ROOM USE ONLY IU3ONOMIC APPRAISAL OF LAND AND WATER RESOURCE PROJECTS IN LESS DEVELOPED COUNTRIES By Douglas 0. Strong A THESIS submitted to the School for Advanced Graduate Studies of Michigan State University of Agriculture and Applied Science in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Agricultural Economics 1965 / "p Approved/’///:ZEEE:Z:?%;Z< lCELArctuc» ) .— - ..4..,_ . , ._,-—-- wrap—A I. Douglas C. Strong -1- Expanded demands for economic and social progress in less developed countries are reflected in increased water resource developments. Evalua- tion cdfvagricultural, economic and administrative aspects of many projects are frequently inadequate for support of loans from financing agencies. Results vary widely'due to differences in criteria used to appraise projects. Since criteria for evaluation in less developed countries are lacking, practices established in the United States are uncritically used which fre- quently are not applicable to existing socio-economic conditions. Obstacles to project evaluation and resource development in less developed countries are more numerous and complex than in this country. Principal obstacles are associated with paucity of data and serious human and institutional factors. Evaluation procedures must be adjusted on a project basis to reflect the national environment of each society, and the encrusted practices in agriculture, religious beliefs, education and tra- ditions of the people. This treatise has indicated the differences in the evaluation proced- ures and criteria used by United States agencies and their implication on the economic feasibility of projects. A conceptual framework was developed which is believed to be more adaptable to evaluation of projects in less developed countries and, in general, elsewhere. The principles of evaluation were related to project studies in West Pakistan, Guinea and Uruguay. This provided a wide range in physical, economic and institutional problems which are believed to be applicable to less developed areas elsewhere. Evaluation techniques used by Federal agencies vary significantly in an Douglas C. Strong .2- basic concepts, measurement standards, and comparability of benefits and costs. The fate of a project may be determined by evaluation techniques acceptable to one agency but not another. Similarly, differences in financing requirements by loaning agencies allows a project to be feasible for one agency but not another. The best criterion for determining project justification becomes an academic question if the sole criterion is merely to satisfy the legal re- quirement that net benefits exceed costs. The net benefit criterion is unsatisfactory if it is desirable to rank projects in optimal order. Rank- ing by the rate of return criterion is preferred since it ensures that the present value of available resources is maximized. It has the advantage also that the computed return is the maximum interest rate which leaves the project barely justified. Benefits from water resource projects can be estimated conceptually as consumer surplus, and alternative costs are reasonable approximations of gain in consumer surplus. The objective of maximizing economic efficiency, inherent in United States standards, is secondary to welfare objectives in less developed countries. Secondary benefits, therefore, should be given greater emphasis in determining project feasibility. Characteristics of rural societies in less developed countries require modification of evaluation procedures. Most obstacles to evaluation can be overcome by adoption of short—cut methods of procedure, from exper— iences on existing projects, and from informed judgment of well-trained project investigators. "w " TABLE OF CONTENTS (IhaEter I II III INTRODUCTION The prdblem . . . Objectives of study Procedure . . . The study areas . . Guinea,'West Africa Uruguay . . . ‘West Pakistan . Sources of data . . REVIEW OF LITERATURE Int roduc 131 on o o 0 Development of basic concepts and definitions Economics of project evaluation . Agricultural development in less developed countries APPRAISAL OF CRITERIA AND EVALUATION PROCEDURES The need for project evaluation Status of development of evaluation procedures in less developed countries less developed countries Current evaluation practices in the United States Development of concepts and practices Differences in evaluation practices Period of analysis Price levels . Investment costs Adequacy of economic analyses of projects in O O O O O O O O O O O O 0 Interest rates for converting cost and variable benefit streams e o o o o o o o o o Allowances for operation and maintenance costs 0 Salvage value of land and major structures . . Allowance in lieu of taxes . . . . . . . Benefits from increased agricultural production Benefits from increased use of nonpagricultural property 0 o o o o e o o o o o FIOOd damage benefits 0 o o o o o o o o NaVigation benefits 0 o o o o o o o 0 water supply and pollution control benefits . Power benefits 0 o e o e o o o 0 Fish, ‘wildlife, and recreational benefits . . Comparison of purposes and financing requirements of major financing agencies . . Export-import bank . . . . . . . . . . . O O O O Page 10 12 15 17 20 ‘ 'l IA‘L_——— ~' TABLE or 00111131313 (Continued) Chapter VI Agency for international deve10pment (AID) . . . International.bank for reconstruction and development (IBRD) . . . . C O 0 International development association (IDA) . . . Interquerican development bank (IADB) . . . Sumary statemnt o a o o u o o o o o o o o CONCEPTUAL FRAMEWORK FOR EVALUATION OF WATER RESOURCES PROJECTS The criterion . . . . . . . . . . . . . The economics of benefits . . . . . . . . . Application of economic concepts in determining project benefits . . . . . F100d contr 01 o o o o o o o o o o o o o Irrigation . . . . . . . . . . . . . . Rec reation o o o o o o o o o o o Critique of secondary benefits . . . . . . . Secondary benefits - practical and analytical view . Secondary benefi s from.projects in less developed countries 0 o o o o o o o o o o o 0 Interest rate considerations, implications and recommendations 0 o o o o o o o o o o 0 Effect of different interest rates . . . Different interest rates for benefits and costs . . Recommended interes I} rate 0 o o o o o o o o The effect of different periods of analysis . . . . Price level and relative price changes . . . . . . OBSTACLES TO EVALUATION OF WATER RESOURCE PROJECTS IN 'WEST PAKISTAN, GUINEA.AND URUGUAY Understanding the national environment . Similarities in socio-economic conditions . . . . . Obstacles to water resource evaluation . . . . . . The problems of agriculture . . . . . . . Critical factors affecting project evaluation . . . . Government policies and goals . . . . . . . . IIaCk or data 0 o o o o o o o o o o o o o m mnure O O O O O O O O O O O O O O smug-IV Statement 0 o o o o o o o o o o o SUGGESTED PROCEDURES AND ALTERNATIVE METHODS FOR PROJECT EVALUATION Physical resources and.agricultural data . Water resources 0 o o o o o o o 0 Domestic and industrial water supplies Irrigation water supply . . . . . 102 106 108 112 112 113 115 115 129 130 13h 137 11:0 lhz n3 11:5 VII TABLE OF CONTENTS (Continued) Land resources 0 Climate . . Soils . . Agricultural data Farm surveys . . Land use surveys Farm product prices Farm costs . . . Projected agricultural conditions Assessment of benefits and economic justifi Project investment . . . . Project costs . . . Project labor costs . Interest cost 0 o o Onpfarm works . . 0 Project benefits . . . Farm budget analysis . Modified income to land Alternative costs . . Land values . . o Benefit-investment relationships Export parity . . . . . Intangible and secondary benefits Financial arrangements . . . Organization and management . . SUI/TART! AND CONCLUSIONS sumary o o o o o o o 0 Conclusions . . . . . . . Current evaluation procedures ooooooooooooooofloooooooso Economic concepts for project evaluation Obstacles to evaluation and resource development Minimum data requirements and alternative procedures at coo.ooooooooooot-“ooooooooo O O O O O O O O O O O O O C O C O O O O O O O O Page 1h? 1h8 153 15h 15h 156 160 161 162 162 165 166 167 169 169 172 17h 175 175 177 178 179 182 186 186 188 188 189 192 19h . _.._. mnA~—e..--n> “h _,.____ ‘ .- LIST OF FIGURES AND TABLES liiggge ‘1 Economics of benefits . . . . . . 2 Economics of benefits . . . . . . 3 Economics of benefits . . . . . . h Benefit-cost comparisons . . . . . .Appendix Tables 1 Agencies which help finance foreign trade and inve 3 went 0 o o o o o o o 2 Benefit-cost ratios of Corps of Engineers projects Page 78 79 81 168 202 203 1" ’.'C 23 La" 3' CHAPTER I INTRODUCTION _Tl_1_e_ Problem Since World War II the demand for economic progress and social in- provenent in the less developed countries has increased steadily. llany countries in the Hiddle East, Africa, Latin America and elseshere have embarked on various types of investment programs for economic develop-eat as scans towards attaining more efficient use ef hut-en and natural re- sources and higher levels of living for their people. Since agriculture is the largest sector in the scenery of these countries and provides the base upon which the industrial and other economic superstructure not be built, agricultural ilprovenent receives considerable emphasis. Large- scale progress have been undertaken fer increasing farm production by such methods as expansion of irrigation and related water resource develop- ments, drainage, increased use of fertilisers, plant pretection, inpreved seed and plants, mechanization, land reform and agicultural extension services. This expansion in agricultural improvement and resource development in the less developed countries is nude pessible by financial and techni- cal assistance largely from Fosters countries. The United States has taken the lead in this activity and has done more than any other country in contributing to relief, rehabilitation, reconstruction and economic development in foreign lands . Befere 19511, nest of the aid from the "1 [-1 l1 .2- United States wont to Europe. Since then it has gone to less developed areas of the world. ll'his study is concerned with that portion of the financial aid loaned to those countries for financing water resource projects. The principal agencies providing loans for this purpose are; (l) the kport-Ilport Bank, (2) the United States Agency for International Development (team), (3) to. International lonetary Fund, (2;) the International Bank for Recon- struction and Development (IBRD) , (S) the International Development Asso- ciation (affiliate of the IBRD), (6) the International Finance Corporation, (1) the Inter-lune“ Development Bank (IDE), and (a) the Inter-Amrican Social Progranu'rrust Fund (administered by the DB). Both technical and financial assistance is available also from the Food and Agriculture Organ- isation (no) , and Special Fund projects addnistered by the United Nations. Iithin limits of the legal, financial and administrative regulation of these financing agencies, projects for which loans are granted last he econonlically and financially feasible. The feasibility studies nay be prepared by a government agency of the borrowing country but because of lack of technically trained personnel nest of then are actually prepared by consultants. Legal provisions governing the Export-Import Bank and USED require that consulting services be procured from the United States. The other agencies require only that the consulting services be procured from Ierer nations of the respective agency; however, a high portion of these are also prepared by consultants from the United States. Il'he quality of the feasibility studies presented to the financing agencies in support of loans to borrowing countries are rated generally as being poor. Personal interviews with officials of the IBRD, for ~3- 1nstance, retooled that in no case were they satisfied with the eval- uation of the agricultural, economic and administrative aspects of the project reports that the Bank had received. The general consensus of opinion expressed by officials of the other agencies revealed that in the sajority of cases the treatment of these phases of project investigations was also seriously inadequate. It was indicated also from these inter- views that there was wide variation in the procedures and criteria used in evaluating resource projects, which undo the appraisal of potential projects difficult and comparison along projects almost meaningless. lunerous requests for loans have been refused because of inadequate coverage and, in sons instances , ilproper application of evaluation pro- cedures. This has resulted in some worthy and badly needed projects being delayed; additional costs being incurred for pro-construction in- vestigation which nest of the countries can not afford; and, in some in- stances, has created bitterness and ill feelings between the financing agency and the borrowing country. This situation has tended to undermine the effectiveness and purpose of the entire assistance program. Questions arise as to why the nonengineering aspects of project investigations in the less developed countries are so poorly covered. W do results of feasibility studies vary so widely? that are the rea- sons for such wide variation in the methods and criteria used to evaluate the feasibility of potential projects? that inprwenents can be ads is the procedures to upgrade the quality of the feasibility studies? Answers to such questions are of particular concern to the financing agencies, to the consultants engaged in project planning and investigation and, of course, to the govern-ant agencies responsible for water resource :rl _ ls! r) II. J!" I, If“ 4;. development. If the assistance program are to effectively accomplish the object- ives for which they were designed, it is iaperative that inprovenents be sado. thoughthere saybenamways inwhich inprovenents canbenade, two obvious ways appear to be by; (1) improved standards and quality of work by the project planners and investigators, and (2) adoption of sore appropriate procedures and criteria by the financing agencies for apprais- 1-“8 potential proj cote. Economists responsible for the feasibility studies face a tremendous chfllenge in evaluating projects in the less developed countries . The obstacles and problem faced are generally more numerous and, in nary respects, sore couple: than those ncrnlly encountered in this country. Seldo- are there reliable statistics from which to assess the present agricultural situation and production of the project area, or the produc- tion of similar areas already developed under irrigation. It is unusual for there to be adequate or reliable data regarding soils, agronow, water duties and production statistics. It is most exceptional to find any worthwhile information concerning the econcucs of fern production. Finally, and perhaps most important, there are usually serious human and institu- tional obstacles which complicate the evaluation processes . These problems lust be solved or, at least, greatly reduced if reasonable standards of agricultural production and project analyses are to be attained. Apart from institutional probless and paucity of data, economic con. ditions in these countries are vastly different. For instance, there is frequently serious imbalances in resource use. Underenployod resources usually include unskilled labor and often, land and water, but know-how, 3'5 fin. .5. managerial experience and capital are usually scarce resources. Proper evaluation of projects in these countries requires that the obstacles to economic development be recognised and clearly understood. Because the obstacles are frequently unlike those encountered by econo- nists in this country, naive application of highly developed tools of economics often yield results that are largely irrelevant and not appli- cable sithin the political and institutional enviroments of the less- developed country. i The investigator must understand that values and goals of other people are different and application of economic criteria and procedures developed in the United States are not always the only techniques or even the best aeans for evaluation of projects in other societies. 