5.
Valuing Inputs and Outputs

5.1 Introduction - the Approach

Once inputs and outputs have been identified, the next step is to develop appropriate value measures.

In a financial analysis, the valuation process is fairly straightforward and market prices are used for all inputs and outputs. Nonmarket effects (externalities or indirect effects) are not valued in the financial analysis, since they do not enter into the cash flow table of the financial entity.

The valuation process is more complex for an economic efficiency analysis, first, because some market prices for direct inputs and outputs may not be appropriate measures of economic value as defined in chapter 3; and, second, because values for nonmarket impacts are considered to the extent possible.

Box 5.1 illustrates the wide variety of use and nonuse values commonly associated with forest. In most cases we are dealing with a continuum of value conditions, from clearly and easily measured market values (e.g., timber) all the way to existence values and the value of biodiversity that cannot at this time be meaningfully put in a quantitative monetary value framework.

5.2 Using Market Prices in the Financial Analysis

A market price is the amount of money which a buyer (consumer) has to pay at a given time in a given market for a good or service, or the amount of money which the seller of a good or service receives in the market. A market price is determined by the interaction of (1) consumers' willingness to pay for a good or service (demand), (2) suppliers' costs and willingness to sell it (supply), and (3) policies which constrain the free interaction of supply and demand. Regardless of how policies, market conditions, and other considerations affect the final magnitude of the market price, the basic point is that it becomes a fact once a transaction has taken place.

World market prices are particularly useful in an economic analysis as a basis for valuing inputs and outputs that are traded in international markets. There are two main types, namely, export prices (FOB prices) and import prices (CIF prices).

Export or FOB price. The term FOB means free on board and includes all costs to get goods on board the ship in the harbor (or other means of transport) of the exporting country, such as, project gate prices, local marketing and transport costs, local port charges and export tariffs and subsidies.

Import or CIF price. The term CIF means cost, insurance, and freight included. It is defined as the price of the good delivered on the importing country's dock or other entry point, and includes the cost of the good at point of export (i.e., FOB price), freight charges to point of import, insurance charges and, in some cases, the cost of unloading from ship to pier at the port of the importing country. It excludes import duties and subsidies, port charges at point of entry (e.g., taxes, handling other than unloading, storage and agent fees), and local marketing and transport costs.

Observed market prices for inputs and outputs reflect present and past conditions of supply and, demand. Values used in project analyses involve consideration of future supply and demand conditions. Thus, to arrive at future value estimates some adjustments in observed prices and trends in such prices may have to be made. The following adjustments are recommended: (1) adjust future prices to take out the likely effects of inflation; (2) adjust for relative changes in prices of specific inputs and outputs; and (3) adjust for potential impacts of the project itself on future prices. These three considerations are discussed in more detail in the following section.

5.3 Estimating Future Prices

An existing or past market price is a fact. It represents what a good or service actually is or was traded for in a given market. Existing market prices can be used directly in valuing inputs and outputs that occur today. When deciding on how to adjust existing prices so they can be used to value inputs and outputs that occur sometime in the future, the analyst has to consider three factors: (1) general price inflation; (2) relative price changes for inputs and outputs; and (3) the Big Project effect.

Inflation relates to general price increases which affect all goods and services. Inflation reflects a decline in the real value of money. In addition, there may be relative price changes for some goods or services. Some prices may be expected to change in value more or less than the general level of inflation and, therefore, change relative to other prices. Other prices may be strongly affected by project activities. In developing future value estimates for project appraisal purposes, it is important that the analyst be aware of the distinction between general inflation and relative and other price changes and make appropriate adjustments for them in estimating future values.

5.3.1 Treatment of inflation

The general approach recommended is to work with prices net of inflation, but to include any relative price changes which are expected (see box 5.2). Thus, if prices of all inputs and outputs for the project are expected to increase at the same rate (i.e., at the rate of general inflation), then the analyst can merely use existing prices as a measure of future prices (keeping in mind that actual money prices will increase with general inflation). The advantages of using price estimates net of inflation, i.e., relative prices, are (1) the analyst does not have to try to estimate general price inflation over the life of the project, which is always difficult to ascertain and justify; (2) the results can be understood more easily; and (3) the analyst will be able to show more clearly the assumptions used in the analysis concerning relative price changes.^[13]

As an empirical point, it should be stressed that relative price changes tend to be more pronounced in situations of high inflation, as investors search for means to hedge against inflation. For example, high inflation tends to encourage investment in land and other real assets that increase in value at a rate greater than or equal to the rate of general inflation. Bank accounts and certain other fixed return investments, on the other hand, have a tendency not to keep up with inflation because the fixed return becomes less valuable in the future as inflation increases. Thus, relative prices of land and certain other assets may be bid up relative to other prices in periods of inflation as demand for such assets increases.

5.3.2 Estimating relative price changes

It is quite common that some prices are increasing (or decreasing) relative to others. For example, in many countries, the price of stumpage is increasing relative to other prices, i.e., it is increasing at a rate faster than the rate of general price inflation. In cases where relative price changes are expected, the question arises as to how the analyst should attempt to estimate or forecast such changes. Forecasting is an area of specialization in and of itself and can be quite complicated to carry out in practice if it is to be done properly. No attempt is made to cover the techniques and approaches in EAFP.^[14]

In most circumstances the analyst dealing with forestry projects will not be able to use sophisticated forecasting techniques to estimate future prices, and must rely on simple approximation techniques.

If acceptable data on past prices are available and the conditions causing these prices are expected to continue, then the simplest approach is to plot prices over time on a graph. If a trend is evident, then the resulting trend line can be extended into the future. This can be done with regression analysis or simply by extending visually the historical price line on the graph into the future. In working with historical data, there are a number of ways of smoothing out variations that occur from year to year and adjusting for inflation to arrive at a long-term trend estimate which excludes cyclical influences and the effects of inflation.

In this type of trend projection, it is assumed that certain factors (other than the project itself) have affected prices in the past, and are likely to persist into the future over the period of the project. Though this is not always the case, this simple type of projection technique is most often used in practice. For example, in many cases the qualitative features of the product change over the time of the projection. This complicates matters. For example, in the case of a teak forest management project, older stands have been depleted and the new teak of smaller diameter. The price per cubicmeter in these circumstances should be adjusted to reflect these changes in the quality of wood. However, in practice this is very difficult to do in a very convincing manner. Because of this, the analysis of price trends is flawed, but there is very little that can be done about it.

For some forest products, records on domestic prices over time may be limited. In fact, this is the usual situation in countries where the contribution of the forest sector is modest and where statistical services are not well developed. In these cases, the analyst can do little more than try to obtain opinions of knowledgeable people and look at trends in relative prices in other countries and adapt these to the analyst's needs. Alternative price assumptions can be introduced in the sensitivity analysis of project results.

In other cases, accurate records exist covering extended periods, and clear trends are readily perceived. This might be the case, for example, for wages, or for some internationally-traded goods, where records can be obtained from international agencies or from the exporting/importing countries' services.^[15]

Some approximations of future price movements are relatively easy to imagine without having much data. For example, if a given region's forests are being rapidly depleted, and population density and the development of general economic activity show a clear increasing trend, the analyst has sufficient reasons to expect a growing scarcity of forest products and rising prices. Thus, the analyst can pick some reasonable rate of increase in prices and test others in the sensitivity analysis.

