Rmarket Failure

Role Of Institutions And Resource Allocation
UNIT-IV
ROLE OF INSTITUTIONS AND RESOURCE

ALLOCATION
Lesson – 1 : Role of the Market and Market Failure
Lesson – 2 : Role of the State and State Failure
Lesson – 3 : Role of the Community and Community Failure
Lesson – 4 : Project Appraisal : Benefit – Cost Analysis
Lesson – 5 : Benefit – Cost Analysis : Economic Appraisal
Lesson – 6 : Economic Prices for Goods
Lesson – 7 : Shadow Prices for Factors of Production
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Economics of Development
LESSON - 1
ROLE OF THE MARKET AND MARKET FAILURES
Role of the Market

In free - enterprise market economies, resources are allocated by Adam Smith’s
‘invisible hand’ of the market in accordance with consumer demand. The market is the
organizational framework that brings together those who supply and those who
demand a product. Who then trade at an agreed price. In a completely free market, the
price will completely clear the market so there are no unsatisfied buyers and sellers.
Decision-making about what is produced is completely decentralized and left to the
market, comprising the decisions of a myriad of private individuals. If the demand for
good increases, the price will rise and producers will be induced to supply more; if
demand falls, the price will fall and producers will supply less. Market prices act as
signals to producers to supply more or less of a commodity according to the changing
profitability of production.
We now come to one of the most important theorems in welfare economics: if
consumers consume to the point where the marginal utility of consumption is equal to
the price of a good, and producers produce to the point where the marginal cost of
production is equal to price, then resources will be optimally allocated since the
marginal utility of production will just equal the marginal cost. Society will have
reached its highest level of utility consistent with its production possibilities. This is
illustrated in figure.
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The curve I1I1 is society’s indifference curve between two goods, A and B,
representing the highest utility attainable, and X1X1 is a country’s production
possibility curve between the two goods, A and B. Point 1 represents the optimum
allocation of resources between the two goods, Any point to the left or right of point 1,
or inside the production possibility curve, would represent a lower level of utility.
The allocation role of markets, however, is only one of the functions of the market
mechanism. To use a distinction introduced by Kaldor (1972), the market also has a
creative function, to provide an environment for change that expands production
possibilities, that is, which shifts the production possibility curve outwards to X2X2,
enabling a higher level of utility at point 2. Change means all the dynamic forces that
lead to technical progress, innovation and ultimately investment. In the early stages of
development, the creative function of markets, producing new opportunities for
growth, may be just as important as the allocative function of markets.
Market Failure
The conditions required for markets to perform their allocative and creative functions
in an optimal manner are very stringent, and are unlikely to be satisfied completely
even by the developed economies. The true benefit of output may not be reflected in
price because of externalities; price may not reflect marginal cost because of market
imperfections; and many developmental goods and services may not be produced at all
because markets are incomplete or missing entirely, and therefore cannot perform their
creative function. In other words, there are likely to be market failures. These
situations where markets fail in the optimum allocation of resources are explained in
detail next.
Public Goods
Public goods are goods that have certain characteristics that make it difficult, if
not impossible, to charge for them, and therefore private suppliers will not provide
them. These characteristics are :
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(i) non - rival : that is consumption by one user does not reduce the supply
available for others, and
(ii) non – excludible : that is users cannot be prevented from consuming the
good.
Market Imperfections
Market imperfections refer to three important phenomena:
First, market prices may provide a very imperfect guide to the social optimum
allocation of resources because they do not reflect the opportunity costs to society of
using factors of production, or the value to society of the production of commodities.
The price of labor may be above its opportunity cost and therefore used too little. The
price of capital and foreign exchange may be below the opportunity cost and therefore
used too much from a social point of view. Likewise the price of goods may not reflect
the marginal cost of production. Monopolies, tariffs, subsidies and other imperfections
in the market all distort free market prices, upon which private producers base their
production decisions.
Second, there is the existence of externalities, both positive and negative, which
means that some goods may be underprovided and others overprovided from a social
point of view because the positive or negative externality is not reflected in the price.
Most infrastructure projects, such as transport facilities, power generation, irrigation
schemes and so on, and social capital, such as education and health facilities, will have
greater social returns than the private return and will therefore be underprovided from a
social point of view unless private suppliers in the market are compensated or
subsidized. Other activities may confer negative externalities by imposing costs on
society that are not paid for by the provider, and therefore the market oversupplies
from a social point of view.
Third, markets may be incomplete or missing altogether. One good reason why
markets may be missing in the case of public goods is the inability of suppliers to
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exclude ‘free- riders’, that is, to exclude people from consuming the good once it is
provided. But there are other important reasons for incomplete or missing markets, for
example high transaction costs can prevent markets from developing, particularly in
developing countries, where poor communications make information costs high and
there is an absence of futures markets to compensate for risk in conditions of
uncertainty.
Asymmetric information, adverse selection and moral hazard, can also lead to
market inefficiency. ‘Asymmetric information’ refers to the imbalance of knowledge in
a market between buyers and sellers. In the market for bank loans, for example, the
borrowers know more about their own circumstances than the lenders, Banks could
make bad loans (adverse selection), which makes them cautious and leads to credit
rationing. It would be very costly for banks to obtain all the information they require
on high-risk customers.
Another example would be the health insurance market, where individuals
know more about their health than the suppliers of insurance. Those who know they
are prone to illness are more likely to take out insurance, and more likely to be turned
down. ‘Moral hazard’ is present when the possession of insurance encourages the
activity that is insured against, leading to resource waste and higher costs (and higher
insurance premiums for all). Governments may step in by regulating private insurance
or providing the service themselves at lower cost.
In addition, there is the problem that there is nothing in the market mechanism
that guarantees an equitable distribution of income in society, or that will direct
adequate resources away from present consumption to build up the means of
production for a higher level of consumption in the future.
Questions for Review

1. Explain the conditions where the market fails to carry out its allocative and
creative functions.
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2. Comment upon the allocative and creative functions of the markets.
References
1. Thirlwall, A P, (1999), Growth and Development.(6th Edition), Macmillan, UK
2. Todaro , Michael and Stephen Smith, Economic Development (8th Edition),
Pearson Education Asia.
3. Meier, Gerald M ; James E Rauch (2000), Leading Issues in Economic
Development(7th Edition),Oxford University Press.
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LESSON- 2
THE ROLE OF THE STATE AND STATE FAILURE
Role of the State