1 clear understanding of the development problem and economic conditions within a country is essential to the appraisal of proposed projects; careful definition of the objectives and the procedures for the investigation, and recognition of the seam available for operation of a project not be understood by both the project investigators and the financing agencies. The procedures and criteria that can be used effectively in the less developed countries for evaluation of projects are still in a state of infancy as conpared with those available for use in this country. 0on— sequently, the financing agencies, the consultants and the technicians .o the borrowing countries look to the United States for acceptable stand- ards with which to evaluate potential projects. However, inspite of the high professional level of the procedures available, there are wide varia- tions and inconsistencies in the aethods and procedures actually used by the various United States government agencies. These variations and Alla .6- inconsistencies are reflected in the project studies made in foreign countries. The procedures and criteria used reflect not only the varia- tions and differences noted among United States agencies, but also of those of individual investigators. Further, feasibility studies are fre- quently prepared by foreign consultants who also have their own procedures for evaluation. This contributes further to the inconsistencies and variations among the studies submitted for financing. The variations in evaluation procedures among the water resource planning agencies in the United States are a reflection partly of basic differences in concepts, measurement methods and standards and in com- parability of benefits and cost estimates. Certain of the difficulties result from legal and administrative provisions applicable to particular Programs, some have grown out of difficulties inherent in practical appli- cation, but a large portion results from the absence of an adequate frame- work of concepts and principles. Aside from these causes of differences, a fairly substantial gap often exists between prescribed practices and those actually applied in the analysis of particular projects. There are needs for determining the similarities and dissinilarities in the criteria and evaluation practices among the United States agencies in order to gain an understanding of the impact of these practices on project feasi- bility; to suggest alternative recommendations for improvement; and to develop a consistent set of criteria and standards which may be applicable for evaluation of projects in less developed countries. The criteria and measurement standards adopted by the United States I‘eSource planning agencies are used also by the international financing afencies to review and appraise feasibility studies of projects in less ‘mh TI ‘4 nu‘\t)\ Li .7- developed countries. The USAID, for example, has adopted procedures recommended in the recently issued Senate Document 97.1 Pravisions of this document are essentially the same as recommended by the ”Green Book',2 and by the United States Bureau of the Budget A447. eh. other agencies look to these references as guides in appraising feasibility studies, although fennel statements specifying precise criteria and standards for use by consultants in preparing reports are not issued as is the case with USAID. But, differences in legal, financial and admin- istrative regulations of these agencies contribute to the confusion and Yeriations in procedures used by the consultants to evaluate projects, Plrticularly with respect to financial feasibility. Seldom does a borrow- ing country know prior to completion of a feasibility study which agency My be receptive to financing the project; and, obviously, the financial feasibility of a project is affeCted by the terms required for financing. There is a need not only for uniform procedures for the appraisal and review of the economic feasibility of projects but also for terms of rfinancing, particularly for similar types of projects. As mentioned previously, application of rigorous standards and 3°Phisticated economic tools developed in the United States, such as ¥ _‘ 1Statement of ”Policies, Standards, and Procedures in the Formu- 1"Chiba, Evaluation, Mam For Use and DeveIEEIEuent 9: water ifid‘aaufia'meea'se-T—‘e. -, ”ammonites. o e comma Wh‘fifi’or,T’grimRm,1ee1th, Education and Welfare; and the Secre- unofthelm. 2m 'Green Back" is the Inter-Agency Subcomittee statement on t’fefioglrreotioee £33 Evaluation 35 River Basin Projects, 1950, 958. u.- n "— -8- those specified by USAID and contained in Senate Document 97 are often Inuealistic and impractical for evaluating projects in the less developed cmnfinies. Under some conditions it is unrealistic to apply more than rather crude tests of economic feasibility. Even the most reliable data from'these countries that can reasonably be expected do not warrant :hwolved economic techniques because of vastly different types of agricul- hne organization, institutional arrangements, economic systems and social goals for economic development. Some quantitative assessment of direct economic benefits from.a pro- ject,thowever,:must be made. For'this purpose, short-cut methods are needed which will give economic results sufficiently accurate to meet the basic requirements of the financing agencies, and to serve the needs of the project planners. But there is aminimum.amount of data from which reasonably sound judgments can be made and short-cut methods applied. It is imperative, therefore, that the project investigators have a clear lumerstanding of the extent and type of data that is absolutely neoessany 'haevaluate the economic feasibility of a potential project. Objectives 2£_Stugy The increased role of the United States in providing technical and financial assistance for water resource development in less developed cOuntries offers many challenges, responsibilities and opportunities for agricultural economists and other agricultural technicians. It is stated that'the quality of our past performance in evaluating the nonengineering aSpects of potential projects in these countries has been rather poor. m . . . . . . . . the overall objective of this study is to evaluate alternative criteria I ’9! 0‘. {A .1? ”-1 - r! .9. and procedures for evaluation of water resource projects, and to suggest additional methods for estimating project benefits and costs under the various physical, institutional and economic conditions comonly encount- ered in less developed countries. This objective will be accomplished in several phases a (1) The first phase will include a review of the evaluation preced- ures and criteria used by major federal water resource development agencies of the United States. The similarities and dissimilarities in these procedures will be noted and implications of these differences on the economic feasibility of projects will be determined. (2) The second phase will be to consider the economic logic of the evaluation criteria in an effort to provide a basis for recomendations for improvement of the conceptual framework for evaluation of water re- lource projects. Alternative criteria and procedures will be advanced Web are believed to be more adaptable to project evaluation in less developed countries. (3) The third phase will be to identify the principal obstacles to Project evaluation in three less developed countries. Just as no twe Projects are alike, neither are the physical, institutional and economic conditions ef two countries alike. It will be demonstrated that differ- flioes in these conditions oft times require new or modified procedures it reasonable analyses are made of potential projects. Short-out methods V111 be developed which may be used te ebtain reasonable estimates of Raj ect benefits in situatiom where highly developed procedures are net a~Pplieable and where sufficient information for detailed studies are hurting. .‘J .‘I ‘ -10- (h) The fourth phase will be to indicate both the minim amount and the type of data from which one can reasonably expect to perform a feasibility study. This will represent the minimum data from which reasonably sound judgments can be made, and from which the principles of project appraisal can be adapted to adverse situations normally en- countered in most less developed countries. We The method of this study was to inventory and analyse all available research and empirical studies on resource evaluation and to relate the fhndamental concepts and principles to the analysis of projects in three less developed countries . The work was organised into two parts, the first involving research and study of the publications of the United States government water resource agencies, and of professional articles and research works by prondnent land economists. Past experiences in resource evaluation work with the Bureau of Reclamation, experience as an assist- ant professor in land economics, and ewerience as a consultant on economic investigations in numerous foreign countries has served as valuable back- zround for development of evaluation concepts and methods .3 The second part of the study relates the principles and concepts of Ptoject evaluation, as developed in the first part, to specific pre— Jeete that were investigated in Guinea, Uruguay and Feet Pakistan. The —L 31gricultara1 Economist with Bureau of Reclamation from 191:3 to 1953, mutant Professor at Utah State University from 1955 to 1962. and Head. gricultural Planning Department of Horse Engineering Company from 1962 Present. .11. data. used for this study were obtained in connection with engineering and economic feasibility studies made in these countries while employed with a private consulting engineering firm. Though some of the basic data used in this study are presented in feasibility reports completed on these projects, this research report represents additional work not related to services provided as a consultant with this engineering firle This study was sentenced in 1962. Data concerning evaluation criteria and procedures were collected from the libraries of Utah State University and the University of Chicago in the early part of 1962. Contacts were made at various times during 1962-6h with officials of the IBBD, mm, and other agencies concerning the general problems of pro- Ject evaluation and financing in less developed countries. Discussions were held with officials of the United Nations, both the Special Fund Operations in low for]: aid the FAO in Rome, during this same period. Three countries, described as 'less developed” by the financing agencies, were visited during the two year period, .1962 and 1963. Work on the project in Uruguay was conducted during April to July in 1962, ' in West Pakistan from January to March, 1963, and in Guinea from April to July, 1963. A water and land resource project was investigated in each of these countries. These countries were selected for this study because a wide range or differences in physical, institutional and economic conditions were ellcountered. These conditions are discussed in detail in Chapter II. It was felt that the range and type of problems in resource evaluation 011 these projects would be sufficiently broad to be representative of typical situations found in most of the less developed areas of the world. u ‘v \H1 -12- The implications and recommendations made in this study should have wide application to resource evaluations of other comparable projects. Some major physical, institutional and economic conditions in the The detailed three countries studies are described briefly below. appraisal of specific factors and obstacles to evaluation of projects within these countries is presented in Chapter V. The Stuck,r Areas 933233,‘west Africa --— Riceland Reclamation Projects Location and Physical Conditions The Republic of Guinea is located on the Atlantic coast of the "Bulge of Africa" about 670 miles Southeast of Dakar, Republic of Senegal. It extends from latitude 9° to 312.5° N and from longitude 