On the input side, records usually exist on prices of imported goods (in the project country or in neighboring importing country customs files, or in the files of importers). Price trends can be derived from such records and projected into the future.

5.3.3 The Big Project effect

Naturally, a new project being analyzed has not yet influenced the way in which prices have changed in the past relative to other prices or the rate of general price inflation. However, the proposed project may be large enough in relation to input or output markets to be able to influence prices in the future. Thus, a pulp and paper project's wood purchases may be an entirely new matter or may strongly influence existing wood prices, and its output might add significantly to supply and result in a decrease in future prices for paper. Or the project requirements for given inputs may be large enough to push up the price of these inputs. If information is available on which to base an estimate of how the project is likely to affect future prices, it should be taken into account. It may only be possible to state the direction of the expected influences. Even though the magnitude of the effect often cannot be estimated, the analyst should still include information on the expected direction of change, so various potential prices can be tested quantitatively in the sensitivity analysis.

5.4 Market Prices and Economic Values - Some Definitions

Market prices should be used in the economic analysis to the extent that they reflect economic values. Therefore, the first logical step is to separate out all those inputs and outputs which are associated with market prices.

Before the adequacy of existing market prices as measures of economic value can be usefully discussed, it is necessary to have clearly in mind the meaning of the terms market prices and economic values. As defined in section 5.2, market prices are the prices that buyers pay and sellers receive for goods and services bought/sold in a given market.

The basic measure of economic value is consumers' willingness to pay (w.t.p.) for goods and services, given existing policies which affect w.t.p. In the case of inputs or costs, the term opportunity cost (OC) is often used. As discussed in chapter 2, the cost of using an input in the project being analyzed is the value foregone by not being able to use it in its next best alternative use, i.e., its OC. However, the value foregone is measured in terms of consumers w.t.p. for the goods and/or services foregone. Thus, both in the case of benefits (outputs) and in the case of costs (inputs) w.t.p. is used as the basis for valuation in the economic analysis.

While this provides an adequate conceptual definition of economic value, it is necessary to be more specific when it comes to applying the concept in practice and deciding on exactly what measure of economic value is appropriate for valuing different types of outputs and inputs.

Figure 5.1 provides a general overview of valuation approaches to be used in the economic efficiency analysis. The remainder of this chapter and the attached annexes discuss the approaches in more detail for various output and input categories.

5.4.1 Appropriate economic value measures for different types of outputs

For analytical purposes, project outputs can have three types of effects (see figure 5.2). First, a project output can increase the total domestic supply of a good or service available to society. This produces two categories of outputs (see output categories I and II in figure 5.2): (1) consumer goods or services, and (2) intermediate or producer goods or services (i.e., project outputs which will serve as inputs in other production processes which produce consumer goods). In the former case, the appropriate measure of value is the consumers' w.t.p. for the output of the project itself. In the latter case, the appropriate value measure is producers' w.t.p. for the project output, which in turn is based on consumers' w.t.p. for the other goods and services which will be produced with the output from the project being analyzed.

Figure 5.1. Valuation conditions and approaches (Gregersen et al. 1987).

The second effect of project outputs is to increase the availability of foreign exchange to the economy. This also produces two categories of outputs (see categories III and IV in figure 5.2): (1) exports, and (2) import substitutes. The value of these project outputs are measured in terms of the local w.t.p. for the goods and services which can be purchased with the foreign exchange earned (in the case of exports), or the foreign exchange saved (in the case of import substitutes). Since it is necessary to measure economic values in terms of local consumers' w.t.p. for goods and services expressed in local currency, the foreign currency earned or saved has to be converted to local currency, and government policies which make local w.t.p. differ from what the country actually has to pay for imported goods and services in terms of foreign currency have to be taken into account. Unadjusted CIF and FOB values (converted to local currency) may not reflect w.t.p. in cases where a government imposes tariffs or provides subsidies for exports and imports.

The third effect of project outputs is to substitute for other domestic supply, thereby releasing resources for other uses elsewhere in the economy (see category V in figure 5.2). Here the relevant measure of economic value is the opportunity cost of the released resources, which is based on the w.t.p. for the goods and services which will be produced with the released resources.

Figure 5.2. Outputs: Measures of economic value.^[16]

Section 5.5 discusses how to determine the appropriateness of market prices and the factors which are likely to cause a discrepancy between the local market price and the economic value for these five categories of outputs.

Means for deriving the measures of economic value for outputs are discussed in annex 5.1 for cases where market prices are not considered appropriate.

5.4.2 Appropriate economic value measures for different types of inputs

Inputs used in a project can have two basic economic effects (figure 5.3). They can: (1) reduce the availability of foreign exchange for the rest of the economy, and (2) reduce the availability of real resources or inputs to the rest of the economy. A reduction in the availability of foreign exchange may result from use of imported inputs when no quota exists, or from the use of locally produced input which otherwise would have been exported (input categories A and B in figure 5.3). Where inputs are imported (input category A), the appropriate measure of opportunity cost is based on the w.t.p. for the goods and services which could have been bought with the foreign currency or foreign exchange spent on the imported inputs for the project. This category also includes project use of a locally produced input in short supply that forces a previous user of the input to import the input. In either case - direct use of imported input or forcing someone else to import it - the effect is the same, and so is the value measure that is appropriate.

Figure 5.3. Inputs: Measures of economic value.^[17]

For locally produced inputs which would have been exported if they were not used in the project (input category B), the appropriate measure of opportunity cost is based on the w.t.p. for the goods and services which would have been purchased with the foreign exchange which would have been earned from exporting the inputs if they were not used in the project.

The second effect of using project inputs is to reduce domestic real resources or inputs available to the rest of the economy when an input is diverted from other domestic use to the project. Here three categories of inputs can be distinguished: (1) locally produced inputs which do not reduce exports or induce new imports (input category C, figure 5.3); (2) imported inputs when a quota exists, i.e., a quantitative restriction exists on imports of the input (input category D); and (3) local resources, primarily land and labor, which are not produced as such (input category E).

For category C inputs, a further distinction can be made for valuation purposes. If the project induces additional domestic production of the input, then the appropriate measure of economic value is the opportunity cost of the resources used to produce the input. If the project reduces the availability of the input to the rest of the economy, then the appropriate measure of economic value is the opportunity cost of the input itself in its best alternative use. In the latter case, it is the opportunity cost of the input itself, i.e., the value foregone by using it in the project rather than in its next best alternative use. (Note that if other users now import the input, then it fits into category A.)

When a quota exits for imported inputs, and is filled (input category D), there is no additional outflow of foreign currency, since the total amount of the input imported into the country remains the same (at the level of the quota). Thus, the relevant opportunity cost is the value foregone from shifting the imported input from some other domestic use to the project. Naturally, if the quota is not being met, i.e., imports of the input without the project are below the level of the quota, then the quota is not effective and from an analytical point of view the input is reclassified as an imported input with no quota (see item A in figure 5.3).

When project inputs are local resources, the appropriate measure of value is simply the opportunity cost of the resource or the value foregone by using the resource in the project rather than in its best alternative use.

Means for deriving these measures of economic value for inputs are discussed in annex 5.2 for cases where market prices are not considered as appropriate approximations of economic values. The following section discusses some of the factors to be considered in determining the appropriateness of market prices.