The State has four key roles to play in the development process:
1. To provide public goods
2. To correct market imperfections
3. To protect the vulnerable and ensure equitable distribution of income, both
intra-temporally (between people at a point in time) and inter-temporally
(between generations over time)
4. To provide an institutional environment in which markets can flourish
(including the maintenance of macroeconomic stability).
There are many public goods that are important for economic development such as
defense, law and order, and the provision of basic infrastructure such as roads, sewers,
clean water and so on. A market in defense, or laws governing property rights and so
on which benefit the whole nation, is not conceivable. Markets in some infrastructural
facilities are conceivable, but not very likely because of the high costs. Also the
providers might have difficulty in charging for and capturing the externalities. The
market would either not provide at all, or it would under provide. Governments can
curb negative externalities through regulation or taxation, and promote positive
externalities through subsidies or providing the output itself, as with education and
health care, insurance, banking etc.
As far as equity is concerned, the state has an important role to play in protecting the
vulnerable and ensuring an equitable distribution of income between people, between
groups in society, between regions and across generations. There is not only a moral
case for the state to help those in absolute poverty, but also a strong political and
economic one. Poor, vulnerable and disaffected people can be a major cause of civil
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unrest and political instability. This deters investment and growth. It is also important
for the state to keep an eye on the welfare of future generations, which may require
altering the balance between consumption and investment in the present. There are a
number of ways in which governments can intervene to discourage present
consumption and raise the level of investment for higher future consumption; for
example, taxation, subsidized interest rates and public investment on society’s behalf.
Finally, the state is essential for providing the appropriate institutional environment for
markets to flourish and operate efficiently. In this sense, markets and government
intervention are complementary. The World Bank devoted its World Development
Report 1997 to the topic of ‘The State in a Changing World’. It conveys three principal
messages:
1. Development (economic, social and sustainable) without an effective state is
impossible. It is increasingly recognized that an effective state - not a minimal
one - is central to economic and social development, but more as partner and
facilitator than director. States should work to complement markets, not replace
them.
2. A rich body of evidence shows the importance of good economic policies
(including the promotion of macroeconomic stability), well-developed human
capital and openness to the world economy for broad-based, sustainable growth
and the reduction of poverty.
3. The historical record suggests the importance of building on the relative
strengths of the market, the state, and civil society to improve the state’s
effectiveness. This suggests a two part strategy of matching the role of the state
to its capability and then improving that capability.
State Failure
Since the supply of public goods is determined through a political process, there is no
guarantee at all that their supply will be socially optimum. As is understandable that a
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short supply of public good represents a major bottleneck to the growth of developing
economies. However, the danger of oversupply of public good should not be
overlooked. The supply of public good entails costs which are ultimately financed
through taxation. If a government activity to correct a market failure entails higher
budgetary cost than social gain from the corrective measure, it represents an
oversupply of public goods. The problem is that government is an organization
inherently prone to oversupply those public goods of relatively low social demand at
the expense of those public goods vitally needed for economic development.
What matters to political leaders or politicians is to maximize their likelihood of
staying in office. Towards this goal, budget allocations among various public goods are
based not so much on considerations of their contribution to social economic welfare,
but on calculations on the strength of enhancing political support.
Moreover, government is a monopolist of legitimate coercive power and has no danger
of bankruptcy. In this organization, therefore, a strong incentive prevails to expand the
organization for the sake of increasing the power and position of bureaucrats. Also,
government organizations are usually less efficient in the absence o profit incentive
and bankruptcy incidence. These forces combine to produce oversupply of unnecessary
public goods.
Because bureaucrats and pressure groups are strongly resistant to any reduction in
vested interests, it is not easy to shift budget allocations from one category of public
goods to another in response to changes in social needs. As a result, it is common to
find that oversupply of unnecessary public goods coexists with sheer undersupply of
public goods critically needed for economic development. Such inefficient budget
allocation that results in reduction in net social welfare can be called “government
failure”.
The government failure is not limited to misuse of budget, but arises from undue
regulations to bias resource allocations. The danger is that the government regulations
tend to become entrenched when those with vested interests seek “institutional rents”
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or excess profits from regulations. Firms protected by a regulation raise funds and
ballots to support politicians in exchange for their support on the preservation of this
regulation.
Good Governance
The world development report argues that many developing countries are not
performing their core functions properly. They are failing to protect property, to ensure
law and order, and to protect the vulnerable, all of which causes unrest and leads to a
lack of government credibility.
World Bank outlines a two- pronged strategy for governments to increase both their
credibility and the effectiveness of the state: first, governments must match the role of
the state to its capabilities and not try to do too much, and second, they must try to
improve capabilities by reinvigorating state institutions.
With regard to the first prong of the strategy, the state should concentrate on getting
the basics right, such as safeguarding property rights and guaranteeing the rule of law,
rather than trying to do too much. In many countries there is too much overregulation
and excessive state consumption. Governments should decide more carefully what to
do and how to do it. The basics should be:
1. Law and Order
2. Maintaining macroeconomic stability.
3. Investing in basic social services and infrastructure.
4. Protecting the vulnerable.
5. Protecting the environment .
But the state does not have to be the sole provider of all infrastructure and
social services. It can contract out and introduce competition into their provision,
coupled with a regulatory framework to protect consumers and workers. Neither does
the state have to be the monopoly supplier of public utilities such as electricity, gas,
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and telecommunications and so on. These activities can be privatized with state
supervision.
Beyond the basics, the state may want to intervene strategically in industrial
policy, for example, if it has the capability, as the successful Asian Tiger economies
have done. The past success of Hong Kong, Singapore, Taiwan and South Korea has
depended on the state and the private sector working in harmony with each other, with
the state providing the economic and legal environment for markets to flourish but with
the government taking an entrepreneurial role and intervening where it thought
necessary.
On the second strategy of improving the capabilities of the state and
reinvigorating state institutions, the task is to provide incentives for public officials to
perform better and reduce the scope for arbitrary action that could lead to bad decision
making and corruption. The 1997 world development report outlines three essential
ingredients of such a policy:
1. There must be effective rules and restraints to check public authority and
prevent corruption. Independence of the judiciary is important, and an
independent commission against corruption would be helpful.
2. Public officials should be appointed on merit, not on the basis of political
patronage, and through a merit based promotion system and adequate
remuneration. Opening up competition in employment in the delivery of
services is necessary to reduce the discretionary power of state officials to
minimize rent seeking behaviour, which is the basis of bribery and corruption.
3. Decision making needs to be brought closer to the people so that they have
more confidence in the state. All government programmes are likely to work
better if there is democracy, if power is devolved, and users are consulted.
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1. Examine the role played by the state in the economic development