17° to 12° W. The country is bounded by Iflortugese Guinea on the northwest, the Atlantic Ocean on the west, Sierra Ifiaone on the southwest, Liberia on the south, the Republic of Ivory Coast CH1 the southeast, and the Republic of Senegal and Mali on the north. Investigations to determine the feasibility for development of rice EH?oduction were carried out along the coastal area of lower Guinea. The cBlimatologic, physiographic and hydrologic characteristics of this area Iilay'an important role in the successful exploitation of the land for rice production. The rainfall is heavy, averaging about 112 inches per year. 1Just all of the rain.falls during the period from.May to November, and tile number of rainy days as well as the amount of rain varies considerabky from year to year. The climate is hot, with high relative humidity, and with little ‘Variation in temperature throughout the year. The average maximum tem- -13- perature is 85° F. and the average minimum 75° F. Vegetative growth practically ceases during the DecembereApril period because of complete lack of precipitation. Crop production is dependent entirely on natural Inecipitation and only one crop per year is possible without irrigation. The relief of the coastal plain is cut deeply by old estuaries. During the dry season when surface run-off is practically non-existent, the estuaries become tidal inlets bordered by saline, muddy lands. Tidal variations extend far inland since the coastal plain is only a few meters above sea level. Because of low elevation, most lands that are potentially suitable for rice production are poorly drained during the wet season and subject to the influences of salt water during high tides. Crop production is seriously restricted due to these physical limitations. The plans for development of this project involves construction of drainage works to remove excess surface water, and structures to control flooding by sea- ‘Water during high tide. General Economic and Institutional Background Guinea became an ihltonomous republic in October, 1958 from the former territory of French C'Tuinea. It has a population estimated at three million and is increasing ad; about three percent per year, putting continued pressure on available productive land. Modern politics in Guinea re superimposed on a network of tribal reElationships. ‘A large majority of the population is Muslin. One- 't}1ird belongs to the Foulah tribe, a Hamitic group with a feudalistic SC><=ial organization; two-fifths are the Mandingo Negroes located mostly 111 the northeast, and about one-fifth the Soussau located mostly along the coast. The remaining population belongs to numerous small tribes. .‘h. ’J -LL'- Although intertribal antagonisms exist, the long-practiced French policy of demanding subservience from the chiefs, and the tactics followed by the independent Guinean government of including opposition chiefs in the Cabinet have weakened tribal leadership, and no serious internal friction is evident. More pressing on the new government are the economic and administra- tive problems arising from the abrupt change-over from French to African rule, and the withdrawal of French technicians and administrators. Almost total illiteracy, estimated at 98 percent, and traditional antagonistic attitudes toward manual work outside of agriculture have hampered develop- ment of a stable, skilled African labor force. As artisans have custom- arily come from castes of a low social status, it is felt that working With metal and machinery is degrading. Also, work is still associated With memories of the forced labor resorted to by the French. Despite excellent mining and industrial potentialities, Guinea is no" a poor and underdeveloped country, with agriculture the mainstay of the About 95 percent of the population is engaged in growing and Subsistence econOUV. processing agricultural products at the subsistence level. agliculture satisfies the basic needs of the people living outside of the money economy but there are frequent and serious shortages of almost all foods in urban centers and on occasions in the rural areas. A variety of climates, generally fertile soil, and favorable topographical fevilli-hires, provide Guinea with a potential for considerable agricultural diversi_1:‘ication and development. The country is not self-sufficient in basic foodstuffs and must import staples such as rice, wheat, flour, dried milk, and sugar. The major obstacles to agricultural development, "1 u. -15- together with problems encountered in evaluating the economic and financial feasibility of potential projects are discussed in Chapter V. Uruguay -- Zapucay Pilot Irrigation Project Location and Physical Characteristics The Zapucay Irrigation fhcject is located in the Departments of Taucarembo and Riveria in the rmrthern part of Uruguay, near the border of Brazil. The topography is smooth and rolling with small rounded hills, and with valleys of small luvers and streams. Like most of Uruguay, the project area is primarily a grass country with few trees so that the entire area can be cultivated or used as pasture. Uruguay is the only Latin American country lying entirehy in the Temperate Zone, although the climate approaches the sub—tropical in the northwest. The average annual rainfall in the project area varies between h2 and 56 inches and it is distributed relatively uniformly through- 0u1;the year. Extremes of temperature are from ~80 to -2h° F., and idle frost-free period extends from about September 1 to may 1. Despite average monthly rainfall that gives an impression of adequate IHeisture for production of most crops, there is frequent occurrence of 143mg periods of drouth. Irrigation is not practiced at present but would ENE required for successful production of most cultivated crops, and would be'beneficial to production of pasture and forage crops. The Zapucay I’I‘oject was planned as a pilot-irrigation project to demonstrate the (Effects of irrigation on production; to stimulate introduction of diver- Sified agriculture into the region; and to train farmers and project Operators in modern techniques of irrigation. Over 90 percent of the land in the area is used for grazing of V :§‘ ‘ 1“ I .16.. natural pastures. There has been no discernible change in land use during the past 100 years. The predominance of the livestock econonw is so great that even though crop production is feasible in many instances there are frequent shortages of many foodstuff; particularly, fresh vege- tables, fruit and truck crops. The sole supply of feed for livestock is from grazing and during the winter months and drouth periods the animals do not have adequate feed. The average age of beef at a market weight of about 1,000 pounds is over four years. There is a need for development of surplus forage for supplemental feeding when grass from natural pastures is not available. Uruguay is one of the richest countries in the world in natural Pastures but numerous problems related to farm organization, land tenure lrrangements , government administration and other obstacles exist that keep the country at a low stage of economic development. These obstacles Ere discussed in detail in Chapter V. General Econoflc 52d Institutional Backgound Though there has been no complete census in Uruguay since 1908, it is estimated that the Population is around three million. This would nice it the most densely Populated country of South America, with about 35 persons per square mile. oVer one-third of the population is concentrated in the Capital, Montevideo. Ul-‘ugzmy ranks as one of the top South American countries in education ‘ith the percentage of illiterates at less than 20 percent. The govern- ‘Bnt is a democracy, suffrage for the citizens over 18 years of age is “hiversal, secret and obligatory. Even though the government favors “zeta ownership of many industries, most of the land is held in private “Inership. Agrarian reform within the country is moving ahead slowly but .‘l .5! I... afle ' won“ .17- through orderly legislation. Uruguay is in a better economic and social position than most ot.r Latin Alerican countries. It is primarily a pastoral econonv with little mineral wealth and with crop production of secondary importance. They have a freehold or private-ownership system of land tenure quite similar to that found in the United States, with less and customs favoring the individual. in abundant supply of land together with liberal policies for distributing the land to private ownership in the country's early history contributed to the creation of large holdings . In the project tree, for enmle, 8.5 percent of the owners hold over 80 percent of the land. The large landowners constitute the most important economic, social and political group in Uruguay, with considerable prestige and influence. For the most part, however, these large I'estancias" are not operated Officiantly. The osners most often do not live on“ their ranches and their primary interests are in political or other economic endeavors 1:: the urban centers. One of the principal problems facing the Government of Uruguay is the large majority in the landless classes, sharecroppers and hired laborers in the rural areas. The advance to land ownership and increased °°onomic well-being of most of these people is blocked by serious econom- ic and institutional problems. These problems, as related to agricul- tural development and resource evaluation, are discussed in Chapter V. ks; Pakistan --- Tarbela Pro; ect (lung 122513) Location and Mica Characteristics West Pakistan occupies the sestern portion of the Indo-Pakistan subcontinent, between longitude at. W: h. Q i ‘n e I’&‘ v [-1 p D . .5! -18- 61° and 75° east and latitudes 21.0 and 37° north. It is bounded on the west by Iran, on the northwest and north by Afghanistan, on the northeast by Gilgit Agency, Azad Kashmier and Jamma and Kashmir, on the east by India and on the south by the Arabian Sea. The Indus Plains, the outstanding physical feature of the Province, contain one of the worlds' oldest and largest irrigation areas. Develop- ment started mam centuries ago, and now includes more than 30 million acres under the command of numerous barrages and thousands of miles of irrigation canals. This irrigation system is unique in that such a large area is completely dependent for water supply upon unregulated natural river flows. Although West Pakistan is situated entirely within the temperate Zone, the climate is tropical or subtropical. The climate is influenced by monsoon winds, which come from the southeast in summer, and by winds rPom the west and northwest in winter. Summer temperatures throughout 1fleet of the Indus Plains are high, with temperatures exceeding 115° F. 1101; unusual. Due to high temperatures, evaporation is high. Theoretical lake evaporation varies from 57 to 75 inches a year in the northern areas, and from 72 to 87 inches 8. year in the southern areas. In the northern Part of the Basin, average rainfall is between 18 to 22 inches per year, but, decreases to less than 1; or 5 inches in the lower part. Most of the Wall occurs from April 1 through October 15. For the most part, the annual rainfall is accompanied by high year-to—year variability. Irri- ga‘lzion is absolutely necessary for successful crop production in over 1‘ Our-fifths of the Indus Plains. Several grave problems affect the irrigated agriculture of the -19- Indus Plains, the principal of which are recurring water shortages resulting from inadequate canal systems, capacities, and water supplies, and rapidly spreading waterlogging and soil salinity in the irrigated areas. As a result, large areas of productive irrigated land have been lost completely to cultivation, or have had production seriously reduced. General Economic and Institutional Background According to the 1961 population census, there were nearly ’43 million people in West Pakistan and population is increasing 2.? percent per year. The popu- lation density averages 38 persons per square mile and there is less than one acre of cultivated land (actually planted) per capita. The great majority of these people are malnourished and deeperately poor. Their aVerage income is less than $0.20 per day; their average life expectancy is less than forty years. Only one out of ten can read effectively or Write more than his own name 3 only one out of a thousand has more than a high school education. They are debilitated by dietary and water- bCI‘ne diseases and by skin infections. Their meager diet is inadequate, both in energy content and in essential proteins. Their watchword is, "our sons will have it better”. Agriculture dominates the economy of West Pakistan. Activities clirectly related to producing and processing agricultural products for domestic consumption provide a livelihood for about 85 percent of the p“Inflation, employment for 67 percent of the labor force and contribute about 60 percent of the national income. Furthermore, much of the manufacturing consists of processing of agricultural products for domes- tic consumption. This includes spinning and weaving, tanning of hides -20... and skins, manufacturing of textiles and leather goods, refining of sugar, processing of oil seeds and grain products and canning fruits. Pakistan presents the disheartening picture of an agricultural nation that cannot feed itself. Not only are crop yields among the low- est in the world, but they have not increased significantly during the past ten years. Total production has increased an average of 2 percent per year, mostly from new land brought under production, but the popu- lation is increasing by about 2.7 percent per year. Imports of agricul- tural products amount to an equivalent of about 25 percent of the total average diet, consisting of less than 2,000 calories per capita. The Potential for increased agricultural production and economic development in West Pakistan are tremendous but numerous obstacles and problems make the task almost futile. These are discussed in detail in relation to the obstacles to evaluation and appraisal of water resource developments Presented in Chapter V. Sources 9}: Data