5.5 Determining Adequacy of Existing Market Prices as Measures of Economic Value

In practice most analysts tend to accept market prices as proxies for the measures of economic values and only attempt to shadow price major inputs and outputs for which the market price is not considered to be an adequate measure of economic value. It should be up to the analyst to show convincing evidence that the magnitude and importance of the difference between a market price and the w.t.p. is great enough to justify the extra effort involved in shadow pricing an input or output. Quite apart from the additional time and funds required to develop shadow prices, there is the danger that inappropriate shadow prices will lead to decisions that, taken in the context of the actual workings of the economy, will be worse for the country than if market prices had been used (which take into account the influences of policies, customs, attitudes, and noneconomic objectives which actually direct the economy).

For any given situation, adequacy of a market price for an input or output depends on (1) the importance of the input or output in the overall project, (2) the estimated degree of discrepancy between market price and w.t.p. or OC for the input or output, and (3) the practicability of developing an acceptable shadow price (which relates centrally to the time and budget available for the economic analysis in each case, and the purpose for the analysis). Each of these three factors is discussed in the following sections.

5.5.1 Estimating the importance of inputs or outputs

Most market priced forestry project outputs contribute to total project benefits, and are potential candidates for shadow pricing.

Many project inputs that can be measured in market prices are relatively insignificant in terms of total costs. Every project involves purchases of a myriad of small items - office supplies, hand tools, etc. Such items generally need not be shadow priced. However, one word of caution is needed here. A project may involve a number of different inputs that individually are unimportant in terms of total cost, but when added together, may have a significant influence on total costs. While it may not be worth the time and effort to shadow price each item individually, it is possible through a sensitivity analysis to test the effect on project outcome of an increase in some or all of the values of these inputs combined (see chapter 7).

Most forestry projects also involve major input items such as land, labor, heavy machinery, processing equipment, etc. Such items may or may not be considered for shadow pricing, depending on time and funds available and the conditions which influence the market prices which exist for them.

As a rough rule of thumb, if an input valued in market price terms represents 5 percent or more of the total present value of the cost of the project, then it is a logical candidate for shadow pricing to determine its economic value. Whether or not it is worth shadow pricing the input depends on the magnitude of the estimated difference between its market price and its economic value (as discussed in the next section). For example, if an item that represents 5 percent of total cost in present value terms has an estimated shadow price that is 20 percent of the market price, then the effect of shadow pricing will be to reduce the cost of that item to only 1 percent of total cost (20 percent of 5 percent) for the economic analysis. This could be significant in terms of a project's economic profitability. On the other hand, if such an item had an estimated shadow price of 90 percent of the market price, then the difference in terms of total cost would only be one-half of one percent (4 ¹/₂ percent rather than 5 percent), which would not be as significant in terms of economic profitability.

Some types of items often listed as inputs can present problems. For example, projects generally include various physical structures, roads, etc. If these have been listed as “inputs” they are likely to be major items in terms of total costs. As pointed out in the previous chapter, such items should be broken down into their component inputs of labor, equipment, various types of materials, etc. In this case, the judgement relates to whether the component inputs are important enough to merit the extra effort involved in developing shadow prices.

5.5.2 Identifying discrepancies between existing local market prices and economic values

A shadow price should be developed for an important input or output if there is likely to be substantial discrepancy between its existing market price and its economic value. Such discrepancies can be caused by government policies and other factors.

Discrepancies caused by government policies

Governments use a great number of policy tools to guide their economies toward what are considered to be the economic and social development goals of the country. Common ones include taxes (including tariffs), subsidies, minimum price and price ceiling laws, and quantitative restrictions on market transactions. Of these, only minimum price and price ceiling laws restrict local price movements and thus affect economic values. Even those policies will cause discrepancies between local market prices and economic values for only some of the input and output categories discussed in section 5.2 (and shown in figures 5.2 and 5.3). It also should be recognized that in many countries policies exist on the books which are, in fact, ineffective and, thus, for analytical purposes they can be disregarded. For example, a government may have placed a price ceiling on lumber for construction. However, if the market price for lumber is below the price ceiling, the price ceiling is ineffective because the price of lumber would be the same with or without the policy or price ceiling. The effectiveness of such policies can be estimated by determining what would happen with the policy in place, and what would happen without the policy.

Minimum price imposed by government. If a minimum price imposed by a government is effective for a given good or service, then supply would tend to exceed demand for that particular good or service at the established minimum price. If supply does not exceed demand at this price, then the minimum price is an ineffective policy tool, since the market price would settle at the same level with or without the policy (the minimum price).

If a minimum price for a project output is effective - i.e., there is an excess supply of that good or service at the minimum price - it is unlikely that a project would be proposed to add to total supply of that output. Since buyers can obtain as much as they want at the minimum price without the project any addition to total supply would likely remain unutilized so long as the policy remains in effect. Consumption would remain the same with or without the project, so the output of the project would be valued at zero. Of course, if the minimum price is expected to be reduced, then this would have to be taken into account.

Evidence of an effective minimum price policy can be observed by looking at the supply situation for goods and services. Some indications of effective minimum prices are as follows:

• accumulation of stocks when a minimum price is imposed;

• excess capacity coupled with an increase in the minimum price;

• creation of a black market (or informal labor markets where labor is hired below the minimum wage set by government);

• producers abandoning the market because of lack of sales; and

• the existence of unemployment coupled with an effectively enforced minimum wage law. The minimum wage (the market wage) is higher than the opportunity cost of labor which should be used in the economic analysis. Caution is needed with this indicator when one is dealing with semicommercialized countries.

Price ceiling imposed by the government. Where a price ceiling imposed by government is effective, buyers will not be able to buy as much as they would like to at the controlled price, i.e., there will be an excess demand at the existing market price. If there were no control on prices, buyers would bid up the market price until the available supply equaled demand at some higher price.

One place to look for evidence of the existence of a price ceiling is the regulatory legislation affecting the marketing of an input or output. However, the mere existence of legislation does not guarantee that price ceiling legislation will be effective. It is necessary, therefore, to look for evidence easily observable in the market that consumption is, in fact, restricted by the government control. Indications of an effective price ceiling policy include the existence of queues, black markets, and various forms of rationing. These are all indicators that the marginal buyer is willing to pay more than the going price for the quantity offered in the market.

The nature and direction of discrepancies between local market prices and economic measures of values caused by effective government controls on local prices (minimum prices and price ceilings) are summarized in table 5.1 for each of the output and input categories shown in figures 5.2 and 5.3. As indicated for several categories of inputs and outputs the policies can either not be effectively applied, or if they are effectively applied, they are not applicable in terms of the measures of economic value used for the particular category of input or output being considered.

This discussion relates to discrepancies between local market prices and economic values which are due to the influence of government policies. Government policies, through the existence of an official fixed exchange rate (OER), can also cause discrepancies between the existing market price for foreign currency (the OER) and the real economic value of foreign currency in terms of what it actually can purchase in the local market in terms of domestic prices. Since several of the output categories (III and IV) in figure 5.2 and input categories (A and B) in figure 5.3 involve use of world market prices (CIF and FOB values) to derive economic values, such discrepancies need to be taken into account if they exist, and foreign currency related effects need to be given shadow prices. A shadow exchange rate (SER) is commonly used. It is explained in Ward and Deren (1991).

Table 5.1. Discrepancies between local market prices and economic values caused by effective government controls on local prices. ^a

^a LP = local price; w.t.p. = willingness to pay; OC = opportunity cost; NA = not applicable in terms of the appropriate measure of economic value shown in figure 5.2 (outputs) or 5.3 (inputs) or that the policy cannot be effective for the particular type of input or output being considered.