process of an economy.
2. Examine the reasons that justify the role of the state in the economic
development process.
3. Discuss the basics of a good governance.
References
1. Hayami Yujiro (2001), Development Economics(2 nd Edition),Oxford
University Press.
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LESSON- 3
ROLE OF THE COMMUNITY AND COMMUNITY FILURE
In the process of economic development of a country, the nature of the economic

system plays a vital role in coordinating the people’s activities and promotion of social
welfare. The economic systems in reality can be expressed as a combination of various
economic entities but in the broader sense it comprises organizations such as the
market and the state. The extent to which the roles of the market and the state are
combined in a particular economic system, however, depends upon the level of
development and socio-economic conditions of a particular country.
Whereas in the initial stages of economic development, the state as a development
agent plays a predominant role, but with the passage of time as the development
process picks up the momentum, economic functions of the market become more
important. If information is perfect so that transactions through the market are costless
and agency contracts between citizens (principal) and government (agent) are faithfully
enforced, the appropriate mix up of these two organizations provides an adequate base
for good governance and development.
In the real world, however, information is imperfect, and the degree of imperfection is
especially large in developing economies, resulting in pervasive market and
government failures. For example, when a producer delivers his product to the buyer
and the buyer fails to honour the contracts of paying agreed-upon prices, the
producer’s supply will be short of the social optimum to the extent that his expected
revenue decreases by the probability of the buyer’s contract violation. It may appear
that this market failure can be corrected by contract enforcement through legal
procedures. However, judicial costs involved in formal court procedures are large,
often exceeding the expected gains from dispute settlement on small transactions
typical of less developed economies. Moreover, where judges and police are not
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necessarily the faithful agents of citizens, it can happen that the market failures are not
only not corrected but even enlarged by government failures.
It has been pointed out that ideologies such as religious codes can play an important
role in suppressing moral hazards under imperfect information. At the same time, the
incidence of moral hazard should be smaller among people whose personal interactions
are intense so that each can predict accurately the others behavior. Also, mutual trust
nurtured through close personal relations should work as an effective brake on
committing moral hazards.
A group of people tied by mutual trust based on intense personal interactions is a
‘community’ by our definition. Theoretically, communities range from the family to
the ‘national community’ and further to the ‘global (or international) community’.
However, the communities discussed here are those in between this range,
characterized by personal relationship closer than the arm’s-length relation. In
developing economies they are observed typically as tribes and villages tied by blood
and locational affinities. However, in developed economies also, community
relationships, which are formed through various channels such as the workplace, alma
mater, church, sport and other hobby clubs, have significant influence on business
transactions and political activities.
In this context the system for the development of developing economies must be
designed not as a combination of market and state alone but as a combination of the
three organizations including community.
What kind of role would the community play in economic development? As people
specialize in various activities, a system is required to coordinate them. The economic
system in our definition is a combination of the economic organizations that coordinate
various economic activities so as to achieve a socially optimum division of labor. The
market is the organization that coordinates profit-seeking individuals through
competition under the signal of parametric price change. The state is the organization
that forces people to adjust their resource allocations by the command of government.
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On the other hand, the community is the organization that guides community members
to voluntary cooperation based upon close personal ties and mutual trust. In other
words, the market by means of competition based on egoism, the state by means of
command based on coercive power, and the community by means of cooperation based
on consent, coordinate division of labor among people towards a socially desirable
direction.
In practice, the community and the state often overlap. For example, a village is a
community defined by the fact that villagers cooperate voluntarily. However, if
villagers authorize a particular individual or individuals to exercise coercive power in
the administration of village affairs, this village can be regarded as a small state. In the
real world, the community and the state are often inseparably combined in the
economic system. However, they are functionally separable. The same applies to the
relationship between community and market as well as between market and state.
Prisoner’s Dilemma
The importance of cooperation for efficient resource allocation can be understood by
conceptualizing the prisoner’s dilemma situation. The prisoner’s dilemma can be
explained by the example of two suspects charged with jointly committing a crime and
taken into custody in separate cells. There they are interrogated by a prosecutor, who
alternately threatens each suspect with a heavy penalty should he continue to deny the
charges while the other suspect confesses, and tempts each with a reduced penalty
should he confess while the other party continues denying.
A pay-off matrix for the two suspects A and B for their two strategies— cooperation
with the partner meaning the continuation of the denial, and defection against the
partner meaning the confession of the crime is illustrated in figure. In each cell of the
matrix, A’s profit is indicated above and B’s profit below. If both continue cooperation
(continued denial) the major crime (such as murder) will not be proven, so that both
will receive only minor punishment for trumped-up charges such as illegal possession
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of a weapon. This mutual cooperation strategy is assumed to give a profit of three units
for both A and B. If both defect from the partnership and confess the crime, both are
supposed to incur loss of two units (-2 of profit) from the sentence on the crime. If A
continues to deny while B confesses, A’s penalty will be elevated to a loss of five units
(-5 of profit), but B’s penalty is lightened equivalent to a profit of five units. Their
profit positions will reverse when B denies and A confesses
B’s Strategy
Cooperation Defection
Cooperation 3(A’s -5
profit) 5
A’s Strategy
3(B’s
profit)
5 -2
-5 -2
Defection
Pay- off matrix of the prisoners dilemma game

