MCom I Semester Managerial Economics Social Cost Benefit Analysis Study Material Notes

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MCom I Semester Managerial Economics Social Cost-Benefit Analysis Study Material Notes

MCom I Semester Managerial Economics Social Cost-Benefit Analysis Study Material Notes: Social Cost-Benefit Analysis An Introduction What is Social cost Benefit analysis or Meaning or SCBA Steps in Social Cost-Benefit Analysis or the Procedure of SCBA How is SCBA Different form Financial Analysis Difference Between SCBA and FCA ) Why Should social cost Benefit Analysis be used or Important of SCBA ( Most Important Notes For MCom Students )

MCom I Semester Managerial Economics Social Cost Benefit Analysis Study Material Notes
MCom I Semester Managerial Economics Social Cost-Benefit Analysis Study Material Notes

MCom I Semester Statistical Analysis Simulation Study Material Notes

SOCIAL COST-BENEFIT ANALYSIS

SOCIAL COST-BENEFIT ANALYSIS (SCBA): AN INTRODUCTION

Social Cost-Benefit Analysis (SCBA) is a powerful analytical technique to evaluate Public Investment. This technique is now at a fairly advanced stage with the emergence of many different manuals (like those of OECD, UNIDO, etc.) for carrying it out. It covers the life of the projects.

WHAT IS SOCIAL COST-BENEFIT ANALYSIS OR MEANING OF SCBA

SCBA is the evaluation of investment proposals in terms of their estimated net impact on the economy. The estimated impact is evaluated by using parameters reflecting Social objectives and national goals. It is a Macroeconomic appraisal and can be said to be a Socioeconomic appraisal of a public investment proposal. Thus, it is concerned with the systematic appraisal of the effects of the project on the economy as a whole.

SCBA measures the economic, social and environmental costs and benefits to the society expected to arise from the implementation of the project. It is a scientific attempt to evaluate the difference to an economy, being other things equal, as a result of a specific investment. It portrays the difference between the economy with the project and the economy without the project.

HOW IS SCBA DIFFERENT FROM FINANCIAL ANALYSIS  (DIFFERENCE BETWEEN SCBA AND FCA)

Normally the private investor, when deciding on whether or not to invest in a project, uses the yardstick of commercial profitability. He is interested in maximising money profits. Hence only inputs and outputs that enter his objective functions are included in the financial investment appraisal and are valued at prevailing market prices, for example, the commodity prices, wage-rates and interest rates are used in computing profitability.

The difference between the financial cost analysis (FCA) of a project and the Social Cost-Benefit Analysis (SCBA) are given below

(1) The social cost-benefit analysis seeks to achieve for the society what financial analysis of a project does for the project operating entitiy.

(2) The financial analysis of a project, particularly for a private investment decision identifies the cash out flows and inflows and the money profit occurring to the project operation entity, whereas social cost-benefit analysis (SCBA) measures the Socio-economic effect of the project on the entire economy.

(3) Social cost-benefit analysis is a useful device for the choice of projects, taking into account the national objectives. Financial cost-analysis is also an important device for purposes of project control and management.

Thus, social cost-benefit analysis seeks to make the maximum contribution to the objectives of a society while financial cost-analysis seeks to make the maximum money profit to the objectives of a project operating entity.

STEPS IN SOCIAL COST-BENEFIT ANALYSIS OR THE PROCEDURE OF SCBA

In order to appraise a public-investment project in terms of SCBA, the detailed project report is prepared. Based on this report the following steps are taken1. Identifying Cost and Benefits

The project cost in terms of financial outlays is taken as its financial cost. It has two components-(i) Fixed investment and (ii) Working capital. The fixed investment covers the payment made for fixed capital goods, i.e. machinery, plant, building, equipment, etc. The working capital covers the running, operational and maintenance costs over the life of the project. The social costs are the costs of the foregone uses of the physical and human resources used in construction, operation and maintenenace of the project. One has also to identify the indirect costs (external diseconomies) and intangible costs of the project. The sum total of all these costs represents the sacrifice made by society for setting up the project. This is its total social cost.

Both the fixed and working costs have to be annualised. The financial costs are not take into account as they do not use-up real, social resources. Among the direct social costs we include the social opportunity cost of land, labour and capital equipment. From among the current cost elements interest charges and depreciation allowance are excluded from social costs. The current cost too can be divided in physical and human resources costs. All these cost element have to be added-up in order to arrive at the total social cost. It means all the cost items have to be expressed in terms of a common numeraire.