In the case of an identified discrepancy between the OER and the real value of foreign currency in local terms, a general SER is derived and used in all calculations of economic values for inputs and outputs which involve earning, saving or using foreign exchange or foreign currencies. Thus, once the SER has been derived, it can be used for all the categories of inputs and outputs shown in figures 5.2 and 5.3 which directly or indirectly involve foreign exchange (i.e., output categories III and IV and input categories A and B). Not only should a general SER be used to evaluate all such inputs and outputs for a specific project, but it should also be used in analyzing other projects in the country. Thus, estimation of a SER should be done at the national level and used systematically for all projects. This contrasts with the situation for many domestic (nontraded) inputs and outputs. For example, in the case of labor there will likely be shadow prices that are unique to given small areas within a country. If unemployment is high in one area (and mobility of labor is low) then a lower opportunity cost (shadow price) for labor would exist for projects in that area than would exist for labor in other areas with lower unemployment.

Discrepancies caused by other factors

In addition to government policies, other conditions in the project's economic environment can cause discrepancies between existing local market prices and economic values for some input and output categories.^[18] The main ones to be considered are

• existence of monopoly or monopsony elements in the markets for project outputs or inputs; and

• existence of speculation or status influences, particularly in the case of land prices.

Monopsony and monopoly. The existence of monopsony power and monopoly power is common in many countries. The power to set prices is a form of monopoly exercised by the government. The distinction made here (in relation to the two categories of policy influences discussed in the previous section) is that this discussion involves monopoly and monopsony power exercised by private (nongovernmental) individuals and/or groups, e.g., corporations or unions. The relationship between the existence of either of these two forms of market control and government policies is often difficult to ascertain, i.e., whether in fact a government is encouraging either or both of them, or it merely permits or condones them in the economy. In some cases, a government is against the existence of monopoly and monopsony in the private sector, but it does not have the political power to do away with them.

The point here, in terms of valuation, is that if monopoly and/or monopsony exist in the project environment and are expected to persist during the period of the project, then their effect should be taken into account when looking at discrepancies between market prices and economic values. For example, if a strong union exists and is expected to persist during the period of the project, then the discrepancy between union set wages and actual opportunity cost of labor should be taken into account in the same way that the discrepancy caused by a government set minimum wage needs to be considered.

MONOPSONY POWER - If one or a few purchasers acting together can alter market prices by modifying their buying policies, then a monopsony condition exists.^[19] A buyer enjoying some degree of monopsony power will change the market price of the input or output to the buyer's advantage. If the buyer's power is effective, then the price paid by the buyer for the input or output will be somewhat lower than what otherwise would have been paid if the buyer did not have the monopsony power. The market price will reflect only partially the buyer's real willingness to pay.

If there is monopsony power associated with the product (good or service) being produced by the project, or monopsony power associated with the inputs required for the project being analyzed, the same kinds of discrepancies can develop as in the case of price ceiling policies. Thus, the direction of such discrepancies for different categories of inputs and outputs can be identified in column 2 of table 5.1.

Evidence of the existence of monopsony forces can be obtained in some cases by examining sales records. If one buyer dominates the market, then there is good reason to suspect that that buyer is influencing market prices in the buyer's favor. In the case of collusive agreements among several buyers, market influence is much more difficult to identify and to measure. Since these types of arrangements are forbidden by law in most countries, they tend to be made in secret or through informal, tacit understanding among buyers. Generally, when this type of influence is suspected to exist in the market, it can best be considered in a sensitivity analysis, since it is extremely difficult to adjust the market price for this type of effect.

MONOPOLY POWER - If one or a few sellers in a market have the power to influence prices by altering their selling policies, a monopoly condition exists.^[20] Whether this monopoly condition will cause a discrepancy between market prices and economic values depends on the type of output or input being valued.

In general discrepancies caused by the existence of monopoly power in the markets for project outputs or inputs will be the same as those shown in column 1 of table 5.1 for government minimum price policies. In other words, monopolists will, in a sense, have the power to set minimum prices. On the output side, if a monopolist sets a higher price than previously existed in the market, it will likely influence the volume of sales, since less will be consumed when the price is increased.

On the input side, discrepancies can arise between the local market price and the opportunity cost associated with an input if a monopolist sets the price. For example, in the case of an imported input when no quota on imports exist, a monopolist that controls the local price of imports can set it above the opportunity cost of foreign exchange used to import the input. Similarly, in the case of local resources, say labor, a monopolist (e.g., a union) can set the minimum wage level at a level above the opportunity cost of labor.

Influence of speculation or status on market prices. Prices for land are often set in the market on the basis of speculation concerning future values of land and/or on the basis of status associated with owning land. Such influences can cause a divergence between market prices for land and the value of land in terms of its alternative productive uses (i.e., contribution to real national income). The valuation approach used (see annex 5.2) eliminates the need to be concerned with such divergences. It is suggested that land should always be shadow priced on the basis of its alterative productive uses over the period of the project and not on the basis of land sale prices.

Comments on identifying discrepancies

It is clear that very often the analyst will be able to identify some of the discrepancies discussed and to estimate the direction of the divergence between market prices and economic values, i.e., whether economic values will be higher or lower than existing market prices. However, it is quite a different matter to be able to measure the magnitude of such differences. Even so, the qualitative knowledge does focus attention on those areas where the discrepancy may have a potentially important impact on project worth. Thus, this type of analysis helps to identify areas of uncertainty to be treated later in the sensitivity analysis.

There is one other point which should be mentioned. This relates to second-round effects, or discrepancies which exist between market prices and economic values one or more steps removed from the market prices for direct inputs or outputs associated with a project. The discussion of discrepancies has concentrated on only the direct or first-round discrepancies which can be identified. It is quite possible that the analyst will have information on which to judge whether there are discrepancies further down the line which should be taken into account. For example, there may be no apparent policies or other factors which are directly affecting the price of locally produced tractors to cause a discrepancy between the local market price for a tractor and its economic value in terms of the project. However, if it is known that there is a discrepancy between the local market price and the economic value for the steel used in producing the tractor, then an attempt should be made to shadow price the tractor, taking into account the shadow price for steel. While in rare instances it may be possible to make such corrections, generally, from a practical point of view, it will not be possible to trace through all the effects of every input that enters into the production of the inputs used in a project. Normally, the analyst will have to be content to deal with the obvious discrepancies directly associated with the prices for project inputs and outputs.

5.5.3 Ease with which acceptable shadow prices can be developed

The final factor which needs to be considered in deciding whether to use the market price for an input or output or whether it should be shadow priced relates to the ease with which an acceptable shadow price can be developed (see box 5.3). In nearly all project analyses, the analyst is faced with a time and a budget constraint. The analyst will not have the time to spend on shadow pricing every input or output item which is important and for which a discrepancy is expected between market price and economic value. For many inputs or outputs which are difficult to shadow price, the choice will have to be made between using a rough guesstimate of an appropriate shadow price (that at least covers some of the estimated discrepancies between market price and economic value) or using the market price, even though it is recognized to be less than a perfect measure of economic value. (In the latter case, the discrepancy is explicitly acknowledged in the analysis report and alternative values can be tested in the sensitivity analysis.) The choice between these two alternatives will have to be made on the basis of the circumstances surrounding the analysis (its purpose) and the judgement of the analyst as to just how critical the value of the particular item is in terms of the selected measure of economic efficiency.