When B cooperates, A will be better off by defecting because A can elevate his profit
to five units, as compared with a profit of three units should he continue cooperation.
When B defects, A will be better off by also defecting in order to reduce his loss to
only two units as compared with a loss of five units from continuing cooperation. The
same applies to B’s choice of strategy. Under this situation, both A and B will choose
defection, each incurring the loss of two units, despite the possibility for both to earn a
profit of three units through mutual cooperation.
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This example of the prisoner’s dilemma illustrates how much loss the inability among
people to establish cooperative relationships, due to the absence of communication and
trust, will produce for society. This loss can happen in all the economic transactions.
For example, in the transaction of a commodity, a buyer may try to reduce payment to
a seller on the false charge of quality deficiency in delivered commodities. Then, the
seller will deliver low-quality commodities thereafter. As their mutual distrust is
heightened, they will stop transactions and thereby close off a mutually profitable
business opportunity.
As another example, consider the case of employment in a private firm or a
governmental agency. If employment is insecure so that employees may be discharged
any moment, employees would make little effort to acquire specific knowledge and
skill for efficient work in this organization. Their employer would then be inclined to
discharge these employees for their lack of effort. In this way, a cooperative
relationship will not be established with the little accumulation of skill and knowledge
needed for efficient functioning of this organization.
Trust as a Social Capital

Is it not possible to solve such a prisoner’s dilemma situation in economic transactions
by the use of the legal apparatus provided by the state? In theory, in either commodity
transaction or labor employment, the dilemma can be prevented from occurring if
contractual terms and penalty clauses against their possible violation are stipulated in
detail in a written agreement, and appeal to mediation by the third party, such as court,
is possible should a conflict arise. In practice, however, it is difficult to set a contract
detailing all the possible conflicts about product quality and delivery time with due
consideration for future contingencies. In general, possible contingencies that may
influence a transaction are nearly infinite, so that it is not possible to stipulate in
advance the appropriate counter-measures to all those contingencies under the
‘bounded rationality’ of human beings.
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Moreover, third party mediation, especially formal court procedure, entails significant
costs and thus it does not pay to apply to conflicts involving small sums of money. Of
course, this difficulty is augmented by insufficient development of laws and the
judicial system.
Since the basic cause of the prisoner’s dilemma situation is lack of communication and
mutual trust between transacting parties, it should be prevented by the formation of
trust through the development of a community relationship. One way to achieve this
relationship is to shift from spot transactions between anonymous agents solely based
on the price parameter to long-term continuous transactions or ‘clientelization’ in
Clifford Geertz’s term (1978). For example, a jeweler may be strongly tempted to
cheat an unknown new customer to his shop by selling low-quality jewels at high
prices. How ever, for a regular customer coming to his shop he would be inclined to
feel guilty and less willing to risk losing a long-lasting business opportunity for a• one-
shot moral hazard. Thus, repeated transactions that are expected to continue over a
long time have the power to protect transacting parties from the pitfall of the prisoner’s
dilemma.
Mutual trust created by long-term continuous transactions can be further reinforced by
multiple interlinked transactions (Bardhan, 1980; Bell, 1988; Hayami and Otsuka,
1993: ch. 5; Besley, 1995). For example, a trader not only purchases a commodity
from a particular producer continuously year after year, but also supplies him with
materials and credits. Mutual trust enhanced by intensified interaction and
communication as well as fear of losing a multifaceted cooperative relationship is a
strong force curbing moral hazards for both parties. The psychological basis of mutual
trust could further be strengthened by incorporating personal elements in business
transactions, such a exchange of gifts and attendance at weddings and funerals.
Relationships of mutual trust created through long-term and multiple transactions
would not only be effective in suppressing moral hazards between the contracting
parties but would also promote collaborative relationships within the wider
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community. Those who were benefiting from transactions based on trust would not
want to trade with one who was known to have betrayed his business partner before, in
terms of both moral sentiment and risk calculation. The cost of such social opprobrium
and ostracism would be especially large in a small, closed community characterized by
a high degree of information-sharing through close personal interactions.
If mutual trust between particular individuals were thus elevated to a moral code in
society, large savings would be realized in transaction costs. The transaction costs
include the costs of contract negotiation and enforcement concerning transactions. If
one can trust the other party in a contract, there is little reason to worry about possible
default. Contract partners would thus not need to specify ex ante detailed clauses on
costs caused by possible contingencies outside the agreement but would renegotiate
faithfully to find the best solution for both in the event of an unexpected business
outcome.
Thus, trust accumulated through personal interactions in the community increases
efficiency and reduces costs associated with the division of labor. In this regard, trust is
a kind of ‘social capital’ similar to social overhead capital such as roads and harbors
(Arrow, 1974; Dasgupta, 1988; Putnam, 1993 Seabright, 1993).
The Community Failure

As is clear that both state and market while performing their economic role are
subject to failures of various types. The community is not also free from this problem.
The question , therefore, arises how to correct these failings so that community will
become an affective component in the modern economic system.
Mutual trust and cooperation, the basic principle of community function,
among community members are often supported by rivalry (or hostility) against
outsiders. Therefore, market transactions supported by the community relationship tend
to be limited to a small area, and long distance trade across regions often remains
inactive because of the pervasive incidence of defection, including fraud and plunder.
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A means of correcting this failure is the deployment of an ethnic community

across region. Typical examples are Jewish traders in medieval Europe and Chinese
traders in South East Asia. They were able to establish dominant positions in
commercial and financial activities, as they were successful in reducing transactions
costs across distant trading posts among the traders and bankers bound by the ethnic
community ties.
Another traditional device is the formation of trade associations such as guilds.
A guild aimed at correcting the market failure arising from moral hazards under the
asymmetry of information by controlling the quality standards of commodities and
regulating the procedures of transactions among its limited members.
In both the ethnic group and the trade association, cooperative relationship
within a closed community means the community’s ability to exercise opportunism
against outsiders. Their success in reducing transaction costs, therefore, was inevitably
accompanied by the formation of monopoly. However, it is well known that the trade
monopoly of guilds became a major fetter on market expansion and economic
development in late medieval to early modern Europe. In advanced market economies,
too, it is common to observe cases in which a firm has long term continuous
transactions confined only to a limited number of trading partners.
Also, it must be recognized that wide and complex transactions among
enterprises cannot be controlled by the cooperative relationship of the community type
alone. Even between firms within the same cooperative group, there is the possibility
of major conflicts emerging from contracts, especially those involving highly
complicated and uncertain new technology developments, which cannot be
compromised by cooperative spirit. Community relationship can play an important role
in modern industrial organizations, but it cannot be a total substitute for the market and
the state.
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1. Do you think that apart from the market and the state, there is a scope for the
community to play a role in the economic functions of a system? Justify your
answer?, or
2. To what extent the market and the state failures can be rectified by the
community action? Elaborate.
3. Discuss the importance of mutual trust and cooperation through prisoner’s
dilemma paradox.
4. Discuss the importance of trust as a social capital for efficient functioning of
the economic system.
References
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LESSON-4
PROJECT APPRAISAL: BENEFIT- COST ANALYSIS
A central issue for fiscal stability and overall economic growth is how to ensure
that the government and private investments are carried out in a way that result in
optimum allocation of resources between the competing ends. One of the most widely
used technique for this purpose is cost benefit analysis or project appraisal that has
grown rapidly in application in recent years. This technique has its genesis in the kind
of analysis done by private firms on their alternative investment projects, but the
technique is also useful in analyzing government development projects. Before
considering the project appraisal it is very important to make a distinction between
financial, economic and social appraisal.
Financial appraisal is concerned with financial flows generated by the project itself
and the direct costs of the project measured at market prices.
Economic appraisal is concerned with adjusting costs and benefits to take account of
the costs and benefits to the economy as a whole, including the indirect effects that are
not captured by the price mechanism.Social appraisal is concerned with distributional
consequences of the project choices both inter-temporal (that is, over time) and intra-
temporal (that is, between groups in a society at a point in time).
BENEFIT –COST ANALYSIS (FINANCIAL APPRAISAL)