From the social point of view one has to take into account the social opportunity cost of using a certain input for the public investment project. This Just as with social costs, social benefits of a project too have to be computed on the basis of the following sequential steps : identification of direct or indirect (externalities) benefits, their quantification or a listing of the non-quantifiable (intangible) benefits, social valuation in terms of shadow prices and conversion of these quantities into a common time perspective by means of discounting at the social rate of discount. In the determination of the social rate of discount, social values, objectives, attitude towards risk and uncertainty and political factors play their important roles.

2. Comparing Cost and Benefit: Decision Rules

The prime objective of investment project appraisal is to compare the costs and the benefits of different projects with a view to determine the project which gives a greater return for the total amount of inputs (goods, services and work) to be put into the project. Social discounting of costs and benefits is an essential part of this exercise.

Important methods of computing discounted costs and benefits are

(i) Benefit-cost ratio,

(ii) Net present value, and

(iii) Internal rate of return.

Present worth of Benefits (i) Benefit-cost Ratio :

Present worth of Costs

Benefit-cost Ratio. The Benefit-cost ratio is exclusively used for economic analysis of projects, or we may say, is related to the concept of social cost-benefit analysis only.

The practical application of benefit-cost ratio becomes very limited because of the interest character of the ratios. If we take two projects A and B and compare the Benefit-cost ratio of the two, it would clearly bring out the limitation of benefitt-cost ratio Project Total discounted Total discounted social Benefit-cost Net present social cost (Rs.in

In this example, we find that the B-C ratio of project A is higher than that of project B and the Net present value of project B is higher than that of project A. Hence the total benefit from project B is higher than the total benefit from project A but the benefit per unit of cost is higher in the cause of A as compared to B. If the total investible resources are Rs. 10 crores then we do not know the B-C ratio of other projects built at the cost of remaining 9 crores and hence we cannot make a comparison in terms of B-C ratio between project A and B. Thus the use of B-C ratio is limited for seeing the return per unit of social cost. It cannot be used for the purpose of selecting from projects A, B, ……………….

The only case where Benefit-cost ratio can be used for ranking is when all the projects from A to Z have the same social cost.

(ii) Net Present Value (NPV). The most straight forward discounted measure of a project worth which aids in the choice is the Net Present Value. Net Present Value of a project is simply the value of the surplus generated by the project in ‘to-days’ term. It is given by the discounted values of the benefits occurring from the project minus the dicounted values of the cost incurred on the project.

(iii) Internal Rate of Return (IRR)-This measure, used by World Bank and other international financial agencies, determines that rate of discount at which the present worth of the project is Zero. Internal or Economic Return is the same as internal rate of return. This term is used to distinguish betwen Financial calculations and Economic appraisals of the project.

There is a direct relationship between the internal rate of return and the net present value of a project. Internal rate of return is that rate of discount at which the net present value of the project comes to zero.

Net present value of a project as a tool for making an investment decision seems to have some advantages over the internal rate of return from the following angles

(a) It takes into account a specific rate of discount (social rate of discount) which the internal rate of return fails to cover in its values. It is imperative to incorporate society’s time preference for the flow of costs and benefits emerging at different points of time.

(b) Present value rule premits the possibility of society’s time preference changing at different points of time over the life of the project. If we take internal rate of return, the rate of return is given as uniform and no changes can be allowed for.

(c) When choice has to be made between two projects which are mutually exclusive (i.e., the implementation of one rules out the other) the internal rate of return becomes very misleading. However, internal rate of return has certain advantages over the net present value. It shows a clear picture of the maximum rate at which funds can be borrowed. Since the real rate of society’s time preference is very difficult to calculate, the internal rate of return gains an advantage over the net present worth of the project.

WHY SHOULD SOCIAL COST-BENEFIT ANALYSIS BE USED ? OR IMPORTANCE OF SCBA

A proper investment decision is important because it sets a series of economic and social factor into operation towards the achievement of SOC10-economic goals and the objectives of society, particularly for India. Social cost-benefit analysis is a tool for making investment decisions best suited to the development strategy and objectives so that the scarce resources contribute most towards the national objectives. In India, the government’s objective while making a public investment decision is the greatest possible attainment of the objectives of society, for example increase in the standard of living of the people as a whole, employment, equity self reliance, regional balance, etc.

Social cost-benefit analysis is a tool for making the best choice from the given alternatives, keeping in view the national objectives and social profitability. The choice of the project rather than another must be viewed in the context of its total national impact. Since SCBA is concerned with the economy as a whole and with the welfare of a society, its project choice is subject to the general objectives of national planning and policy.

Money served over a period of time yields interest and here in lies the concept of time value of money. It has been suggested that the acceptability or otherwise of an investment should be judged from this principle. There are two methods that take account of this principle-namely the Net Present Value (NPV) and the Internal Rate of Return (IRR).

The social cost-benefit analysis (SCBA) is an extension of the NPV technique of capital budgeting.

 

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