Finally, for most forestry projects the analyst will encounter indirect effects (externalities or nonmarket priced effects) for which it is difficult, if not impossible, to develop acceptable shadow prices (e.g., in valuing scenic beauty, increases in self-reliance, reduction of drudgery). In such cases, the best the analyst can do is to describe the effects in physical and/or qualitative terms and suggest how they are likely to affect the project outcome and its impact on society.

Some of the practical considerations which influence the decision on whether or not to attempt to shadow price an input or output are discussed in more detail in annexes 5.1 and 6.2.

Annex 5.1
Shadow Pricing Outputs

Introduction

This annex deals with an approach to shadow pricing outputs for an economic analysis when existing market prices are considered inadequate direct measures of economic value.

As shown in figure 5.2, there are five basic categories of project outputs which can be distinguished for purposes of valuation. These are

1. consumer goods or services which add to total domestic supply available;
2. producer or intermediate goods or services which add to total domestic supply available;
3. output substituting for existing domestic supply;
4. exports; and
5. import substitutes.

The eventual effect in all cases is an increase in the goods and services available for domestic final consumption. However, the appropriate approaches to shadow pricing such increases depend on the category of output being considered and the nature of the links from immediate or direct project output to the increase in availability of domestic consumption goods and/or services. In the case of the first two categories, the relevant measure of value is the w.t.p. for the output of the project. For the third category, the relevant measure of value is based on opportunity cost of the resources released. The last two categories of outputs involve earning or saving foreign exchange. Thus, the relevant measure of benefits is based on what the foreign exchange earned or saved can buy for domestic consumers in terms of local prices, i.e., w.t.p. for imported goods in local price terms. The remainder of this chapter discusses appropriate approaches to deriving these measures of value.

Consumer Goods and Services that Add to Total Domestic Supply

This category of output is often considered to be the most difficult type to value for an economic analysis when the local market price is rejected as a measure value. Fortunately, most forestry project outputs are not final consumer goods that are added to total supply. If they are, then it is frequently found that their existing market prices provide a reasonable approximation of economic value or w.t.p. The main exception is a market priced good or service for which a price ceiling has been set (see below). As mentioned in chapter 5, in cases where a minimum price has been set which creates a discrepancy between market price and w.t.p., it is unlikely that a project will be proposed to add to total supply. This follows from the fact that an effective minimum price is associated with excess supply, so a project would not likely be proposed that would merely increase that excess supply.

The appropriate measure of value for this first category of output is consumers' w.t.p. for the increased output. If the existing market price is judged to be inappropriate as a measure of w.t.p., then the analyst has to try to estimate an approximate schedule of w.t.p. for the output. The usual way is to conduct a survey among prospective consumers (see box A.5.1).

In some cases a forestry project output will add to total supply of a group of goods which have the same end use (i.e., relate to the same consumption objective). The goods themselves may be different, but the use is the same; thus, they should be considered together. For example, fuelwood and coal may be used interchangeably for fuel by local villagers. A fuelwood project may add to the total supply of fuel available. It may be substituted for coal by local villagers, but the released coal in turn will be added to the supply available for and used by urban and industrial fuel users. If there is no market price established for fuelwood which is acceptable as a measure of economic value for the additional project output, then the market price for coal may provide an acceptable measure of value when appropriately converted to some common measure of fuel/energy value (e.g., calorific value). This would be the case if the market price adequately reflects w.t.p. for coal.

In this case a first reaction might be to value the fuelwood as a substitute for coal. In fact, while the fuelwood is being substituted for coal by villagers, the coal will be used elsewhere, i.e., the total supply of fuel available has been increased. Thus, the appropriate measure of value is the w.t.p. for the additional fuel indirectly made available to society by the project. The point is that w.t.p. is based on use or consumption value and there may be several seemingly diverse products which have the same use value. For the purpose of the economic analysis, they are considered together when defining supply available and determining whether a project output adds to or substitutes for existing supply.

In the case of a project which would add to total supply of a consumer good or service for which a price ceiling exists, a situation of excess demand may be encountered, i.e., at the prevailing maximum allowable market price, consumers are willing to buy more than suppliers are willing to sell. As indicated in chapter 5, evidence of such a situation (an effective price ceiling) includes the existence of queues, black markets, etc. The black market price can provide an upper limit on the actual w.t.p. for the good, but should generally not be used as a proxy for w.t.p., particularly if the black market is fairly small relative to the total market. Rather, some value in between the administered price (the ceiling price) and the black market price could be used. The best approach in this case is probably to test a number of value assumptions in the sensitivity analysis. If the project produces an acceptable measure of economic profitability using the administered price, then there is less need to consider higher prices (such as the black market price) since they would merely serve to make the project even more profitable (or to increase the measure of economic efficiency).

A final comment relates to the suggestion sometimes made that world market prices can be used as proxy measures of economic value for this category of outputs. Based on the valuation system adopted in EAFP, if for policy or other reasons a market priced good or service could not, or would not be imported in the absence of the project, then its world market price (CIF value) should not be used as a measure of value for it. Similarly, if a good could have been exported, but is produced by the project for domestic consumption, then the export price should not be used as the basis of value for local w.t.p. In this latter case, it can be said that the decisionmakers who decided that the good will be consumed domestically instead of being exported must consider the local consumption value to be at least as great as the export value to the nation. Thus, the export value provides an estimate of the minimum value of the output from the viewpoint of decisionmakers. However, actual w.t.p. by local consumers may be quite different from the decisionmakers' interpretation of the minimum value of the product and it is this local w.t.p. which is relevant.

Intermediate Goods Which Add to Total Domestic Supply

Many forestry project outputs fall in this category. The appropriate measure of value should be based on the relative contribution of the project output to the value of the final consumer goods or services which will be produced with the project output, then such value is measured in terms of consumers' w.t.p. for those final goods or services. For example, lumber produced by a project should be valued on the basis of its contribution to the value of final consumer goods - housing, etc. -which will be produced with the lumber. In practice it is exceedingly difficult and time consuming to develop such a value measure, and this difficulty has led to the common practice of valuing such project outputs on the basis of producers' or converters w.t.p. for them, where the converters are those who will take the project output and convert it into final products for consumption.

If there is a local market for such intermediate goods and it is competitive enough to make the price an acceptable reflection of w.t.p. for the output, then there are no problems of shadow pricing. However, if there are administered prices associated with the market or there is evidence of monopsony power on the part of those buying the output or monopoly power on the part of the sellers of the final products to be produced with the project output, then problems arise, for the market price no longer can be taken as an acceptable measure of economic value.

Similarly, in other cases there will be no established market for the project output (i.e., the final processing activities which will use the project output have not yet been established). Thus, there will be no established market price. The best approach in such cases is to evaluate the proposed project as part of a larger integrated project which would include everything up through the final production of consumers goods. For example, if the initial project were defined as one to produce pulpwood for a proposed pulp and paper mill, and there is no other market for pulpwood, then the pulpwood output could be considered as an intermediate input (cost) in an overall project (pulpwood, pulp and paper project) and the pulpwood could be valued as an input on the basis of the opportunity costs involved in producing it (see annex 5.2).