Data from many sources have been used in this study. References on resource evaluation procedures by agencies of the United States government were relied on heavily for analyzing the differences in current Concepts and criteria. The most important of these were the manuals on DI‘Oject investigation by the Bureau of Reclamation; the Soil Conservation Seilf'vice Handbook; the manuals on procedures by the Corps of Engineers; the Bureau of the Budget, A—h7; the Inter-agency Sub-committee reports on Proposed Practices and Procedures, commonly referred to as the "Green Book”, as modified; and the more recent publication, Senate Document 97. .21- These references were supplemented by numerous articles in the Journals of the American Farm Economic Association and the Western Farm Economic Association, and the Journal of Land Economics. Field investigations were conducted on the projects in Guinea, Uruguay and West Pakistan during 1962 to 1963 in connection with overall engineering and economic feasibility studies by teams of experts of the Harza Engineering Company of Chicago, Illinois. As a member of these teams, basic data for the economic feasibility studies for these projects, and for supplemental data for this study were collected by the author. The basic data were collected during extended visits to these countries While the analyses were completed in Chicago. Personal interviews with farmers and agricultural leaders in each cOuntry were made through the use of interpreters to obtain first hand information pertaining to the organization and operation of typical farms 01' operating units. Because of difficulties in obtaining reliable data fI‘om farmers, particularly in West Pakistan and Guinea, it was necessary to supplement nmch of the data by alternative means. For instance, crop Yield estimates were obtained from agronomists and soil scientists on the basis of experience and knowledge of the performance of particular creps under similar environmental conditions in other areas. These esti- In‘a‘tes were then compared with the crop yields obtained by personal inter- views and adjusted when necessary on the basis of the experienced judg- ment of the technicians. Secondary sources of infomation on conditions of each economy, 1°<3al institutional arrangements, and social conditions, import-export data, population, etc., were relied on heavily for much of the data. 1 1.. u“- u-u‘: . "l--¢-. -22- These included local government reports, embassy reports, statements from government officials, and representatives of businesses and govern- nmnt institutions working on agricultural problems in these countries. Personal interviews with officials of USAID, IBRD and other financing institutions in Washington.D.C.; and their representatives in these countries provided data pertaining to methods of evaluation and proced- ures, terms of financing and organization of the institutions. CHAPTER II REVIEW OF LITERATURE Introduction Literature on resource evaluation in the United States is consider- able. Studies on various aspects related to economic development in less developed countries are far less extensive but there has been con- siderable interest in this area since World War II. However, most work has been directed more toward problems related to causes of economic smith than to problems of resource evaluation. Land econofists, political and social scientists and other tech- niciam concerned with resource development in the United States have dealt with problem of evaluation since the first public project. In- terest in this area of study has increased with the gradual expansion in resource developments, paralleling the growing concern and public interest in our resources as larger and more costly projects influenced more and more people. This chapter is concerned with a review of some of the past studies that have been conducted by new of these people in their special areas 0f interest. It is not intended to compile an exhaustive listing of Past studies on resource evaluation and related topics, but to sumarise *1 few of the njor works in this general area with a view to the relation- 3111p of these studies to the general topics of this study, and their Possible contribution to this work. .21... Develgpment 2.1; Basic Concepts :93 Definitions The report in 1950 by the Presidents ' Water Resource Policy Commission represented the most comprehensive statement on resource evaluation up to that time;l This Committee was organized at the request of the President to formulate mutually acceptable principles and proced- ures for determining benefits and costs for water resource projects. The first authoritative statement on project evaluation was the "Green Book' published in 1950.2 These works provided the format for many succeeding studies involving modifications and suggested recomendatiem for improvement in evaluation principles and procedures . Gloss traces the changes in rules for determining financial feasi- bility of projects by the Bureau of Reclamation, Corps of Engineers and the United States Department of Agriculture.3 He noted that in the beginning of the Federal Reclamation program in 1902, authorization of Projects was granted on the basis of being financially feasible if cost of construction could be returned to the United States by the water users in not more than 10 annual installments. Congress gradually changed its feasibility procedure and in 1926 a new provision was added requiring that repayment contracts provide for repqment in not more 1Presidents' Water Resource Policy Commission, Vol. 1, .4. Water Poli for the American Pee 1e. United States Government Printing- ce,'Tis to n, Deco er, 950. 2Pro sed Practices £95 Economic $1? of River Basin Pro ects, $301195" e er tar—agency River as Effie, WashIn—géon, , l 0. 3mred R. Gclze, Reclamation in in: United States, New York: McGraw-Hill Book Company, Inc., 1957!? pp. M6. N nF‘\. -25- than hO years. In recent years, some repayment contracts of 60 years have been authorized by Congress. Recognition of multiple-use features of projects was largely inci- Cmntal. Congress provided authorization for public power development by UmaBureau of Reclamation in 1906, but the first truly multi-purpose gnpject, specifically authorized and designed as such, to be built in the Ikfited States was the Hoover Dam. Enacted in 1928, the legislation recog- nized flood control, navigation, irrigation and hydroelectric power gener- ation as purposes of this project.’4 Again, in 1939, Congress recognized the difficulty of financing large and expensive multi-purpose projects and modified the rules of feasibility by recognizing benefits that were national in character, such as flood control and navigation, to be non- reimbursable.S In l9hh, Cooke recognized that multiple-use of resources added em- Phasis for the imperative need of unified resource development. He states, ”from a social standpoint the river itself becomes a vastly important, nIt‘lltiple-purpose agency'which must be nurtured in manifold and unaccustomed t'O'ways while the dam becomes simply an important servitor of the river. In fact, it may be that our present concentration on the dam and the beneficent Ixmwer it creates has blurred the picture and kept us from realizing all that 18 involved in the total river use as affecting regional development".6 hU.S. Department of Interior, Bureau of Reclamation, Federal Recla— mation Laws.Annotated,'Washington, U.S. Government Printing Office, l9h7, p. Q Scoize, 22, 333., p. 125. 6Morris Lo Cooke, "Multiple Purpose Rivers", Journal Of the Franklin W. 00mm, No. to April. 19th, pp. 251-255:— -- -— ——— 2.? hi (I I -26- The Presidents' Water Resource Policy Comittee recognized the mlti-purpose aspects when they stated "the selection of projects and combinations of functions depends on an“ evaluation which views the program as a whole in all its complexities. ... Project evaluation, if it is to give useful answers, must consider all the various facets of the basin development program. These include the technical, the financial, the economic and the public aspects. In a similar manner, program evaluation met comider all features related to national objectives".7 Studies by Huffman noted that 'as these multi-purpose potentialities become evident to more and more people, there has been increased emphasis on the etch and evaluation of all possible uses in planning for resource development'.8 He added that ”until recently, (1953), Public irrigation development. and resource development generally, has been farmlated, Ovaluated and authorized on the basis of projects. With the advent of the river basin system of resource development, a broader basis of eval- ution and authorization came to the fore. He stated further that ”pro- grams of development for entire river basins replaced projects as the unit of planning and operation; while projects are constituent parts of Such programs . The problems of evaluation becomes much broader than is the case of project by project consideration because the former is con- cerned with economic evaluation and including public values". He makes rle'ther distinction between projects and programs when he states "the 7Presidents' Water Resource Policy Committee, Report 23: 22. 31.2., Vol. I, p. 58. 8Roy E. Huffman, Irri ation Develo ment 2‘1 Public Policy, The Ronald Press Germany, ew or , , p. . .27... budgeting procedure for determining the value of irrigation water is typical of the method by which the benefits of a single-purpose resource development may be assessed as they apply to direct beneficiaries. As public resource development became more and more concerned with high—cost projects, it appears imperative that all benefits and detriments be in- cluded in the analysis'.9 Much has been written regarding the lack of coordination and the conflicts among government agencies, and private vs public interests in water and related land resource developments. Some writers have indicated an extreme amount of competition among agencies.10 The shift from single- Purpose resource development to conprehens ive multi-purpose stream plan- ning has done such to expand these conflicts. Huffman distinguishes be- tween four concepts of conflicts; the public vs the private, the public Vs the state, the public vs the public, and the long-run vs the short-run. He takes the stand that economic factors may make it impossible for aw- One except the state to take a sufficiently long—run viewpoint, ani that eExploitive development and use of resources may be such that only the State is in a position to represent a viewpoint consistent with the long- run public interest.11 Marv writers have pointed out the great variation in the terminology used to distinguish between the benefits from resource development which 9Ib__i_,d p. 190. J-0]:.eslie A. Miller, “The Battle That Squanders Millions ," m __n_i_ng P__o__et, Kay 1t, 1919. llfluffnan, 32. £13., pp. 176-185. I ‘ .28.. can be measured in monetary terms and those benefits to which dollars cannot be assigned. The Presidents' Water Resource Policy Commission used "intangibles" as if it were synonymous with public or social values.12 This definition is questioned by several writers in view of the fact that intangible benefits are not limited to the general public. Private beneficiaries may also profit from resource values which cannot be assigned a monetary value. Kelso added refinement to the terms of direct and indirect benefits by relating direct benefits to microeconomic analysis -- gains and losses to individual firms -- and indirect value to macroeconomic analysis -— gains and losses to the economy as a whole. Factors mea- surable in monetary terms are referred to as tangible.13 Wantrup added still further refinement by classifying the benefits as having either market value or extra—market value, the latter referring t0 those benefits currently outside the existing market structure.1h He noted that recreational benefits are most prominent among the extra- market values for which monetary measures are being sought. The approach c=<>mmonly used is to calculate the amount of money the public spends in Pursuit of a particular type of recreation which suggests that the tangible 12Presidents Water Resource Policy Commission, Report of 92. 333., Vol. I, p. 87. 1315.15. Kelso, "Economic Criteria for Conservation and Development Of Public Lands", Proceedings of the Western Farm Economic Association, Davis, California, flune 2535,1953: pp. 85:97. 1ltSJI. Ciriacy-R'antrup, Resource Conservation; Economics and Policies, University of California—Hess, BerREley, I952, pp. {SB-2%. -29- cost of a sport is indicative of its intangible value. The new different definitions and practices being used by the var- ious federal agencies caused the Federal Inter-Agency River Basin Committee to appoint a Subcommittee on Benefits and Costs in 19h6 to formulate mutually acceptable principles and procedures for determining benefits and costs for water resource projects.15 The work by this Committee is the most comprehensive treatment of the principles involved in apprais- ing the economic feasibility of resource developments and the measurement of benefits and costs both in terms of principles and in relation to specific types of projects. The Committee was given the responsibility to work out a uniform system of economic analysis which would eliminate the differences in procedures used by the various agencies. This work resulted from the general recognition by many people working in resource Valuation of the neceSSity of a common basis of project analysis for evaluation in terms of river basin programs and national resource policy. Economics _o_f_ Project Evaluation There are my writings available on various aspects of the economics of resource evaluation. The primary concern of most workers in this area, though interrelated, may be grouped into these general categories: (1) Studies related to the principles and assumptions of benefit-cost nan. lie; (2) Definitions and standards for understanding and utilizing the benefit-cost principles and criteria; (3) Practices in applying these ”Federal Inter-Agency River Basin Committee, Proposed Practices £25 W £52.12 Si 3219!. 