subBA. Part of that is
paid for subsidy ECBA
Increase in amount WTP for
Price
S
Pos B Ssub
Pis = P1m/(1-S) A subsidi, S
Increase in amount WTP for
new supply Q1subQosubDC
Economics benefits per output
Pis = P1m/(1-S) A subsidi, S
Pod=Pom C Ssub+proj
P1d=P1m E D
D
Q1s Q0sub Q1sub Quantity
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is
id
id is
is
id
id id
im is
Q
Q
Q
Q
P
S
P
q c
q
c
) 1 (
If both subsidy and tax are imposed, economic benefit
per unit of output can be formulated:
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id
id is
is
id
st im id
im is
Q
Q
Q
Q
t P
S
P
q c
q
c
) 1 (
) 1 (
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id is
Q
MEASURING ECONOMIC BENEFITS OF NON-TRADED OUTPUT IN MARKETS
WITH DISTORTION
Price Control on Projects
Output
At the artificial low price,
there is excess demand of
seat (Qod-Qos)
The total amount that people
would have been WTP (Pd)
for the limited seat (Qos) is
Pmax
Pd A S
Sp
Pe B
for the limited seat (Qos) is
0QosAPmax
The project will expand the
service at fixed price to Qod.
The economic benefit is
QosQ1sBA, there will no drop
in real fare and no displaced
alternative producer
Pe B
Pf D
E
D
Qos Q1s Qod Passanger
kilometers
MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS WITH
DISTORTION
Sales Tax on Projects
Input (Steel)
As the project push out the
demand curve (Dst to Dpst)
Increase new production (Q1st-
Qost). Market price is
(P2s+P1s)/2 and the economic
cost is QostQ1stCD
Displacing existing consumers
(Qost-Q1d) loss of welfare.
Price
P2d A
P1d B
S (Qost-Q1d) loss of welfare.
Market price is (P2d+P1d)/2 and
the economic cost is
Q1dQostCD
Economic cost per output:
S
Po
P2m=P2s D
P1m=P1s
C D
Dpst
Dst
Q1d Quantity Qost Q1st Qo
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+
is
id
jd js
is
id
st jm jd js js
Q
Q
Q
Q
t P P
q c
q c ) 1 (
MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN
MARKETS WITH DISTORTION - SUBSIDY ON PROJECTS INPUT
Supply Price :
Economic cost per output (subsidy)=
) 1 ( S
P
P
jm
js

=
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js
jd
jd js
js
jd
jd jd
jm js
Q
Q
Q
Q
P
S
P
q c
q
c
) 1 (
If both subsidy and tax are imposed, economic cost per unit
of output can be formulated:
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js
jd
jd js
js
jd
st jm jd
jm js
Q
Q
Q
Q
t P
S
P
q c
q
c
) 1 (
) 1 (
MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS
WITH DISTORTION PRICE CONTROL ON PROJECT INPUT
Minimum Wages for
Unskilled Labor
The increase demand for labor
as the result of the project will
cause the reduction on excess
supply
The true of cost workers of
Price
S
Wf
The true of cost workers of
supplying Qdl is 0QdlAWs
If the project increase the
demand for labor, economic cost
will be measured by the supply
cost of labor (QdlQdpAB), there
will be no change and no
displaced employer
B
A
Ws Dp
D
0 Qdl Qdp Qsl Quantity
MEASURING ECONOMIC COSTS OF NON-TRADED INPUT IN MARKETS
WITH DISTORTION PRICE CONTROL ON PROJECT INPUT
Price Controlled Input (Coal)
The project cause the excess
demand increase
The economic cost is the
amount that displaced
consumers would have been
Price
E
S
C
consumers would have been
WTP (QrdQosCE).
Pf
S D Dp
0 Qdr Qos Qod Q1d Quantity