The analyst also could attempt to survey converters' w.t.p. for the project output. Such surveys are fraught with various difficulties similar to those mentioned for consumer surveys. The problems are even more difficult if the project output will not be sold competitively, since converters or producers of the final goods are not likely to reveal their true w.t.p. if they realize that they will be the only ones buying the output. Yet, under the circumstances, this type of survey coupled with judgement on the part of the analyst may provide the best information possible.

Another common approach used in financial analyses of forestry projects is to calculate a surplus value for the intermediate output and then attribute that value to the project producing the intermediate output. The surplus value is derived by estimating the final product price and then subtracting all costs other than the value of the project output (which will be an input in production of the final product). The amount left after these subtractions is then divided between profit and the surplus value to be attributed to the project output. This approach can provide an approximation of what the producer of the final product could afford to pay for the project output and still make an acceptable return or profit. (In calculating the surplus value, allowance should be made for a profit element, usually equal to the going rate of return on similar types of investments.) In the absence of other means for approximating values, and if it is not possible to combine the proposed project with the further processing stages so the total integrated operation is treated as a whole, then the surplus value approach can at least provide some order of magnitude estimate of value.

It should be emphasized that the process of calculating a surplus value can be extremely difficult and time-consuming and also is fraught with potential errors if adequate information is not available on the economic value of the final product and all the intermediate costs down to the proposed intermediate output of the project being analyzed. For example, in the pulpwood plantation project mentioned earlier it would be necessary to develop an estimate of the value of the final paper production, estimates of all the costs involved in producing it and an estimate of the normal profit which could be expected. If there is no paper production in the country, then these estimates can only be derived by going through a complete economic analysis of the proposed pulp and paper project, in which case, an evaluation of both the pulp and paper project and the plantation project as an integrated whole might be done.

Output Substituting for Existing Domestic Supply

In this case, total supply available remains the same. The project would substitute for another domestic source of supply, which, when curtailed, would release resources for other uses (production of other goods and services). It is consumers' w.t.p. for these other goods and services (which would not have been produced in the absence of the project) that is used as a measure of value of the project to society.

This approach is quite different to the one for an output which increases supply. In a project that adds to total supply, it is the w.t.p. for the additional output of the project itself that is relevant.

In a project that involves substitution, the relevant comparison is between the opportunity costs of alternative sources of the same output, since with or without the project the total amount of the good or service would be the same.

In some cases tracing the relevant substitution impact of a project can be a difficult process (see boxes A.5.2 through A.5.5).

Many projects may involve both substitution and additions to total supply of consumption. For example, there may be an increase in the consumption of fuel because a fuelwood project provides it at a lower financial cost to the consumer than the price of the present fuel (the one for which the fuelwood will substitute). In this case, the two components have to be separated - the substitution part and the increase in total supply part - and each has to be appropriately valued according to the guidelines above. Suppose, in a case where fuelwood substitutes for coal, that without the fuelwood plantation project one million calories per day is consumed now using coal and that with the project, because of a lower financial price put on plantation fuelwood, consumption increases to 1.2 million calories per day. Substitution of fuelwood for the 1 million calories could be valued on the basis of the opportunity cost for production of the coal for which the wood is substituting. However, the additional consumption - 200,000 calories per day - should be valued on the basis of the consumer's w.t.p. for the additional consumption, since it is adding to total supply and not substituting for the domestic coal. It is only being consumed because the financial price is lower for the fuelwood. The w.t.p. for it (its economic value) is also likely to be lower.

To summarize, for a category of output that will substitute for other domestic supply of the same product or another product with the same use value, the appropriate measure of value of the benefits due to the project is the opportunity cost of the resources released, or the value of what these resources would produce if they were released. If the resources released have no other use, then the value of the project output may be zero or close to it. On the other hand, if the resources released are otherwise fully employed in the economy, and they are traded in a fairly competitive market, then the prices of the resources released provide an adequate approximation of the value of the project output. In between there will be cases where some of the resources released will have alternative uses and some will not.

The analyst's task is to identify the various inputs released and then to determine their alternative use values or their opportunity costs. Finally, if the proposed project output, say lumber, will substitute for other domestic lumber supply, and that other supply will now be exported, then the project output is treated as an export output for valuation purposes (see following section).

Exports

In this case the relevant measure of value is the local w.t.p. for the goods and services which will be purchased with the foreign currency earned. The foreign currency earned is reflected in the FOB value for the exports. If there is a free market exchange rate and no tariffs or subsidies attached to goods or services which will be imported with the foreign currency earned through the project, then the FOB value expressed in foreign currency (say dollars) can be converted to local currency using the market exchange rate that is expected to exist at the time the project output is exported.

However, in reality there will seldom be a situation where there is a free exchange rate and no tariffs or subsidies. This means that something other than the existing exchange rate has to be used to convert the FOB value to local w.t.p. terms. For this purpose a shadow exchange rate (SER) can be used.

The shadow exchange rate (SER)

Before suggesting guidelines for the use of a SER, it is necessary to look at how it is derived by national planners. The SER is defined as the real purchasing power of a unit of foreign currency expressed in local market price terms. It measures the average difference between local prices including tariffs and subsidies and prices calculated using the existing exchange rate, i.e., the average level of price distortion caused by tariff barriers. In an economic analysis the analyst is interested in actual w.t.p. or opportunity cost in local price terms. Therefore, the influences of tariffs and subsidies have to be included in the estimates. Sometimes the SER is adjusted to reflect nontariff barriers, e.g., import and export quotas and controls on buying and selling foreign exchange.

The SER is generally calculated to reflect the average price distortion in the economy, considering all imports and exports.

Some guidelines for forestry project planners follow. As mentioned in chapter 6, the SER used in a country should be a general one that reflects the entire trade picture and the average tariff or trade barrier effect on trade, where the average is calculated as a weighted average of all tariffs and subsidies on trade (i.e., tariffs and subsidies weighted by the amount of the trade to which they apply). Thus, it should be calculated by national planners for use in all project analyses in the country.

If such a national SER is available, it is recommended that analyst use it. If the analyst believes that s/he has a strong case for modifying the SER imposed by the Central Planning body, s/he can try to persuade this body to change it. Until it is changed, the analyst should use the given SER. In any case, the analyst can develop a test of sensitivity of the project to potential alterations in the SER.

If a generally accepted SER is not available in the country (developed by the national planning office or some other national planning body), then the existing exchange rate can be used. The analyst of forestry projects should generally not try to develop a SER of the analyst's own, since the task is quite complex, and if it is not done correctly, it could easily lead to distortions and to results which are not comparable with those for other projects. However, the analyst should test the sensitivity of the project results to alternative rates considered to be closer to the actual w.t.p. than the existing rate of exchange.

An alternative way to adjust the relative prices of traded and nontraded goods is to use a standard conversion factor (SCF). The SCF is equal to the official exchange rate divided by the SER (or 1 divided by 1 plus the foreign exchange premium expressed in decimal terms). The key point to note here is that both the SER and SCF valuation procedures generate the same relative net present worths; and the internal rates of return do not change. Project selection based on profitability of alternatives results in the same relative rankings for projects (see Ward and Deren [1991] for a comparison of the two approaches).

Valuing exports using FOB values and the SER

As mentioned earlier, the gross amount of foreign currency earned by an export project is measured by the FOB price for the output times the volume of output. In other words, the FOB price becomes the unit value of the export output expressed in foreign currency. Since local w.t.p. for goods and services expressed in local currency is being used to measure economic value, the foreign currency has to be converted to w.t.p. for what the foreign currency can buy in terms of local prices expressed in local currency. This is done by multiplying the FOB value by the SER.