Benefit cost analysis as a tool for evaluating the profitability of the investment
projects of a firm involves three steps. These are
1. Forecasting the net cash flows
2. Calculating the net present value (NPV)
3. Comparison among the projects with different NPVs
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Net Cash Flow

Forecasting the net cash flow of an investment project over its life time is the
first step involved in benefit cost analysis. Net cash flow is the difference between the
cash revenues generated from the sale of the products of the investment project and the
cash outlays on investment, material inputs, salaries, wages, purchased services and so
on.
Net Present Value

The second step involves calculating the present value of the cash flows that are likely
to occur in different time periods of the investment project. This involves the
observation that cash received in the future is less valuable than cash received
immediately, because in the interim the firm could earn interest (or profits) on these
funds by investing them in bonds or savings accounts. For example, a firm or
individual, asked to choose between $1,000 today or $1,000 next year, would take the
money now and place it in a savings account earning, say, 8 percent a year. Then, after
one year, the interest payment would boost the savings account balance to $1,080. So
the prospect of $1,000 a year from now should be evaluated as equivalent to only $
1,000/1.08 = $926. This process of reducing the value of future flows because funds
earn interest over time, is called discounting. Because interest also is earned on
previous interest, discounting must allow for compound interest. In the second year
another 8 percent would be earned on the balance of $1,080, and increase it to
$1,166. The payment of $1,000 two years from now would then be discounted to yield
a present value of only $1,000/1.166 = $858. A general expression for the present
value, P, is
P= F/(1 + i)n
Where F= the value to be realized in the future ($1,000, in our example) i = the
interest rate (8 percent), and n = the number of years. As the interest rate or the delay
in payment increases, the present value decreases.
23
An investment project will result in a series of net cash flows over time: They flow out
in the early years as investment are made, then they become positive, perhaps
gradually, as the new facilities begin to generate revenue in excess of recurrent costs.
Such a time profile of net cash flow is depicted in the figure.
Figure -1. Time Profile for Investment: Net Cash Flows
It is the most common of several possible profiles. To summarize the value of this net
cash flow in a single number, each year’s net cash flow is multiplied by the respective
discount factor and the resulting present values are added to give the net present value
(NPV):
𝑛
NPV = ∑(𝐵𝑡 − 𝐶𝑡)/(1 + 𝑖)𝑡

𝑡=𝑜
Where Bt, and Ct, the benefits (revenue) and costs, including investment, in
each year t; i = the discount rate; and n = life of the project. For a firm, the correct
24
discount rate is the average cost at which additional funds may be obtained from all
sources - the firm’s cost of capital.
If the net present value of a project, discounted at the firm’s average cost of
capital, happens to equal 0, this implies that the project will yield a net cash flow just
large enough to repay the principal of all funds invested in the project and pay the
interest and dividends required by lenders and shareholders. In that case, when NPV =
0, the discount rate has a special name, the internal rate of return (IRR). If the net
present value is positive, then the project can cover all its financial costs with some
profit left over for the firm. If negative the project cannot cover its financial costs and
should not be undertaken. Clearly the higher is the net present value, the better the
project
The cash flow of figure is discounted at a rate of 12 percent in table using
above equation. The net present value is a positive $518,
which indicates that the investment project will earn enough to repay the
total investment ($2,500 over years 0 and 1) with a surplus of $518.
We now come to the final step in project appraisal.
Table- Calculation of Net present value

Year Cash flow Discount factor at 12% Present value (dollars)
(dollars) 𝟏 𝟏
(𝑩𝒕 − 𝑪𝒕 )𝒙 𝒕
Bt - Ct (𝟏 + 𝒊)𝒕 (𝟏 + 𝒊)
e -1,000 1.000 -1,000

1 -1,500 0.893 -1,340
2 -300 0.797 -239
3 400 0.712 285
4 500 0.636 318
5 800 0.567 454
25
6 800 0.507 406

7 800 0.452 362
8 800 0.404 323
9 800 0.361 289
10 800 0.322 258
11 1,400 0.287 402
Net present +518
value
Comparison among the Projects

We already know that a project should be considered for investment only if its
net present value is positive. But how does one choose among many projects, all with
positive NPVs? The answer is to select the set of projects that will yield the highest
total net present value for the entire investment budget. This assumes that
the firm has a set of alternative projects to consider at any one time and
an investment budget that can accommodate several but not all of these.

