Wednesday, February 23, 2011

NUMERICAL EXAMPLE SHOWING THE APPLICATION OF THE LITTLE - MIRRLEES AND UNIDO APPROACHES TO PROJECT APPRAISAL

(Source:Thirlwall A.P. Planning, Resource Allocation and Choice of Techniques, page no. 212/213)
Let us assume that world prices are measured in dollars ($) and domestic prices in rupees  (R), that the shadow exchange rate is 1.25 rupees per $, and that the standard conversion factor for converting non-traded goods prices into world prices is 0.8, i.e. 1/1.25. We further assume that;
1.         All output is exported with an annual value of $3000.
2.         The cost of the investment has a foreign component of $1000 and a local (non-traded) component of 1000 rupees.
3.         There are traded inputs of $1000 and non - traded of 1000 rupees.
4.         The accounting rate of interest is equal to the consumption rate of interest.
We can now apply out net present value formula in equation (1) using the two approaches. Using the Little-Mirrlees approach we must convert all the prices of non-traded goods into world prices using the standard conversion factor of 0.8, and using the UNIDO approach we must convert all values at world prices ($) into domestic prices using the shadow exchange rate of 1.25. We will do the analysis for three periods only (as shown in table). The results of using Little-Mirrlees approach and the UNIDO approach will differ only to the extent that the shadow exchange rate is different from the actual exchange rate. To obtain net present value, the net benefit streams in years 1 and 2 must be discounted by the appropriate discount factors which we here to be the same using both approaches. Assuming a discount rate of 10 percent we have
Using Little-Mirrlees
NPV  = $1200  +  $1200  -  $1800 = $282.6
              (1.1)         (1.1)2
Using UNIDO
NPV  = R1500  +  R1500  -  R2250 = R353.2
              (1.1)         (1.1)2


A comparision of the Little-mirrlees and UNIDO approaches to project appraisal

Little - Mirrlees
UNIDO
Cost of investment (K)
Year 0
Year 1
Year 2
Cost of investment (K)
Year 0
Year 1
Year 2
1. Foreign component
$1000


1. Foreign cost converted into Rupees at shadow exchange rate of  1.25
R1250


2. Local component =1000 Rupees x conversion factor  0.8
$800


2. Local Component
R1000


Input Costs (C)



Input Costs (C)



1. Traded inputs

$1000
$1000
1. Traded inputs converted into Rupees at shadow exchange rate of 1.25

R1250
R1250
2. Non-traded inputs = 1000 rupees X conversion factor 0. 8

$800
$800
2. Non-traded inputs

R1000
R1000
Benefit flow (V)

$3000
$3000
  Benefit flow in Rupees

R3750
R3750
Net benefit
$1800
$1200
$1200
Net benefit
R2250
R1500
R1500


The Little-Mirrlees result will yield the same rupee value if the actual exchange rate of dollars into rupees is equal to the shadow exchange rate of 1.25.
Little and Mirrlees conclude their own evaluation of the two approaches by saying 'there is no doubt that the two works adopt basically the same approach to project evaluation. Both treatments single out the values of foreign exchange, savings and unskilled labor, as crucial sources of a distorted price mechanism. Both go on to calculate accounting prices which will correct these distortions and both carry out these corrections in an essentially similar manner. Both advocate DCF (Discounted Cash Flow) analysis and the use of PSVs (Present Social Values). Both method works making explicit allowance for inequality and distributional considerations in project choice through manipulation of the shadow wage. In the UNIDO approach this is done through giving greater weight to the increased consumption of the poor than of the rich, which reduces the present value of lost consumption. In the Little -Mirrlees approach distributional considerations are taken account of by working out the value of   S0 taking account of the standard of living of the particular extr4a workers employed., Extra consumption of the rich (or out of  profits) may be given no future value  and treated as a pure cost. This would reduce S0  and reduce the shadow wage, favoring more labor intensive projects and present consumption.

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