In deriving the FOB value the market to which output will be exported can be determined, and using the CIF price in that market the FOB value for the output at the port of export can be derived. Obviously, if a FOB value already exists at the port of export, that value can be used. If several possible markets are being considered, then the FOB values associated with each can be derived, and if they differ, the highest can be picked under the assumption that exports would go to the most profitable market. If the output is intended for several specific markets and they result in different FOB values, then a weighted average FOB value can be used, basing the weights on the proportion of output that will go to each market.

Projects that indirectly result in increased exports can also be considered in this category. For example, assume that the project output of sawnwood will replace other locally-produced sawnwood in the local market and this other sawnwood will now be exported. In this case, the FOB value still provides the relevant basis for measuring benefits, since the project will result in an increase in the nation's exports which will permit expanded imports of other goods and services. Applying the with and without test, the shadow priced foreign exchange value of the exports is the relevant measure of value for the benefits due to the project.

Import Substitutes

If the project output will substitute for imports which actually would have taken place in the absence of the project, then the correct basis for valuing the output is the foreign exchange savings made possible by the project. The CIF price in foreign currency of the substituted imports is multiplied by the SER to obtain the local w.t.p. value, just as in the case of exports.

The project output may also substitute for another completely different imported product which has the same use. In this case, the project output can be valued on the basis of the CIF price for the other product times the SER, when appropriate adjustments have been made to equate the use-value of the project output with that of the other product.

For example, assume that project fuelwood will substitute for imported kerosene. In this case, the CIF price for the imported kerosene for which the fuelwood will substitute can be used to derive the shadow price for the fuelwood, by converting fuelwood and the imported kerosene to a common basis, e.g., cost/kilocalorie. An example is given in box A.5.7.

Avoiding Some Potential Output Valuation Errors

Several of the valuation approaches suggested are based on the assumption that a project's output will substitute for some other good or service. In using this approach the analyst should pay particular attention to the following questions:

• are the goods indeed substitutable technically and in terms of consumer preferences?

• if they are, will the assumed level of consumption (substitution) actually take place?

With regard to the first question, the analyst can draw on technical information and perhaps carry out a survey of consumer willingness and ability to substitute the two products. For example, some cooking and heating systems might be able to burn kerosene but not be properly designed for wood. In this case, the analyst looking at a fuelwood project that would substitute wood for kerosene would either have to doubt substitutability or suggest to the project planner that the project also include a component for redesign or remodelling of cooking/heating systems, if such is not already included. At the same time the analyst would also want to check very carefully the substitutability of wood for kerosene in terms of some common heating and/or cooking values. Such measures may be calories per unit volume or weight, or it may be in terms of less accurate measures such as average amounts needed to cook common foods or to provide heat in homes, etc.

The same type of considerations would be necessary in looking at the substitutability of lumber or plywood for other building materials, domestic paper production for imported paper, etc.

The last point brings up the second question raised. Assume that it is found that the marine plywood would be substituted for the interior plywood that had been used in exterior uses. Would the same quantity be consumed? This would likely depend on the actual pricing policy adopted for the project output (i.e., a financial consideration). If it were to be sold at the same price as the interior plywood, it might be substituted in equal quantities. But if the price were to be higher (because cost would be higher), then volume would likely be lower. In this case, the analyst has to watch the assumption about quantities of project output that would actually be directly substituted for interior plywood. Similarly, if it is to be sold at a subsidized price below the price of the substitute, volume may increase (see box A.5.8).

Finally, it should be reemphasized (as was done in chapter 5) that relative values often change over time, i.e., the value estimated for an output today may not be the relevant or appropriate value for some future period, even after taking out the influence of expected general price inflation. Thus, to the extent possible, the analyst should attempt to estimate what likely changes in output values still take place over time due to the same types of factors discussed for market prices in chapter 5. It is often difficult to project values into the future. There is uncertainty and many unquantifiable variables involved. Often the best thing to do is to assume constant relative values over time and then test the sensitivity of project results to potential changes in values. This is discussed further in chapter 6, which deals with the treatment of uncertainty.

Annex 5.2
Shadow Pricing Inputs

Introduction

This annex deals with approaches to shadow pricing project inputs. As shown in figure 5.3, inputs can be classified into five main categories for the purposes of empirical estimation of shadow prices

1. inputs that are imported when no quota exists on imports;
2. locally produced inputs which would have been exported if not used in the project;
3. locally produced nonexportable inputs;
4. imported inputs when a quota on imports exists; and
5. resources (land and labor).

Each of these categories is discussed separately in the following sections. As in the case of outputs there are several categories of inputs that involve foreign exchange effects. The SER, as discussed in chapter 5, is used to value such inputs. Specific uses of the SER are discussed below where they are needed.

Imported Inputs When No Quota Exists

Imported inputs not limited by any quota are valued on the basis of the local value of the foreign currency required to import them. This is measured in terms of the CIF value for the input times the SER. There are two exceptions to this approach

1. In some cases, inputs are financed by a grant which is tied to the project, i.e., a grant which only can be spent on importing the input for its exclusive use in the project. If this is the case, then there is no difference in total foreign exchange availability for other uses with or without the project. Therefore, no alternative benefits are sacrificed by using foreign exchange in importing the input. The economic cost to the domestic economy of the input financed by a tied grant is equal to zero.

2. When the input is financed with a tied loan, the economic cost does not materialize when the input is paid for (imported), since there is no alternative use permitted (no opportunity cost) for the foreign loan. The cost occurs at the time of repayment of the loan, when alternative imports could have been financed with the foreign exchange used up in paying the debt (principal plus interest).

Exportable Locally Produced Inputs

If the input used by the project actually would have been exported in the absence of the project, then the value foregone by the economy by using the input in the project is represented by the reduction in the availability of foreign exchange. The domestic w.t.p. for the imported goods and services foregone is the correct measure of the economic cost of using the input in the project. The basis for this value is the FOB price of the input (the foreign currency earnings foregone) converted to local prices of imported goods/services using the SER.

Nonexportable Locally Produced Inputs

The appropriate value measure for a nonexportable locally produced input (i.e., an input for which local production cost is greater than FOB value or where prohibited by government policy) is related to whether or not use of the input in the project reduces total supply of the input available to the economy (see input categories C1 and C2 in figure 5.3).

• If the project's use of the input reduces total supply of the input available to the rest of the economy, then the relevant shadow price of the input is based on the net benefits which are sacrificed (i.e., opportunity cost) in using the input in the project rather than in the next-best alternative use.

• If the project use of the input induces additional local production of the input, then the relevant cost is measured in terms of the value of the resources used up in increasing the supply of the input, i.e., their opportunity costs.

Note that if use of the input in the project induces additional or new imports of the input for use elsewhere in the economy, then the input can be treated as an imported input for valuation purposes, i.e., the foreign currency cost (CIF value) becomes the relevant measure of economic value when converted to local prices using the SER. (This parallels the case of a local consumed project output which induces exports of the same product from other producers.)

Imported Input For Which a Quota Exists

If there is an import quota affecting an imported input, its value should be measured in terms of the w.t.p. for its contribution to the value of alternative outputs that would have been produced with the input elsewhere in the economy if the project were not implemented. The reasoning is that the total amount of input allowed by the quota would have been imported with or without the project and, therefore, in these circumstances there would be no net drain of foreign exchange induced by the project. If imports of the input are below the quota, then the quota is ineffective and, from the point of view of the analysis, it does not exist. Thus, the input's CIF value could be used as a basis for valuing the input.