3.292 32233322: Washingtm: 559% . -30- principles, criteria concepts and definitions to various problem situa- tions and project purposes. Numerous writers have contributed to this field of study, but the following works are recognized as being perhaps the most comprehensive and significant: S. V. Ciriacy - Wantrup, Resource Conservation, Economics and Policies (1952); Roy H. Huffman, Irrigation Development and Public water Policy (1953); V. Webster Johnson and Raleigh Barlowe, Land Problems and Policies (1956); and Otto Eckstein,;flater Reg §5mmce Development, Cambridge, Harvard University Press, 1958. There is wide agreement among these and other writers that the conditions necessary for optimum use of resources and the purpose of economic analysis include; (1) meeting an existing or potential demand, (2) being designed to maximize net benefits, (3) determining the least costly of alternative means; and ()4) development of projects in order of? their relative desirability. The central principle of optimum de- Velopment expressed by this group is summarized by this statement by JOhnson and Barlowe: "There is no single method for land development emu: conservation, and assuming that some type of project is socially just- ifiable, the analysis of costs and benefits is particularly significant iJIproject formulation and design. The aim is to develop a program.that ‘Will make for the most effective use of the resources, and do so in a manner that will maximize the excess of benefits over costs. Thus, one Very significant purpose of an economic evaluation is to determine the combination of resources and the degree of development which will result in maximum net benefits. In doing this, it is necessary to consider alternative uses for funds and to choose between types of projects and .31.. their sizes for different purposes” .16 There is little disagreement among writers on the definitions of direct benefits and costs as presented by the Subcommittee on Benefits and Costs of the Federal Inter-Agency River Basin Committee in 1950 'direct costs are the value of the goods and services needed for the es- tablishment, maintenance, and operation of the project and to make the immediate products of the project available for use or sale (associated costs) ... direct benefits are the value of the immediate products and services for which the direct costs are incurred".17 The principal research work on evaluation has involved the complex problem of secondary benefits and costs of water-use projects. Signifi- cant examples of these works are that of u. M. Kelso,18 s. v. Ciriacy- 19 Hantrup, Otto Eckstein.20 Numerous other scientists have made valuable contributions to the understanding of this complex problem. Kelso clari- fied the issue that returns from investment of public funds are matters of 'real' output rather than ”money” output when he wrote that "increased *i 16V. Webster Johnson and Raleigh Barlowe, Land Problems and Policies, New York: McGraw-Hill Book Company, Inc. 19514, P. 139. 1792. 933., p. 7. 18mm. Kelso, ”Evaluation of Secondary Benefits of Water-Use Projects,‘r Report No. 1, Committee 93 t_h_e_ Economics at; Water Resource Development, 1953, PP- h9 0 ”SJ. Ciriacy—Wantrup, "The Role of Benefit-Cost Analysis in Public Resource Investment”, Report No. 3, Comittee 93 the Economics pf Water Resource Development, 1953, pp. 18-2 . 20Otto Eckstein, Water Resource Development, Harvard University Press, Cambridge, Chapter vn';"I§SB"'"'"‘. “ .32.. national real income, however it may be caused, may arise as a result of a project from am one of 3, and only 3, conditions:21 (1) Employed resources may be shifted from less to more productive uses. Productiveness may be increased in a number of ways such as giving resources a better and more plentiful supply of complimentary resources to work with; or resources may be used to stimulate more efficient use of other resources; or production may be shifted to improved qualities and types of goods, the test of the latter being that people will pay more for them. (2) Employed resources may be employed closer to desirable capacity. Under this condition production units may be operated at a more efficient scale or interrelated processes may be better coordinated or operation of the units may be made steadier and part time use of them be reduced. (3) Otherwise unemployed resources may be employed as a result of the developments occasioned by the proj ects. Kelso also clarified the issues of benefits ”stemming from“ and ILin-- duced by" projects. Whereas the Sub-Comittee onABenefits and costs as others apparently thought of these as being additional effects of the project, Kelso reasoned that this results in double counting of the benefits, i.e. benefits "stemming from” the project are a form of “supply effects", and that benefits "induced by- the project are a form oi" 'demandeffects". He pointed out that it is entirely appropriate to value some of the benefits on the one side of the circle and some on the other, so long as the same benefits are not measured on both sides of the circle. 2:l-Kelse, 22. 23:, p. 52. -33- Theoretical and emphirical work of most writers on the subject of secondary benefits leads the majority to the predominate questions; (a) whether such benefits do in fact exist in a significant amount except in periods of depression (idle resources), and (b) whether they can be measured with any degree of accuracy if, in fact, they do exist. Wan- trup stated "when I now try to draw conclusions from this analysis of secondary benefits and costs, I am forced to suggest that all classes of secondary net benefits be dropped from consideration if the problem area is project selection and when one is dealing with the national accoun ".22 Wantrup recognized that in spite of weaknesses in the bene- fit-cost analysis a major advantage for its use in resource evaluation was "that of stimulus to scientific understanding". ‘Huffman pointed out that the benefit-cost analysis is similar to the marginal analysis of equating marginal costs and marginal returns, and that it is little different from determination of financial feasibility. He adds that "whenever extra-market gains and losses are considered, it I>ecomes obvious that projects and programs may be justified at some other level than the marginal point in benefit-cost analysis. Obviously, he Says, "if extra market values are judged to be of sufficient importance, Public'expenditures for water resource development can be carried to the Point where the over-all benefit-cost ratio for a project is l to l, or it can be carried beyond that point inasmuch as the benefit-cost ratio includes only market values".23 22Wantrup, op. cit., p. 27. 23Huffman, 92. §_i_t_., p. 199. «rd 1.1 -3u- Regarding prices to use in the benefit-cost analysis, most writers agree with the Subcommittee that "all things considered, the most satis- factory approach would result from using prices estimated as they are eXpected to be at the time when costs are incurred and benefits received".2)+ Regan and Greenshields took a somewhat different point of view as they wrote "forecasts of the dollar prices actually expected to prevail at the timeof benefit and cost occurrence are not necessarily essential. It is more important that the projections reflect the relative worth of goods and services under the resource employment conditions expected during the period of installation and operation of the project. With a high average level of resource employment expected to prevail throughout the life of a project, primary emphasis would be on the "real" values of the goods and services as measured by their purchasing power. Under Such conditions, proper evaluation of projects requires comparisons of the purchasing power of the goods and services invested with that of the goods and services produced, each measured at time of occurrence. Enphasis on real values eliminates secular trends in the general Price level as a factor in evaluation. The expectation of inflationary Price trends should have little or no significance in determining justi- fication from a public viewpoint. With stable levels of resource employ- Inent, the expectation of deflationary price trends would also be elim- inated from consideration in analyzing economic justification".25 21:92. 93-1., 1). 19. 25 M. M. Regan and E. L. Greenshields, "Benefit-Cost Analysis of Resource Development Programs", Journal of Farm Economics, XXJCIII, No. 1+, Part II (November, 1951), pp. 856-78. -35. It is not clear in the statement by Regan and Greenshields, or by other writers that have suggested a similar point of view, that project- ing real values is am easier than estimating future price levels. The elimination of the effects of inflation and deflation from the evaluation process is recognized by all economist, however, as being highly desirable. Dr. Foltz argues for the necessity of public investment during the downward phase of a business cycle. He states, 'investments in develop- mental projects such as water resource program are of the nature of autonomous investments with powerful induced investment potentials. Investments of a developmental variety such as water resource projects will have a greater potential for induced investment than other types. The most favorable model would be one in which the initial investment is undertaken during a period of widespread unemployment and low utilization of resources. Finally, to make the model still more favorable, the full impact of production of the area occurs at a time when there is severe scarcity of agricultural commodities, so that the effect is to keep prices from becoming inflationary. Under these most favorable assumptions, the benefits of irrigation would be maxinfimed' .26 Wantrup took exception to this thesis when he wrote "historically and theoretically the evidence does not support that the induced invest- ment argument offers no convincing reason that an autonomous public investment in water resource development is economically sound if its own benefit-cost ratio is smaller than unity or smaller than that of some 26W.E. Folz, ”Water Resources and Economic Development of the West", Report No. 0, Committee on 213 Economics of Water Resource Development, December, 1951—‘753, pp. 56': "'"""‘"" ""'" _"‘"" I“ l a, ..-, ~"AI~ I ...! NI haw.“ -\ . \e“ In 0 up q 4'. I» r Ill 4 I I" -35- alternative public investment in other sectors of the economy.27 He concluded that theory of market forms is more useful than.business cycle theory, especially that of the Keynesian variety. Most scholars of economic theory argue that it should.not be assumed that public investment is never justified in a full employment situation.and always justified in a situation of underemployment of resources. The extent of the inflationary effects of public investment is related to the manner in which the public secures the funds it uses. If autonomous public investment is financed through taxation or borrowing from consumers, the inflationary effects will be greatly reduced. If the government borrows the money from banks rather than consumers of goods and services, the inflationary effect may be large. One of the latest works on economics of project evaluation is by Eckstein.28 He sketches the theoretical framework of benefit-cost analy- sis and the selection of the appropriate criterion; the theory of the competitive economy and its implications for evaluation of public projects. Ebkstein considers the competitive model adequate as the primary base for theoretical framework, subject to possible modifications under such con- ditions as increasing returns, immobility of labor, unemployment, income distribution impacts and imperfections in the capital market affecting the allocation of resources over time. 270p. Cit., pp. 61-66. 28Otto Eckstein,‘water Resource Development: The Economics of Project Evaluation, Cambridge: Harvard University-PFEs§I5I§SBT"TEis work‘has a complementary relationship with the authors joint work with John.Kristilla, Multiple-Purposes River*Development. .37- Eckstein is in agreement with Barlowe and others in use of benefit- cost analysis for measuring relative rather than absolute value. He is of the opinion that alternative costs are not a substitute for market values of benefits unless they are certain to be undertaken; that the total Federal cost is usually the most appropriate form of budget re- straint and the benefit-cost ratio the preferable criterion. He argues that projects should be formulated so as to maximize benefits within given budget restraints, with the benefit from the marginal dollar of expenditure the same for all projects and purposes. The most controversial issue in Dr. Ecksteins' treatise is his treatment of interest. He favors treating risk through a premium.allow- once in the interest rate and feels that the depreciation rate should be geared to the true rate of capital absolescence. He proposed a comp promise in handling interest in which a relatively low interest rate would be used in evaluation and design, but only projects constructed having sufficiently high benefit-cost ratios to assure an average rate of return as high as in the sources from which resources are diverted. Since the passage of the Flood Control.Act of 1936, with the proviso that a project is justified I'... if the benefits to whomsoever they'may accrue are in excess of the estimated costs ..." there have been numerous attempts to put a price tag on intangibles and secondary benefits in project evaluation. This has stimulated studies to develop methods of identifying and measuring these benefits. However, there is wide di- vergences of opinion between economic purists who want to judge projects entirely in economic terms and others who would assign important social political and other noneeconomic value considerations to proposed i. “5“ - bio-I [mi-c: I-‘I w“ I ssge‘,1 ".. " -38.. developments. An excellent example of an attempt to measure project intangibles in monetary terms is Clawsons' work on the value of outdoor recreation.” Whereas, Hammond is critical of benefit-cost analysis as it applies to all water resource projects and as being second best for water pollution control projects. He concludes that "water-pollution control projects, as a class, do not lend themselves tohbenefit-cost analysis'.3o His arguments presented for neglecting economic efficiency considerations in justifying pollution-control projects are: (l) The costs are not onerous compared with other items of nmnicipal expenditure; and, (2) Water my be underpriced and, therefore, it is rational to welcome any measure that increases its price. He concludes that cost-sharing arrange- ments between cities would lead to a more economical solution to the pollution-control problem. Perhaps the "Chicago" group is most notably for concentrating effic- iency criteria and marketfitheory analysis to water resource evaluation. Hirshleifer, et. al., find it difficult to take intangible and secondary benefits seriously. In their view, intangible benefits are usually "in- vented" ... ”they seldom have any important weight and usually are . dragged in to serve purpose of securing the real magnitudes of benefits 29Marion Clawson, "Methods of Measuring the Demand for and Value of Outdoor Recreation”, Washington, D.C., Resources £93- 212 Future, $22., RFR Reprint Ser. 10, 1959. 