1. What is net present value? How is it calculated?
2. Explain various steps in the constructions of benefit- cost analysis of a private
investment project.
References
1. Gills, M ; Perkins, Romer, Snodgras, Donald (2001), 5th Edition W Norton and
Company, New York.
26
LESSON-5
BENEFIT-COST ANALYSIS : ECONOMIC APPRAISAL
In conducting benefit-cost analysis from the economic point of view, we have to

consider additionally certain indirect benefits and costs that may arise from the project
and also need to consider how to adjust divergences in market prices from social
values for goods and services and factors of production in order to ascertain their
economic value to the society.
Indirect Effects
There are three major indirect effects to consider:
Some projects, of course, such as an irrigation scheme, are designed to have an impact
on the immediate vicinity and their benefits would be counted as direct benefits, but
other projects will have incidental indirect effects both positive and negative. A new
road for example which is designed to cut travel time, may raise output in the
immediate vicinity. This is a positive benefit. On the other hand a new dam to generate
electricity may flood arable land and reduce agricultural production. This is a negative
indirect effect.
Second there are the price effects upon local markets. If, for example, prices fall as a
result of a project, this represents a gain in consumer surplus, and this needs to be
added to the value of the project. A new road that reduces supply costs will reduce the
price of local supplies and represent an indirect benefit of the road.
Third, there are the consequences of a project for other sectors that supply inputs to the
project. If a project demands more inputs, this is income to the suppliers. For example
a new dam will require local materials; a new factory will demand steel, and so on.
These repercussions need to be taken account of.
27
Beyond the secondary (or indirect) effects of projects, the market prices of goods
produced and the factors of production used may not reflect their value to the economy
as a whole. The prices need adjusting to reflect their true economic value to society.
Divergences Between Market Prices And Social Values

The market prices of goods may diverge from their social value for a number of
reasons.
First, government imposed taxes, subsidies tariffs and controls of various kinds
distort free market prices. Opportunity cost must be measured net of taxes and
subsidies.
Second, imperfection in the market will raise prices above the marginal cost of
production. Prices set by private monopolist and public utilities may be
particularly distorted.
Third, the existence of externalities, both positive and negative will mean that
the prices of goods do not reflect their true value to society
The market prices of factors of production may not reflect their true cost to society that
is, the opportunity cost of using them measured by their marginal products in
alternative uses. Labour’s market price in the industrial sector (that is, the industrial
wage) is likely to exceed the cost to society of using labour if there is disguised
unemployment on the land or in the petty service sector. Capitals market price will be
below its social cost if it subsidized. Foreign exchange may also be too cheap from a
social point of view if the foreign currency is kept artificially low by exchange controls
of one form or another. A project will be profitable to society if the social benefits of
the project exceed the social costs, or, to put it another way, if the net present value of
the project to society is greater than zero.
The question is: how should a project’s social benefits and costs be measured, and
what common unit of account (or numeraire) should the benefits and costs be
expressed in, given a society’s objectives and the fact that it has trading opportunities
28
with the rest of the world so that it can sell and buy outputs and inputs abroad (so that
domestic and foreign goods need to be made comparable)? There are two broad
approaches to this question.
First, benefits and costs may be measured at domestic market prices using consumption
as the numeraire, with adjustments made for divergences between market prices and
social values, and making domestic and foreign resources comparable using a shadow
exchange rate. This is sometimes referred to as the UNIDO approach. Second, benefits
and costs may be measured at world prices to reflect the true opportunity cost of
outputs and inputs (also obviating the need to use a shadow foreign exchange rate),
using public saving measured in foreign exchange as the numeraire (that is, converting
everything into its foreign exchange equivalent). This is referred to as the Little-
Mirrlees approach.
In economic appraisal (as opposed to financial appraisal), we now have to redefine the
variable in the net present value formula to ascertain whether a project is profitable to
society at large.
Bt is the flow of social benefit measured at economic (or efficiency) prices.
Ct is the social cost of inputs (measured by opportunity cost).
r is the social rate of discount.
Market prices adjusted for these various divergence and distortions are called shadow,
social, economic or accounting prices. Adjusted market prices for goods we shall call
economic prices, and adjusted market prices for factors of production (including
foreign exchange) we shall call shadow prices.

1. What factors account for the divergence between market prices and social
values that render the financial appraisal inappropriate from the social point of
view. Explain.
29
2. What is the difference between Little-Mirrlees and UNIDO approaches in

evaluating the economic prices of goods and services?
References
1. Gills, M ; Perkins, Romer, Snodgras, Donald (2001), 5 th Edition W W Norton
and Company, New York.
2. Thirlwall, A P, (1999), Growth and Development.(6th Edition), Macmillan, U
30
LESSON-6
Economic Prices for Goods
In project evaluation, from the economic point of view, the economic price of the
goods can be measured either by correcting the domestic market prices for various
distortions and imperfections with the domestic and foreign prices made comparable
using a shadow price of foreign exchange (the UNIDO approach) or goods may be
valued at world prices as recommended by Little and Mirrlees. However, the method
prescribed by Little and Mirrlees, it is argued, will give a truer measure of the social
valuation of goods than the UNIDO approach which measures some goods at domestic
prices (with adjustments), traded goods at their international prices, and then making
domestic and foreign goods comparable using a shadow foreign exchange rate that
may itself be subject to distortions.
If the world prices are used, the economic price at which to value a project’s
output is its export price if it adds to exports, or its import price if domestic production
leads to a saving in imports. Similarly , on the cost side, the price at which to value a
project input is its import if it is to be imported, or its export price if greater domestic
use leads to a reduction in exports.
To give an example, it the purpose of a project is to produce more wheat for
domestic consumption actually reduces the wheat import. The true economic value of
the wheat output is the border price of wheat import (what is saved in foreign
exchange). But if wheat is exported, its true economic price will be border export price
(what is received in foreign exchange).
The Little- Mirrlees approach of using world price for valuation of true economic
prices poses no major challenge when goods are tradable but problems arise in case of
non-tradable goods. These goods have no world prices. For converting the domestic
31
prices of non- traded goods into world prices conversion factors are required which can
be calculated as given below.
Non-traded Goods and Conversion Factors

A conversion factor (CF) is used to convert the prices of non-traded goods into
the world prices. A conversion factor is defined as a ratio of economic price (shadow
price) to the market price, that is,

f CF = Economic Price (Shadow Price)
Market Price
So that
Economic Price (Shadow Price) = Market Price x CF
In practice, however, it is difficult to find the conversion factors of non-traded
goods. Because, for that purpose each goods has to be decomposed into its traded and
non-traded component in the successive backward rounds of production. A detailed
input-output table will be required for each separate good with a specific conversion
factor. The process is very complex. In practice, however, only special inputs and
outputs are treated this way like, roads and railway, electricity and water supply,
buildings and labor.
Standard Conversion Factor