Resources: Labor

The objective in valuing labor is to arrive at a measure of the value of the benefits foregone by employing labor in the project rather than in its next best alternative use. If labor is hired away from other productive work and there is little unemployment in the project region, the value of the labor in the other work, or the market wage, provides an acceptable measure of opportunity cost for the economic analysis. This section discusses situations where these conditions do not hold, i.e., the market wage does not adequately reflect opportunity cost.

Unskilled labor

The main questions of interest in shadow pricing unskilled labor relate to the following situations:

1. Labor hired in the project is from the pool of unemployed persons in the project region. The value of these unemployed workers is equal to the production foregone by putting them in the project. If they were producing food or materials at home for their own consumption, and they have to give this up when they work in the project, then the value of what they give up is an appropriate measure of opportunity cost. If they were producing nothing (which is an exceptional case), then a shadow price close to zero can be used. The cost will probably never reach zero since there is generally some cost involved in training, housing or otherwise taking care of unskilled labor that has been unemployed for some time. This cost has to be added in somewhere in the accounts as a cost.

2. Labor hired in the project is taken from other productive jobs, but there is unemployment in the project region (i.e., persons willing and able to work in paid jobs). In this case the assumption generally adopted is that even if the project merely hires workers away from other jobs, these other now vacant jobs will then absorb new workers from the pool of the unemployed. Thus, the project will result indirectly in a reduction in unemployment and the labor used in the project should thus be valued in the same way as for (1). Application of the with and without test demonstrates the logic of this approach.

3. Labor is hired only part-time in the project. In the case of unskilled seasonal labor, it is generally desirable to take into account general periods of seasonal employment and unemployment. First, the analyst can determine by observation, or from records, the periods of general seasonal employment existing in the market area for the labor that will be used in the project. The analyst can then compare these periods with the periods during which temporary employment is required by the project. To the extent that the two periods do not overlap, the analyst can use the shadow wage for unemployed labor as derived above in valuing seasonally unskilled labor employed in the project, since, by definition, such labor is unemployed during the off-season. However, if the project's requirements overlap with the general period of seasonal employment (for crop harvest, planting, etc.), and if there is no general unemployment during the period of seasonal employment, then the analyst has to attribute a shadow price for seasonal labor employed in the project equal to the actual wage paid for seasonal labor in the regional economy.

A case study from Korea indicates how this was done in the case of fuelwood plantation project.^[21] Since the fuelwood labor requirements overlapped somewhat with the seasonal requirements for agriculture, an average shadow wage rate based on the full seasonal wage rate and the off-season income (monetary and in-kind) of unskilled village labor was used as the shadow wage rate. The weighting was based on the proportion of project employment which overlapped with the period of general seasonal full employment.

In handling these three types of situations it is necessary to look at the nature of the market and distinguish between unemployment in an economic sense and unemployment in the sense that it appears that people are doing nothing. In an economic analysis it is unemployment in an economic sense that matters. This is determined by both supply and demand. As an example, assume a situation as indicated in box A.5.9.

In cases where unemployment exists due to some policy and/or regulation of minimum wages, a shadow wage rate based on alternative production foregone has to be ascertained, and this will likely be lower than the regulated minimum market wage. For example, if a government-set minimum wage is in effect, it may be possible to locate an informal competitive labor market in rural areas where the actual wage paid is below the set minimum. This would provide an approximation of the appropriate shadow wage rate. If no informal market can be located, then the analyst will have to rely on rough estimates of what the unemployed would give up in terms of other production if they were employed in the project. This information might be obtained from surveys of local community households.

Confusion sometimes arises if the unemployed who will now be employed in the project are receiving unemployment payments (benefits) while they are unemployed. This type of payment is a transfer payment, or a transfer of consumption from some members of society to others. While it is relevant in a financial analysis carried out from the government's point of view, it will not be relevant in the economic analysis, where the analyst is attempting to estimate the opportunity cost of labor, or the value of consumption foregone by employment labor in the project being analyzed.

Professional and skilled employees

Professional and skilled employees are required by most projects. In many developing countries there is an acute shortage of this type of employee. It is also common in these countries that the government imposes wage and salary increase limits (salary ceilings). As in all cases where an effective maximum price is imposed, the result is that the willingness of employers to pay the skilled labor might be higher than the current salary level. Skilled persons may be fully employed, but they are being paid less than the producers are prepared to pay, i.e., their real opportunity cost. In such cases the analyst may wish to use a shadow wage or salary level above the market level.

If skilled or professional labor is unemployed in the economy, then it can be treated in exactly the same way as unemployed unskilled labor, i.e., valued on the basis of its opportunity cost without the project.

Resources: Land

The appropriate measure of value for land is the highest net return that actually would have been obtained from the land in the absence of the project. The analyst thus needs to estimate what the net return would be from the best actual alternative use. This the analyst uses as the shadow price for land.

In estimating the opportunity cost of land, the analyst can use information obtained from interviews and data on land use in the project region, particularly as such relate to land availability and uses of land similar to the proposed project lands.

In valuing land, the analyst should guard against overvaluation of land cost due to

• attributing to the land a net value from alternative use which will be obtained from some otherwise idle area if the project is implemented;

• ignoring the fact that in some cases an alternative use which would take place in the absence of the project would not continue over the entire project period; and

• forgetting to subtract all costs (other than land) needed to obtain the gross benefits from the best alternative use (i.e., it is the net value foregone which is the relevant opportunity cost).

Each of these points is discussed in greater detail in the following paragraphs.

In many cases, there are few actual alternative uses for lands devoted to forestry projects. This may be because of the low quality of the land for other uses, but it also may be because there is no land pressure in the project area and abundant other lands exist to accommodate other potential uses (see box A.5.10).

Another potential overvaluation error to avoid relates to the assumption that a piece of land considered for a forestry project will have an alternative use which will continue to be viable over the entire project period (see box A.5.11).

A third potential overvaluation error relates to what is included in the opportunity cost calculations. It is the net value foregone which is relevant as an opportunity cost, not the total value of the output foregone. Thus, in a particular situation, a plantation project may be taking land out of crop production where the total or gross value of the crop foregone is $100/ha/a. To get an appropriate shadow price for the land, the analyst would have to subtract all the costs (other than land) required to bring forth that $100 of gross value. It may be, because of a depressed price due to oversupply of the crop that the costs would be equal to the $100 of gross value, in which case the opportunity cost of the land would be zero in terms of the forestry project. Society would not be giving up any net consumption benefits, since the costs would equal the benefits and the net value foregone would be zero.

Changes in Shadow Prices Over Time

As indicated in chapter 5, when market prices are used as a basis for shadow pricing, the analyst should keep in mind that the opportunity costs associated with inputs may change over the life of the project. Such expected changes have to be taken into account.

Similarly, in situations where there is some indication that the employment situation existing at the beginning of the project will not hold over the entire project period, e.g., unemployment is expected to decrease due to general improvement in economic conditions even without the project, the analyst may wish to make adjustments in the shadow wage rate for latter years of the project. Again, this remains a matter of judgement. If the situation is very uncertain, the analyst may merely wish to consider such possibilities in the sensitivity analysis.