30R.J. Hammond, Benefit-Cost is and Water Pollution Control, Food Research Instituté, Sanford fifiversityz—Em, I955. h ' V :r 7’ h 'r 1 . ,‘l .39.. and costs ...“.31 Johnson and Barlowe, after pointing out the serious effect of deficiencies in file present framework of economic investigations summar- izes with this statement ... I'Deficiencies in the program of economic investigations in connection with Federal resource projects cannot be overcome merely by developing uniform interagency standards at benefit- cost analysis at the individual project level. Coordination and improve- ment of individual project investigations would indeed be helpful, particu- larly in appraising individual project and alternative choices of operation in a particular situation. But needed also is an expanded investigative framework under which individual project investigations will be complemen- tsted by coordinated investigations of the public-welfare aspects of these projects from regional and national perspectives".32 Huffman stated ”evaluation procedures must include a combination of economic analysis and value judgment. The individuals who contend that the evaluation of public resource development can be handled entirely within a precise economic formula are as open to criticism as those who would ignore economic analysis and depend on judgment alone".33 Bunce stated “The economics of today must deal with individual economics, social economics and the basic causes of divergence between individual and social net returns if it is to be useful in the formulation of social policies. Similarly, social planning should make use of relationships revealed 31H:i.rshleifer, J . , J .C. De Haven, and J .W. Milliman, Water Supply, University of Chicago Press, Chicago, 1960. 32Johnson and Barlowe, 93. cit., pp. MIL-1115. 33Huffman, 22. 333., p. 215. -L0- through theoretical analyses in order to develop the most reasonable policies".3h Kuznets has this to say regarding adequacy of market economics to deal with processes of economic growth: "The field of study (economic growth) has been plagued by looseness in definitions, unusual scarcity of data, and measures of strangely held opinions. If we are to deal adequately with processes of economic growth, processes of long-term change in which the very technological, demographic and social frameworks are also changing -- and in ways that decidedly affect the operation of eco- nomic forces proper -—- it is inevitable that we (economists) venture into fields beyond those recognized in recent decades as the province of proper economics. For the study of the economic growth of nations, it is impera- tive that we become more familiar with.findings in those related social disciplines that can help us understand population growth patterns, the nature and forces in technological change, the factors that determine the characteristics and trends in political institutions and, generalky, patterns of behavior of human beings --— partly as a biological species, partly as social animals. Effective work in this field necessarily calls for a shift from market economics to political and social economy".35 Agricultural Development in_Less Developed Countries The increased role of the United States in international affairs BhArthur C. Bunce, Economics of Soil Conservation, The Iowa State Press, Ames, Iowa, 19h2, pp. 155-133. 3SSimon Kuznets, "Economic Growth and Income Inequality", The American Economic Review, March, 1955, p. 25. -h1- in recent years has resulted in new stimulus to both theoretical and empirical studies on economic growth and development. Many American colleges and universities have committed themselves, and have often pro- vided the leadership in marshalling human and technical resources to bear on socio-economic problems in less developed nations. Many of these studies have resulted as side effects from the primary assignments of personnel in these countries in their special fields of interest. Several writers have had a primary aim of exploring the possible role of water resource development and related projects as major vehicles for developing agricul- ture and the rural communities. Only those studies of particular signif- icance to this study are listed here. One of the most notable contributions to this field is Nurkses' work in 1953. He outlined many of the problems and means of capital formations in under developed countries. He contended that the amount of capital available for investment may be augmented.by'utilizing the saving poten- tial concealed in rural underemployment.36 Mellor concluded that the crucial roles of agriculture in early stages of economic development are: ”(1) providing agricultural produc- tion to meet the growth in demand generated by a growing population and rising per capita income”; (2) providing the labor force for expansion of the nonpfarm.sector of the economy; and, (3) providing capital for economic transformation”.37 He argued also that any official encouragement 36Ragnor Nurkse, Problems of Ca ital Formation in Underdevelqped Countries, Oxford Unive mity Press, E955. 37John'W. Heller, "The Process of Agricultural Development in Low- Inccme Countries", Journal gf Farm Economics, August, 1962, pp. 700-716. 4:2- to development of agriculture in poor countries requires (1) identifying the scarce and the plentiful factors of production, and (2) setting the stage to use the former sparingly while fully exploiting the latter. Bot- tomley questions Mellors' thesis that agricultural labor in underdeveloped countries is plentiful nor is land scarce as far as more extensive culti- vation with existing techniques is concerned. He states that ”it is the arrangements under which the land is held that creates the illusion of scarcity“ .38 Work in Pakistan and India by Bredo led him to conclude that develop- ment of agriculture is essential at an early stage in order to feed the population and finance the development of the country. Rapid economic progress requires interdependence carefully planned of industry and agri- culture. He states "if economic development programs are to be supported, there must be an increase in foreign exchange earnings, as well as an in- crease in national income to provide a broader tax base".39 From studies by Neumark in Africa, he concluded that one of the great needs is a link between the so-called subsistence sector and the rest of the economy. He believes that the missing link is transport and marketing facilities, and that capital spent on technical improvement of production may be largely wasted unless transportation and marketing facilities are made available simultaneously.” Walker believes that the "break--through'I 38Anthorw Bottomley, "Cements on The Progress of Agricultural Develop- ment in Low-Income Countries", Journal Farm Economics, Vol. 15, No. 2, May, 19631 PP. 11146-11148. 39William Bredo, "Rural Industrilization for Agricultural Development" , Journal Farm Economics, December, 1959, Vol. ILI, No. 5, pp. 1332-1th. ’408.D. Neumark, "Some Economic Development Problems of African Agri- culture”, Journal Farm Economics, February, 1959, pp. h3-50. I e o ‘. ... pun-II . null ‘ . -00 i P" Pa 33116 i":l: ““u 4:3- requires concentration upon exports, and if such a policy is successful increased inter-regional trade and specialization will follow.“ I Paste criticizes studies made in less developed countries for being oriented to macro-malys is when actually "it is shown that lucrative opportunities for raising productivity and employing labor more fruit- fully exist right on the farm". He also noted that lack of planning for efficient use of water on farms has been especially evident in irrigation projects. Most often overlooked is provision for showing farmers how to reorganize their farms from dryland systems to one under irrigationJ‘2 Nervik and Hughjoo argue against contemporaries who contend that mechanization of farms upset the prevailing social system and forces mam' farmers off the land. They contend rather that -- ”farmers leave the fun because of low farm incomes and rising living costs, and therefore, more farmers have been displaced by oxen plows than tractors" .l‘3 Brewster maintains that the dominant striving of peoplegof all cul- tures is status aspirations. He states, "this status aspiration function can become a powerful generator of economic growth if it is guided by the belief that proficiency in economic as well as non-economic employment is the appropriate way of earning an even higher valuation of himself in h3-David Walker, A Note on the Economic Development of East African Agriculture”, Journal Farm Economics, February, 1959, pp. 871-878. 142Jerome K. Pasta, "The Role of Farm'Management in Underdeveloped Countries} Journal Farm Economics, Vol. ILIII, August, 1961, pp. 606-625. 1t30ttor Nervik and E. Hughjoo, "Mechanization in Underdeveloped Countries”, Journal Farm Economics, Vol. ILIII, August, 1961 pp. 663-666. ’fl‘n «Ao- nut. van! ‘ Q O f"; “Hair 'V 'oiV‘Uu I .‘.‘::;rc‘.e ‘- , 0.. .a _ 4-3:. EV“ and nu v: ‘ ”his ' "Nu-av c '9"; .... 1:1 ~33 of “19:, t] .358 ‘9 " e-nerz _hh- his own eyes and in the eyes of others”.M4 In conclusion, emphasis might well be placed on the point that water resource development by itself provides no guarantee of economic develop- ment. This involves the interplay of numerous factors but probably no factor can play a more strategic role in less developed countries than development of natural resources. The intangible and secondary effects from project developments in these countries are usually much greater than from a similar project in a highly developed country. It often acts as the catalyst that sets in motion the whole stream of economic, social economic development. This has not been intended as an exhaustive review of all possible fields of interest in resource development and causes of economic growth. Rather, this selection of articles presented here is intended to show the general areas of interest in these fields of study and some problems that this has brought out. tAt best, it may be taken as a cross-section of interest displayed in the whole problem.area that seems to follow evaluation and development of resources. References to other outstanding contributions to specific topics under discussion are made throughout the text of this study. thohn'H. Brewster, "Beliefs, Values, and Economic Development", Journa1.Farm Economics, Vol. ILIII, November, 1961, pp. 779-812. CHAPTER III APPRAISAL OF CRITERIA AND EVALUATION PROCEDURES The Need For; Project Evaluation The development of water resources is a major area of government policy in most every country. The investment decisions made in this area are necessarily collective ones; the very nature of the resources invol- ved largely preclude the private sector from making adequate investments in water resources. However, the principles which determine individual action are equally applicable to public decisions. Some water resource project activities will not be voluntarily under- taken in a predominately free-enterprise society even though private in- vestment funds may be plentiful. These activities are those which do not produce an easily marketable product, (i.e. flood control) or where some common resource is involved that cannot be uniquely claimed by any of its several users. Net gains are available to an economy in transferring resources into these types of activities, and only a government has the incentive to do it; only a government can operate them without direct receipts from sale of output or be able to organize the resources in the face of adverse institutional arrangements. Application of carefully chosen criteria and evaluation techniques is necessary to avoid favorable decisions on non-economic investments; namely, those investments which earn a collective return less than they would in alternative investments. To fail to undertake a justified 1. ”y .311 ““2 “is. _la" :1. ‘ §~la 3 ‘, 0"..- .‘9m ~l o- I I. A! 5' a. 4:6- project -- an investment which contributes as much or more to national income as the resources involved would in the absence of the project -- is, of course, no lesser evil than decreasing income and welfare by undesirable projects. In addition to choosing between the I'good" and."bad" projects, the decision-makers must strive to obtain the benefits at the least cost. This will maximize the return to the government investment in the sense that all benefits which can be economically obtained are available with the smallest possible reduction in alternative activities. Application of this basic concept in the selection of the type and the scale of pro- jects is especially important in less developed countries as economic consequences to overall development of the economy is more serious when investment funds are extremely limited relative to the alternative investment opportunities. In addition to providing decision-makers with a means to judge the feasibility of proposed investments, decisions on water resource develop- ments must reflect the philosophies, attitudes and values of their society. These are usually embedded in the goals of government policy, and the effects of water resource development on the realization of these goals is not an inconsequential consideration. The actual decisionpmaking must be responsive to both.the positive economic facts and the realization of these goals. Evaluation of water resource projects is needed to meet basic loan requirements of the financing agencies. is a primary criterion, all agen- cies require that projects be economically and technically sound. This requirement forces the borrowing country to have projects evaluated in mm: he "‘5'"; cu” 'u- 3‘. 