Beyond The Rule Of Thumb

Methods For Evaluating Public Investment Projects

Tito Boeri

• Publisher: Routledge
• Year: 2019
• Print ISBN: 9780367012984
• eBook ISBN: 9780429713958
• Topic: Social Sciences
• Subtopic: Sociology
• Index: Social Sciences

This book discusses the rationale for correcting market prices in the evaluation of public investments. It also aims at covering techniques of project appraisals, such as the effects method, cost efficiency techniques, multicriteria analysis, and related logical frameworks.

1
Understanding Shadow Prices

Fifteen or twenty years ago it was much easier to consider project appraisal as a well-defined technique based on the theory of cost-benefit analysis. The publication of the celebrated Little and Mirrlees manual [Little and Mirrlees, 1974] as well as of other guidelines for project evaluation in developing countries [Mishan, 1971a; Dasgupta and Pearce, 1972; UNIDO, 1972; Squire and van der Tak, 1975] reflected a broad consensus on the validity of cost-benefit analysis. The evaluation rules prescribed by these guidelines were considered both theoretically sound and operationally significant [Little and Scott, 1976]. International organizations, such as the World Bank, and agencies operating for national governments were using cost-benefit tests as screening devices in deciding upon alternative allocations of their funds. It was a rare example where theoretical and practical advances combined into a set of rules and converged into what should be called, strictly speaking, a methodology.

Today theoreticians and practitioners of project appraisal are much less sure of their answers. Standard shadow pricing rules are challenged on theoretical grounds as simplistic and inadequate to cope with the actual constraints facing public decision-making. In particular, the neglect of interactions between private and public decisions and an unrealistic description of the control over the economy owned by governments are considered as major limitations of standard cost-benefit rules. Practitioners are more and more dissatisfied with the large number of value judgments and arbitrary assumptions required in order to measure welfare changes induced by public investments. In the absence of such judgments and assumptions, the "rules of thumb" of the manuals are not applicable and are, indeed, not applied. Welfare weights and other measures of distributional effects of public investments are, for instance, quite systematically avoided in applied work. More important, policy-makers do not often seem to pay much attention to the outcome of cost-benefit tests, and the usefulness of using shadow prices instead of relying only on financial evaluations is largely questioned.

Given the current state of the art on cost-benefit analysis, there seems to be limited scope for new manuals on project appraisal or even for updated revisions of the existing ones. Manuals are appropriate whenever there is a sufficiently broad area of agreement on the foundations and implications of a discipline. In the absence of that, manuals become a misleading framework and a source of possible misunderstandings. Hence, the approach followed in this book will be quite different from that of the literature on project appraisal. Instead of trying to prescribe practical ways to estimate shadow prices under different circumstances, we will confine ourselves to exploring the rationale and underpinnings of shadow pricing rules and to finding ways to distinguish between theoretical errors and empirical approximations. In order to do that we first need to develop a framework for discussion: this is the task set out in this preliminary chapter.

The framework proposed relies on recent developments of public finance and social choice theory as well as on the theory of economic planning. Some authors¹ continue to consider this as a simple refinement of the conceptual framework of cost-benefit analysis. However, there is reason to think that it has little, if any, to share with the manuals of the 1970s as well as with the basic analytical tools of the pioneers of project appraisal. The proposed setup is useful because it is sufficiently general so as to enable us to consider project appraisal techniques alternative to cost-benefit analysis (e.g., the so-called effects method or some commonly used cost-efficiency techniques) as empirical approximations of the cost-benefit test relevant whenever--as is often the case--the conditions required in order to define meaningful and computable shadow prices are not met.

The plan of the chapter is as follows: a general framework is initially proposed together with a glossary of the definitions recurrent in the remainder of the book (the reader familiar with these concepts can skip this part); the relevant links between project evaluation and taxation rules are then emphasized and a statement of the assumptions required in order to institute a meaningful cost-benefit test is made; finally, the basic trade-off embodied in any applied work between consistency and feasibility, or between informational requirements and simplifying assumptions is assessed.

Objectives, Constraints and Policy Instruments

The purpose of cost-benefit tests applied to project appraisal is to provide binary decision rules for public choices. Binary decision means that the test establishes which of the two outcomes is preferable: the one with or the one without² the project. Public means that the test embodies some representation of "social preferences" and/or some derived objectives of policymakers. Finally, choice means that the test is related to actual political decisions.

The content of cost-benefit tests is an assessment of the public intervention stance in the economy. There is a principal agent deciding upon economic policies. This is generally a government, endowed with some instruments, e.g., taxes, which enable it to influence the behavior of private units. It is assumed that the principal agent rationally acts to achieve goals [Lindblom, 1977], and the task is to identify which projects are consistent with these objectives, and feasible in the light of available instruments. Public choices take place in a decentralized [Hurwicz, 1969], mixed economy.³ Hence, projects are accepted or rejected depending on whether or not it is possible, and deemed necessary to supplement the market mechanism.