Another way of converting the non-traded goods prices into world prices is by
way of finding standard conversion factor (SCF).
The SCF translates the domestic prices into border price using official
exchange rate (OER) that is
(SCF) Pd = Pw (OER)
Where, Pd = domestic price
Pw = world price
32
OER = official exchange rate measured as domestic price of a foreign

currency.
Therefore,
𝑃𝑤
(OER)
SCF = 𝑃𝑑
Or
SCF = 1
Pd/Pw (OER)
In this way, SCF is the reciprocal of the shadow price of foreign exchange because
Pd/Pw is the shadow exchange rate (SER) ,that is, the price of a good in domestic
currency relative to world price
=SCF = 1 1
SCF
SER/OER PF
From the above calculation it is clear that the SCF to convert the prices of non-traded
goods into the border prices (World Prices) can be determined by estimating the
shadow price of foreign exchange. Let us take an example. Suppose that the world
price of a bicycle is $50, and the official rate of exchange is Rs.40 = $1. Therefore, in
India the border price of bicycle will be Rs.2000 (world price x OER). Suppose that in
India the actual price of bicycle is Rs.2500. The SCF, using the formula given above
will be:
SCF = 1 1 = 0.8
SCF =
2500/ (50x40) 2500/2000
Now in order to convert the domestic price of the bicycle that is Rs.2500 into world
price of the bicycle, Rs.2500 can be multiplied by SCF, which becomes equal to 0.8.
This gives the world price of bicycle equal to Rs.2000 in domestic currency.
Extending this line of argument to many commodities, the shadow price of foreign
exchange may be written as
33
𝑃𝑑𝑖
𝑃𝐹 = ∑𝑛𝑖=1 𝑓𝑖(𝑃 )
𝑤𝑖 (𝑂𝐸𝑅)
Now what about shadow exchange rate. Here in our example we noted that the
domestic price of bicycle using the official exchange rate is Rs.2000, while as actual
price at which bicycle sold in the domestic market is Rs.2500. It means the domestic
price of foreign exchange (the official exchange rate) is too low. Lower the exchange
rates more the overvalued domestic currency is with respect to foreign currency.
The shadow exchange rate which is worked against the actual domestic price of
the bicycle comes about to be Rs.50 per dollar. Therefore, shadow exchange rate is
higher than official exchange rate. We can again calculate the shadow price of foreign
exchange, which by definition is the ratio of shadow exchange rate to the official
exchange rate, that is, 50/40 = 1.25. The reciprocal of which is 1/1.25 = 0.8. This is
standard conversion factor.
Now in contrast to UNIDO approach which makes use of domestic prices, the
Little- Mirrlees approach recommends that goods and inputs be converted into their
world prices using the official exchange rate, and standard conversion factor for
converting the value of domestic inputs into foreign exchange equivalent. According
by this method net benefit is defined by the following equation:
Net benefit = (OER) (X-M) – SCF (D) -------LITTLE MIRLEES
Where
OER = official exchange rate
X = export
M = import
SCF = standard conversion factor
D = domestic inputs
If we manipulate the above equation by defining SCF as the ratio of OER to the
SER (which is also the inverse of shadow price of foreign exchange)
34
SCF = 1 OER
SCF = =
SER/OER SER
This equation can also take the form:

Net benefit = (OER) (X-M) – (OER/SER)(D) -----UNIDO
Now if we again manipulate the net benefit equation as given by UNIDO
approach, it will yield the same net benefit equation as given by Little-Mirrlees
approach as under:
Net Benefit = (OER)(X-M) –(OER/SER)(D)
= (SCF×SER)(X-M) – (OER/SER)(D)
= (OER/SER)(SER)(X-M) – (OER/SER)(D)
= (OER)(X-M) –SCF(D)
It can now be proved that UNIDO and little-Mirrlees approaches for evaluation of the
profitability or desirability of the projects from the social point of view are quite alike
and yield the same results. For example the net benefit to the society, using UNIDO
approach, for a project producing exports by using both domestic and foreign inputs
can be estimated by the following equation:
Net benefit = SER (X-M) –D
Where
SER implies shadow exchange rate
X implies border price of exports
M implies border price of imports
Here in this method goods are valued in domestic prices, but revalued using
shadow exchange rate rather than official exchange rate. The use of official exchange
rate is believed to be artificially maintained and hence does not reflect accurately the
true value of foreign exchange, if the net benefit is positive the project is profitable.
Net benefit = [𝑂𝐸𝑅/𝑆𝐸𝑅][(𝑆𝐸𝑅)(𝑋 − 𝑀) − 𝐷]
35
= (OER) (X-M) - (𝑂𝐸𝑅/𝑆𝐸𝑅)(𝐷)

= OER (X-M) – (SCF) (D)
From above it is clear that the two equations under these two approaches give
the same result.

1. What is a conversion factor? How is it used to convert the domestic prices of
non-traded goods into the world prices?
2. What is a standard conversion factor? How is it used to convert the domestic
price of non-traded goods into the world prices?
3. Explain Little-Mirrless approach to the valuation of economic prices of non-
tradable goods. How is it different from UNIDO approach?
References
1. Thirlwall, A P, (1999), Growth and Development.(6th Edition), Macmillan,
U.K
2. Jhinghan, M L, Economics of Development and Planing. Vrinda Publications (
P) Ltd.
3. Misra, S K and Puri (1999), Economics of Development and Growth.(8th
Edition), Himalaya Publishing House
36
LESSON-7
SHADOW PRICES OF FACTORS OF PRODUCTION
The Shadow Price of Labour

In developing countries where unskilled labour is available in abundant supply,
there is a real scarcity of skilled labour. It is on account of this basic difference
between the supplies of two types of labour that no uniform approach can be followed
with regard to the choice of wage rates in respect of both skilled and unskilled labour.
It is generally agreed that in most developing countries market wage rates for skilled
labour represent real scarcity values and therefore also the real social costs of this
factor of production. This is, however, not true of unskilled labour. Unskilled labour in
many developing countries is so much in excess supply that its marginal productivity is
believed to be zero or very close to it. But the shadow price of labour depends on not
only the foregone product in its previous employment, but also the disutility of extra
effort that may be required in the new job. Thus, even if the foregone product of a
hired unskilled workers is negligible, the shadow price must be set at the price which
will induce him to work in the new job.
According to Little and Mirrlees, industrial labour in developing countries is
generally paid considerably more than the agricultural subsistence wage. Some of this
excess over what labour could earn in agriculture is necessary in order to induce it to
migrate from the countryside to industrial locations, but most of it is an artificial
creation of trade union activities or government intervention in favour of labour
Therefore, proper shadow price for unskilled industrial labour lies somewhere between
its actual market price and the agricultural subsistence wage.
The Shadow Price of Capital