'I 'I 3‘ .. . h‘ \‘1 .ln.."_‘ ””001.‘ '3‘“ w #0:. _ 1‘; ‘u, exun 'v'“ ‘ l n 3"»: -h7- sufficient detail to meet the financial requirements of the loaning agency.1 For instance, the Foreign.Assistance Act of 1961 specified that in exercising the authority granted to the President of the United States to make loans and grants to promote the development of less developed countries a major criteria would be ”the economic and technical soundness of the activity financed". The soundness of a project is to be judged by the following general criteria: (1) Technica1.Soundness A project is considered technically feasible if: (a).All pertinent aspects of the project have been taken into account in the analysis; (b) The planned construction or procurement conform to accepted engineering standards and practice, suitably modified in light of the actual stage of development of the applicant country, and its projected rate of development; (c) The estimated cost of the project is as low as any other reasonably available alternate which would produce the intended results. (2) Economic Soundness A project will be considered economically sound if the resulting economic benefits over a stated period will equal or exceed the total costs of construction, maintenance and operation over the same period. ‘With respect to water or related resource projects, the 1961 USAID Appropriation Act requires that the computation of benefits and costs for 1Basic conditions and requirements for loans by each of the major financing agencies are summarized in.Appendix Table I. FIE. #53150 II It! ‘ 0 an. Q4 - II 1’ C‘I “\U n II I.‘ . I“ ...... V‘ s I Rue . . . u m “'0" ”It QML .. . ‘ N‘.‘ that “\Ib \ Mus. v ‘1 ID; lea-GNNM‘I ' c * v 1 ~ all! I "In lea 'u} \ | M I. as \ u a u 48-- new flood control, reclamation or other water or related land resource projects or programs be made by the methods prescribed in Circular A-h? of the United States Bureau of the Budget, and that the standards and criteria of that Circular be met.2 This includes all projects involving water supply, regulation or improvement of waterways, hydro-electric power, and development and improvement of ports and harbors. The International Bank for Reconstruction and Development (IBED) and its affiliate, the International Development Association, also makes loans only for projects which are technically and economically sound. That is, for projects which, in their judgment, can be effectively exe- cuted and operated and will result in benefits which will justify the investment and strengthen the economy of the particular country. The evaluation procedures and criteria specified by the Bureau of the Budget, 14:7, and the more recent document, of course, meet requirements and standards expected by the IBRD although there is no official directive specifying that these specific references be used. Status of Develo ment of Evaluation Procedures __33 rise DeveTSpecYCountries Procedures developed for evaluation of water resource projects in West Pakistan, Guinea or Uruguay are in a state of infancy compared with 2Circular No. A-h7, Bureau of the Budget, Executive Office of the President, December 31, 1952 has been superseded by Senate Document No. 97, Policies, Standards, and Procedures in the Formulation, Evaluation", and Review of PIans For Use and Devefi mEEt—BT Water and Related Land . Resources, prepared Fn'der the—direction 31' the Presidents' Water Esource Council, 1962. mint 7 C myth-«3: Hawaii} ‘ . "Me 4 'u'uie a. . . .A . a D ‘.J ...-‘5 I‘ll,‘! .lfi c ...... J6. t: are ,I‘a‘ &. "“4. u. Fl: A“ ..- w . " U was... 6’; a. “v AIS C Isl up I; 4:9- those in this country; This situation is apparently true for many other countries of the world.3 Interviews conducted in these countries by the author with officials of appropriate government agencies indicated little knowledge of procedures for benefit—cost analysis, cost allocations or other basic resource evaluation concepts. Of the personnel interviewed who were working on resource development, few were found that had any formal training in agricultural economics. It was apparent that trained personnel, regardless of their field, are employed mostly in administra- tive positions of their governments. All.known reclamation and irrigation projects planned in these countries in recent years have had some kind of economic analysis. For irrigation projects, this usually consisted of very rough estimates of anticipated increases in gross crop value. Estimates of farm costs are made occasionally but in no case was there reliable data on farm.produc- tion costs. Financial analysis involving repayment of project costs have been entirely neglected except for some very vague discussion and gener- alities. In.the majority of cases, the water users were not expected to repay project costs except for operation and maintenance. Decisions to construct some projects were justified on the basis of need for additional food, or because of ”political promises" to do something for a particular area. V 1 Projects in these countries financed by loans and grants from for- eign sources require evaluation as a condition for obtaining the foreign 3s.v. Ciriacy-Wantrup, "The Role of Benefit-Cost Analysis in Public Resource Development", Re ort fig, 3 on Benefit-Cost Analysis by Committee on the Economics of water .esourcé‘bevelopment, December,fil9SE:'p. I3. r; ‘n 'va- A: I i,“ -50- exchange component of the investment costs. The services of foreign con- sultants are usually engaged to conduct the feasibility studies. The evaluation procedures used in the feasibility studies of all projects known to have been financed from.foreign sources in West Pakistan, Guinea and Uruguay were patterned after those used by government agencies in the united States. .As far as could be determined, similar procedures were used also on the studies that had been completed.by non-United States con- sultants. Because evaluation procedures have reached a higher professional level in the Uhited States than elsewhere, and'because this is the major source of funds for financing projects, it can be expected that procedures similar to those used by united States government agencies will be used for evaluating potential projects in less developed countries. Adequacy gf_Economic Analysis gf_Projects _ig less Developed Countries Officials of the IBRD, USAID and IDB in Hashington, D.C., and the FAD in.Rome indicated that most feasibility studies submitted in support of project financing have been inadequate. For instance, during a two- year period, 1961-62, the IERD received feasibility reports on 26 irri- gation projects for which loans were requested by governments of various less developed countries. Of these, only 1h were recommended for approval by the Bank. Consideration of loans on seven projects were deferred for further study and five projects were rejected. The feasibility studies on five projects were undertaken by irrigation authorities of the borrow- ing countries and 21 by consultants under contractural arrangements. There was positive indication that the feasibility studies performed by _a .51- consultants were of better quality than those received directly'from local irrigation authorities. One IBRD official stated that there was no case where the Bank was satisfied with the agricultural, financial and administrative aspects of the project studies submitted to them.h This was true also for projects that had actually been approved by the Bank for financing. It was reported that in the majority of cases, the treatment of these aspects was COD! sidered seriously inadequate. Results of interviews with officials of the other financing agencies, including the FAQ in Rome, supported the statements of the IBRD officials. The reasons given for inadequate feasibility studies and sub-standard performances in evaluating potential projects in less developed countries were summarized as follows: (1) Almost invariably, engineers have primary responsibility for the feasibility studies of irrigation and related water resource projects. Too often their attention has been focused on the means of achieving the purpose of the project instead of on the purpose itself. They are so closely concerned with the works of the project that they have concentra- ted on these to the exclusion of the non-engineering aspects. There is a tendency to overlook the fact that an irrigation project is for irri- gation and productive use of the land, rather than the construction of a dam and a distribution and drainage system alone. (2) There is a general lack of coordination of the evaluation among hm. Reid, Chief, Agriculture Division, International Bank for Reconstruction and.Development,'Washington, D.C. i‘. , .0. \I; 75* 5? I." I .52- the investigation team, and frequently engineers, agriculturalists and agricultural economists are not closely associated in the feasibility study. In some instances, the agricultural and economic studies had been carried out independently of the engineering studies. An agriculturist, just as an economist or an engineer, tends to look at a project too much from his own viewpoint. It is necessary for these viewpoints to be coordinated so that the project can be assessed as an entity. (3) Inadequate agricultural and related data. This deficiency was an unanimous criticism of most feasibility studies. Reliable statistics from which to adequately assess present production of a project area or the production of similar areas already developed under irrigation were lacking. The most serious inadequacies pertained to lack of data regard- ing soils, agronomy, water duties, markets and economics of farm.production. (h) Inadequate coverage of institutional problems which could ser- iously prohibit attainment of reasonable standards of agricultural produc- tion and operation of the works after the project is constructed. (5) Inadequate coverage and consideration of different economic systems and the imbalances in existing resource use. There was insuffic- ient consideration of the effect on successful completion and operation of a project due to lack of technical know-how, managerial experience and capital. Too little consideration was given to administrative Opera- tion and management of a project after it was constructed, and to agricul- tural development programs necessary to attain the projected production levels 0 -53.. Current Evaluation Practices in the United States Development 95 Concepts and Practices The development of prevailing concepts and practices in water re- source evaluation in the United States has been an evolutionary process. While benefit-cost analysis antidates the Flood Control Act of 1936, that act laid down the proviso that a project is justified " -- if the ben- efits to whomsoever they may accrue are in excess of the estimated costs --".5 It was not until 1950, however, that specified procedures and recommendations were spelled out in a formal statement by the government. This reference is commonly referred to as the "Green Book" and has been revised since 1950. 0 ‘ The Bureau of the Budget Circular, A447, was issued in December, 1952. This circular reflected the Inter-Agency Comittee considerations, and contained some modification of proposed practices of the Green Book. The work of the 1950 subcommittee was modified in 1951i and its name changed to Inter-Agency Connnittee on Water Resource with a Subcommittee on Evaluation.Standards. ti considerable part of the work of this Subcommit- tee was that of reviewing the 1950 report to revise and reissue such changes as necessary to reflect views current to that time. Circular A-h? was revised in November 19514, and again in May 1960, but never 18811“. The Presidents' message of February 23, 1961 to Congress on natural Seubcomnittee on Benefits and Costs, "Proposed Practices for Econ- omic Analysis of River Basin Projects". are ort to the Federal Inter- Agggcy River Basin Committee, May, 1950, WasEEEgton-DI, Kemed, E, 19 . .55.. resources stated that he was "instructing the Budget Director, in con- sultation with the Departments and agencies concerned -—" to reevaluate current standards for appraising the feasibility of water resource pro- jects". In response to this directive, the Budget Bureau proceeded to estab- lish a panel of independent consultants, arrange for interagency partici- pation in the reevaluation of standards, and draft a proposed executive order defining responsibilities with respect to natural resources and public works.6 A.report was submitted to the Bureau of Budget in June, 1961 and made available to the federal agencies. On April 21, 1961, a letter signed by 22 Senators was sent to the Secretary of Interior, with copies to other selected resource agencies, citing the inadequacies of Circular A—h7, the need for new policies and directives, and new administrative arrangements. On October 6, 1961, the President sent a memorandum to the Secre- taries of Interior, Agriculture, Health, Education and Welfare and.Army requesting them to review existing standards for the formulation and evaluation of water resource projects and to recommend any necessary changes. On May 15, 1962, the four Secretaries submitted to the Presi- dent a statement, ”Policies, Standards and Procedures in the Formulation, Evaluation