Private and Social Benefit Cost Analysis

The private and social benefit cost analyses are also known as financial and economic analyses, respectively. Under the former the economic viability of a project is evaluated from the point of view of the individual investor while under the latter the same is examined from the point of view of the society as a whole. The two analyses on three important counts:

(a) Objective
(b) Inclusion/exclusion.
(c) Valuation

While an individual investor aims at the maximum possible return on investment (ROI) the society normally pursues multiple goals. These include ROI, economic growth, employment generation, reduction in economic inequalities over regions and peoples from different categories, self-reliance, etc. Thus, it is possible that a project might be viable from the individual point of view but not from the society’s point of view, and vice versa.

The second difference between financial and economic analyses is with regard to the inclusion and exclusion of benefit and costs. Investment projects involve some transfer payments in the form of taxes and subsidies which are costs and benefits as far as the individual investor is connected but not from the point of view of the society. Similarly, there are externalities (side effects) associated with the projects, which are irrelevant for the private analysis but are relevant for the social analysis. These include benefits, such as recreation and picnic spots availability if the project happens to be of building of a dam, developing of a swimming pool or rose garden, etc., and costs such as air pollution, traffic congestion, and accident hazards if the project leads to setting up of units in the hearts of a town, producing inflammable items (e.g. Union Carbide in Bhopal). While these benefits and costs are difficult to quantify, they must be given due consideration in the social analysis.

The last significant difference between the private and social analyses is with regard to the valuation of various benefits and costs associated with the project. The valuation must be performed on the basis of the price received and paid by the investor concerned. Thus, the individual investor receives and pays the market price for its outputs and inputs, respectively, and accordingly the valuation is carried out on the basis of market prices for the private analysis. However, this is not case for the society. There are two approaches for valuation for the social analysis. The one is recommended by Little and Mirrlees (1974) and the other by the UNIDO Guidelines (1972) .

Under the former approach the benefits and costs are valued at the world price (exports f.o.b. and imports c.i.f.) and under the latter they are valued at the shadow price (resource cost). The World Bank approach (1975) synthesizes the two approaches under which the tradable items are valued at the corresponding world process and non-tradable at the corresponding shadow prices. In both these approaches, foreign exchange earnings and uses are valued at the shadow exchange rate (SER) and not at the official exchange rate (OER), and the labor cost at the shadow wage (SWR) and not at the market wage rate (MWR). There are systematic methods to compute these shadow rates but that is beyond the scope of this book. Suffice it to say here that the planning Commission would normally indicate both the shadow exchange rate and shadow wage rate from time to time.

One more factor which must be taken into account there is with regard to the discount rate. In the private analysis, the weighted average cost of capital for the project would serve the purpose of the discount rate. However, in the case of the social analysis, the relevant rate would be the cost to the society of the funds employed in the project. This perhaps would be the rate at which the country obtains funds from international organizations.