The outcome of cost-benefit tests depends on the solution of a planning problem. The planner is the evaluator who operates for the public decision-maker. Planning is needed because projects draw from resources available for alternative uses. Furthermore, planning means co-ordination and co-ordination aims at preventing inconsistent decisions: if it were possible to attain the targets of the project even without undertaking its resource commitments, then there is no reason to make the investment. However, insofar as the use of instruments outside the control of the public authority cannot be planned, co-ordination might be limited by the segmentation of decision-making. There is indeed virtually no difference from the planner's standpoint between private agents and other autonomous decision units belonging to the public sector. In all cases where public decision-making is not monolithic, cost-benefit tests applied to the same project can also considerably vary across different units of the public sector, e.g., local and central administrations.

The basic elements of the planning problem are the social welfare function or objective function, the policy instruments or choice variables and the model or constraints of the planner. The social welfare function is a representation of values of the community and/or of decision-makers that ranks alternative states of the economy defined in terms of resource allocations.⁴ The choice variables are not necessarily of any value by themselves: generally they are considered relevant in terms of the social welfare function only as long as they condition the states of the economy. The mechanism by which the policy instruments actually affect private demands and supplies is described by the model of the planner, which is also a statement of its limits on choice. The social welfare function, the policy instruments, and the model of the planner contain all the relevant information required to make a decision because they define, respectively, what a social welfare improvement looks like, what needs to be chosen and what can be chosen.

The objectives of the public authority can be one or more, basic or non-basic, compulsive⁵ or non-compulsive. When the goals are multiple, but non-compulsive--e.g., they concern the increase in the levels of well-being of different individuals-they can be assigned a relative weight. In the case where these weights, e.g., welfare weights, are not defined, then there is no way to attach a social value to each possible state of the economy, and it might be impossible to consistently evaluate alternative courses of action. When the representation of the objectives of public authorities does not allow the association of a small change in social values to any small change in resource allocations, then the planner has to rely on a social welfare ordering instead of on a social welfare function.⁶ The problem with discontinuous rankings of states is that they might well lead to (dynamically) inconsistent decisions: projects could be accepted ex-ante and rejected ex-post because the scoring of resource allocations is subject to discrete jumps. This is why the definition of a complete and continuous ordering is a desirable property in project appraisal. As is discussed extensively in Chapter Three, these requirements are generally met by combining some subjective goals of public authorities (such as the commitment to increase employment, or the housing stock) and some "individualistic" representation of private agents' preferences. Such combination of public and private--paternalistic and individualistic--pieces of information is generally required for making interpersonal and intergenerational comparisons of welfare. Information on households' preferences, albeit detailed, is not by itself sufficient to institute a complete and continuous ordering of social states in economies where all the agents do not have identical tastes.⁷

The constraints faced by public decision-making can reflect physical, legal, administrative, political,⁸ distributional and budgetary restrictions or also further limitations due to the presence of uncertainty [Eckstein, 1961], This rich taxonomy can be reduced to the basic distinction between first-best and second-best constraints [Lipsey and Lancaster, 1956], discussed further in Chapter Four. The first-best constraints reflect resource availability conditions--i.e., demands should not exceed supplies--and irreducible technological restrictions facing the production of goods in the economy. The second-best constraints can be direct or indirect, they can be related to an imperfect co-ordination in public decision-making--e.g., restrictions on the mobilization, at least beyond a certain threshold, of policy instruments, such as quotas on imports outside the control of the authority undertaking the project or targets on public expenditure—or to economic magnitudes affected by the policy instruments, such as externalities in public production, factor market imperfections, non-competitive behavior, etc.. When binding, such constraints are sources of distortions because by removing them it would eventually be possible to get a higher level of social welfare even without an increase in the resource endowments of the economy, i.e., they prevent the economy from reaching a condition of full optimum.⁹

Finally, choice variables can be conveniently classified according to whether they correspond to the basic quantity instruments of the so-called "counter" planning [Weitzman, 1974]--e.g., targets on production, quotas on consumption, licensing of private investments, state participation in production, compelling transfers of resources (or purchasing power) between households, firms and the public sector—or to the signal instruments of de-centralized planning—indirect taxes, administrated prices, tariffs, exchange rate management-whose effectiveness is crucially dependent on the existence of market interactions. This taxonomy is indeed aimed at distinguishing between the instruments that directly affect the resource allocations, and those acting on the distribution of factors and commodities only indirectly, ...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Contents
• Preface
• 1 Understanding Shadow Prices
• 2 Projects and Plans
• 3 Measurement and Choice
• 4 Shadow Prices and Market Prices
• 5 Appraising the Appraisals
• Bibliography
• Index