The capital costs of a project are generally viewed from two different angles for
shadow pricing. First, one can consider the capital costs from what is known as the
37
asset angle. When a project is undertaken funds allocated to it are converted into real
physical assets. A second way to look at the capital costs of the project is to consider
the opportunity cost of the investment in the project concerned. The financial resources
used for investment in the project are withdrawn from the national pool of savings that
could be used for investment in alternative projects. Obviously in the existing project
the assets created as a result of financial investment must yield a benefit or rent, at least
equal to what they are expected to earn elsewhere.
The shadow pricing of capital thus has two dimensions. In the first place, it
must be settled as to how we can measure the value of the real physical assets per se.
Secondly, we should also decide as to how we can estimate the rental value or
opportunity cost of capital. As far as the first problem is concerned, we can answer it
very easily. Pricing of physical assets is done exactly in the same manner as of any
other resource. We can here consider three possibilities. If a physical asset that has
been created for the project is a fully traded good, its last price may be considered as
an adequate measure of its cost. In case the asset is partially traded or non-traded, we
shall have to determine its shadow price which will be equal to its economic cost of
production if the project induces domestic production of the good to increase by the
amount of its demand. If the project attracts the asset from alternative users, its shadow
rice is to be fixed in terms of consumer’s willingness to pay.
When one considers the capital cost from the opportunity cost angle, the
analysis proceeds strictly parallel to that for other resources. Thus the economic cost of
capital is seen as (i) the cost of generating capital resources through additional savings;
or (ii) the value of additional production in alternative uses. UNIDO’s Guide to
Practical Project Appraisal states. “To the extent that capital for the project is generated
from additional savings, its economic cost is the price or rent savers must be paid to
forego an additional unit of present consumption, the consumption rate of interest
(CRI). To the extent that the capital is taken away from competing investments, its
38
economic value is its marginal product at shadow prices in the 'marginal investments',
the investment rate of interest”.
Foreign Exchange
Most developing countries are now facing balance of payments problems, and as a
result, foreign exchange for them has become such a scarce resource that it can
justifiably be treated as a separate production factor. These countries generally allow
their currencies to remain overvalued and handle their balance of payments problems
by adopting a variety of exchange controls. This implies that the demand price for
foreign exchange in these countries is greater than the official price at which the
foreign exchange is transacted. The given figure clearly illustrates this point.
The problem a cost-benefit analyst faces in this case is as to how should he price
imports and exports. Most economists agree that in this case official exchange rate has
little relevance. They argue that the most logical approach would be to use a shadow
price of foreign exchange
39
corresponding to the demand price. In this manner both imports and exports
will be valued higher than their nominal prices. Their adjusted prices will thus measure
their social value in terms of the prices of domestic goods. The rationale of this
approach in respect of imports is not difficult to follow. In most of the developing
countries where foreign exchange problem is acute the value of imports has to be
adjusted upwards so as to make it conform to their scarcity value indicated by the
demand price for foreign exchange. Prices of exports have also to be adjusted upwards,
if one makes the assumption that the government will permit only Re. 1 worth of extra
exports to pay for Re. 1 worth of extra imports. Little and Mirrlees do not subscribe to
this viewpoint. In their opinion both imports and exports are to be valued at their
unadjusted prices. They suggest that value of non-traded goods may, however, be
adjusted downward.
Questions for review

1. What points are taken into consideration to work out the shadow
wages in a dual economy?
2. Describe the method employed in the estimation of shadow price
of the capital?
3. How is shadow price of the foreign exchange determined?
References
1. Thirlwall, A P, (1999), Growth and Development.(6th Edition),
Macmillan, U.K
2. Jhinghan, M L, Economics of Development and Planing. Vrinda
Publications ( P) Ltd.
3. Misra, S K and Puri(1999), Economics of Development
and Growth.(8th Edition), Himalaya Publishing House
40

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Role Of Institutions And Resource Allocation

ROLE OF INSTITUTIONS AND RESOURCE

Lesson – 1 : Role of the Market and Market Failure

Lesson – 2 : Role of the State and State Failure

Lesson – 3 : Role of the Community and Community Failure

Lesson – 4 : Project Appraisal : Benefit – Cost Analysis

Lesson – 5 : Benefit – Cost Analysis : Economic Appraisal

Lesson – 6 : Economic Prices for Goods

Lesson – 7 : Shadow Prices for Factors of Production

ROLE OF THE MARKET AND MARKET FAILURES

Role of the Market

Questions for Review

2. Comment upon the allocative and creative functions of the markets.

THE ROLE OF THE STATE AND STATE FAILURE

Role of the State

Questions for Review

1. Examine the role played by the state in the economic development

ROLE OF THE COMMUNITY AND COMMUNITY FILURE

In the process of economic development of a country, the nature of the economic

Pay- off matrix of the prisoners dilemma game

Trust as a Social Capital

The Community Failure

A means of correcting this failure is the deployment of an ethnic community

Questions for Review

PROJECT APPRAISAL: BENEFIT- COST ANALYSIS

BENEFIT –COST ANALYSIS (FINANCIAL APPRAISAL)

Net Cash Flow

Net Present Value

Figure -1. Time Profile for Investment: Net Cash Flows

NPV = ∑(𝐵𝑡 − 𝐶𝑡)/(1 + 𝑖)𝑡

Table- Calculation of Net present value

e -1,000 1.000 -1,000

6 800 0.507 406

Comparison among the Projects

Questions for Review

In conducting benefit-cost analysis from the economic point of view, we have to

Divergences Between Market Prices And Social Values

Questions for Review

2. What is the difference between Little-Mirrlees and UNIDO approaches in

Economic Prices for Goods

Non-traded Goods and Conversion Factors

Standard Conversion Factor

OER = official exchange rate measured as domestic price of a foreign

This equation can also take the form:

= (OER) (X-M) - (𝑂𝐸𝑅/𝑆𝐸𝑅)(𝐷)

Questions for Review

SHADOW PRICES OF FACTORS OF PRODUCTION

The Shadow Price of Labour

The Shadow Price of Capital

Questions for review

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