and Review of Plans for Use and Deve10pment of water and Re- lated Land Resources”. This statement is commonly referred to presently as Senate Document 97. The President acknowledged the statement, and 6The panel consisted of Maynard M. Rufschmidt, Chairman; John Krutilla; and Julius Margalis. Stephen A. Harglin assisted in the pre- paration of the report of the panel. .55.. the Director of the Bureau of the Budget irmnediately rescinded A447. Though nothing really basic was changed from previous procedures by Document 97, some modifications and clarification of concepts were made. These are discussed in connection with the appraisal of current proced- ures in the next section. Differences in Evaluation Practices Among United States Agencies The objective of the Senate Subcommittee has been to develop a theoretically sound basic framework in order to provide a more systematic and consistent basis for economic analysis of projects. To this extent there has been considerable improvement and, in general, the procedures of analysis are now quite similar among the various water resource develop— ment agencies. For example, the annual benefit—cost ratio is now the criterion uniformly accepted by the United States Army Corps of Engineers, Soil Conservation Service, Bureau of Reclamation and the Inter-Agency Committee on Water Resources. In spite of efforts by the Senate Committee, however, evaluation practices vary significantly between Federal water resource agencies; thus, in some cases the recommended practices are accepted by some agen- cies and not by others. Basic differences exist in concepts, measurement methods and standards, and in the comparability of benefits and cost estimates. Certain of the difficulties result from legal and adminis- trative provisions applicable to particular programs, some have grown out of difficulties inherent in practical application, but a large portion results from the absence of an adequate framework of concepts and princi- ples. Aside from these causes for differences, a fairly substantial gap often cadets between the prescribed practices and those actually applied -So- by resource agencies in the analysis of particular projects. major differencies in practices among the agencies are noted below: gfgggglg£_Analysis The Corps of United States Army Engineers (Corps) and Soil Conservation Service (SCS) agree on a 50ayear maximum.period of analysis; the Bureau of Reclamation (BR), however, makes its studies both on a 50 and a lOO-year basis. The Bureau of the Budget (BB) recom- mends the estimated economic life or 50-year time horizon as a maximum, while the Internlgency Committee admits a period up to 100 years. Senate Document 97 recommends that the period of analysis should be the shorter of either the physical life or the economic life of the structure, facility, or improvement with 100 years normally considered for irrigation projects. Some exceptions to the 50§year maximum apparently exist for some of the agencies. The effect of the differences in the period of analysis is not independent of the treatment of salvage value or the shape of benefit and cost streams over time. Shortening of the period of analysis reduces the attractiveness of the project either by reducing the benefits or by increasing annual capital costs (via the reduced amortization period). The $08, which uses a 50-year period of analysis, has in.the past offset the detrimental effects (on project justification) of the reduced time horizon by increasing salvage values (remaining salvage productivity value). In this way they have largely nullified the effect of the 50qyear maximum for project analysis. Paigg_£§zgls_ Current price levels are used by all agencies for esti- mating project costs. The Corps use present prices in all benefits and cost projections while the BR utilizes these prices for only the power aspects of projects. 0n the other hand, long-term.price projections are ra. 35:13 ' c \- A _._9. I'd... in ‘ 5%?2.C r7 -57- employed by the $05 as well as by the BR for other benefits and costs. The variation in prices assumes more importance the greater the overlap there is in the functions of the separate agencies. Since the benefits of projects undertaken by the various agencies are of different natures the effect of this variation will vary with the importance of a particular function. That is, in some cases, current prices are reason- able predictions for future prices; however, this is perhaps less plausible for irrigation projects than elsewhere. It is not known if the Corps, for example, would use current prices if analyzing a project of strictly agricultural benefits but if so, the Corps would find larger benefits than, say, the SOS. Senate Document 97 states that prices for project evaluation should reflect the exchange values expected to prevail at the time costs are incurred and benefits accrued. Price relationships expected with a sta- bilized general price level and under relatively full employment conditions of the economy (projected normal prices) should be used to estimate benefits and deferred costs. In the absence of actual or simulated market prices for products and services, the cost of alternative means that would most likely be utilized to provide the equivalent products or services will be used as benefits. 'When a projects' output is sufficient to affect prices, a price mid-point between "with” and ”without" prices is recom- mended as a basis for estimating project benefits. This will tend to in- crease benefit—cost ratios compared to a system.in which project benefits are valued at market value. Investment 223223 For all agencies, investment costs cover all costs subsequent to authorization of a project necessary to establish that “a! A h .58- project. {Except for the SOS, interest during construction is included. Both the BR and the Corps reduce this cost by the salvage value of the project; the Corps' practice in this regard is much more conservative than that of the BR. The Interquency Committee on'flater Resources specifically recomp mends that investment costs include any induced adverse effects whether compensated or'not. 0n the other hand, the BB spell out that these costs include everything connected with the program regardless of whether they are incurred by the Federal government or not. This latter defini- tion is somewhat more broad than any currently in use. The differences existing in practice can be traced to treatment of specific items such as interest during construction and allowance for salvage. Senate Document 97 emphasizes that 'both national and local employb ment conditions are to be reflected in the benefit-cost ratio". For in- stance, in the case of local unemployment this is done by increasing bene- fits by the amount of unutilized or under utilized resources. This concept has particular significance in evaluation.of projects in less developed countries where labor resources, in particular, are frequently chronically unemployed or under employed. If resources are otherwise unemployed, their opportunity cost is zero, and payments to laborers in constructing a project may simply involve a redistribution of income for the total economy rather than an economic cost. If treated as increased benefits rather than reduced project costs, the benefit-cost ratio is affected in a conservative direction. It would be more desirable to have the benefit-cost ratio represent the economic costs and returns to the nation or country as recommended by "i "no - \ . ..- n... , ”.- - .4- VI av. -59- the Interquency Committee. It appears that the main reason for including costs for unemployed resources as benefits rather than reduced project costs is because the cost figures represents needed appropriations for the project. Interest Rates for Converting Cost and Variable Benefit Streams The in- terest rate to be used in plan formulation and evaluation for discounting future benefits and costs to a common time basis is specified by Senate Docu- ment 9? to be based on the average rate of interest payable by the Treasury on interest-bearing securities of 15 years or more. However, the rate struc- tures employed by the various agencies are more complex. For converting vari- able future cost streams to annual costs interest rates now used are as follows: Corps of Engineers: 1. Federal Costs 2 7/8 Percent 2. NonéFederal Government Costs 2%>- h% Percent 3. NoneFederal Private Costs h - 6 Percent h. Land Costs 5 - 6 Percent Soil Conservation Service: Cost Eligible for Assistance under P.L. 1018 2% Percent Other Costs (Non—Federal, Public A long-term rate not less and Private) than Federal rate. Interagenqy Committee on water Resources: Projected long-term rates, -_' approximated by average yield of long term government bonds plus risk premium. Bureau of Reclamation 2 7/8 Percent Bureau of the Budget The average rate payable on outstanding treasury obliga- tions at the end of the fiscal year preceeding calculations which upon issue had maturities not more than 12 months longer or shorter than the economic life of the project. (Same dis- count rate as used for benefits). —60- The average rate for all costs by the Corps will be greater than that used or recommended by any other agency. Thus, the Corps' rate will tend to reduce the annual equivalent costs relative to other agencies. This different treatment of the various types of costs by the Corps is not understandable because it makes economic sense only if it can be shown that the variability of the several cost estimates is such that the rate differential represents a risk premium. The impact of interest rate differentials as affected by the time shape of the benefit and cost streams is discussed in more detail in Chapter IV, but is briefly summarized here. The higher interest rate discriminates against those projects with increasing benefit streams over time; the lower rate against those with benefit streams declining over time. Since most benefit streams are assumed to increase to a maximum.(capacity) and then stabilize, the practice of the Corps and the $03 will generally result in lower annual equivalent benefits than that of the BR. Whether or not a historic average rate of interest is economically sound or meaningful is discussed later. Discount rates for amortizing investment for each agency are the interest rates Specified above. The implication of this difference in rates is not independent of the time horizon. Annual amortization costs will be higher, the higher the interest rate, the nearer the time horizon, or the lower the salvage value. Since the BR uses the longest time hori- zon and the lowest interest rates, it will, other things equal, have the lowest amortization costs. The 808 while using a somewhat higher effective interest rate, reduces the amortization cost by inflating salvage values. Finally, the Corps will have the highest amortization costs due to the 50-year time horizon, as well as higher interest rates. 0-“ I I‘ ar!‘ ~ '- vuvw than ‘i‘: .- ‘ . (I) {'2' 'Q -61- Allowance For Operation and Maintenance Costs These costs are to include all those costs not considered initial investment costs; 1.9. all charges necessary for the operation and full utilization of the project once it is installed. There appears to be no variation among the several agencies in the manner in.which they say they define costs. The only differences that do exist are with respect to the prices used for actual prediction of these costs. The SCS and the BR use projected future prices. The IntereAgency Committee and Senate Document 97 suggested that these costs be estimated in terms of long-range projected prices. Salvage Values of Land and Major Structures Both the Corps and the BR restrict salvage to the present worth of nonpproject uses of the in- vestment.7 The Corps, however, includes only land, while the BR includes the junk value of the major structures or facilities. The SCS nmkes additional allowances of "remaining salvage productivity value", which apparently reflects expectant (discount) value of net benefits for the remaining (projected) life of the project.8 The differences in treatment of salvage values is essentially to change the time horizon. In effect, the 803's practice is to use a substantially longer time horizon than the Corps or the BR. The Interquen y Committee on'Water Resources and Sen- ate Document 97 suggest a procedure similar to that of the BR. Allowance in Egg of 11x33 The SCS makes no allowance in lieu of taxes as it assumes no land is taken from the tax rolls. The implicit assumption here is apparently that the resources invested by the 7Present'worth of a sum of money in the future will be higher, the lower the compound interest rate and the nearer the time horizon. 8Described in the Soil Conservation Service Handbook. -62- government would yield no tax revenue if put to alternative uses. The BR likewise makes no allowance except in the case of hydropower, where it includes at least part of the taxes foregone on the alternative source of power. The Corps does likewise. Thus, there is no basic difference in philosophy; only private steam.power installations foregone are con! sidered sources of tax losses, and since the SCS is not developing power it neglects taxes completely. The Interquenqy Committee recommends that adjustments be made representing the difference between government services required with the project and its alternatives, if any; The BB corrects by the change. in state and local tax revenues less changes in costs of services. Sen- ate Resolution lh8 is the most comprehensive. It considers increased state and local taxes as costs and increased services as benefits; in addition, it recommends tax revenue foregone on the private alternative to be entered as a cost. Further analysis of taxes foregone as a cost is presented in Chapter IV. Benefits Egg-m. Increased @cultural Production The Corps and the SCS both measure these benefits as increases in net farm income. The BR also adds indirect benefits (increases in profits of local business) and public benefits (increases in settlement opportunities). The recommenda- tions of the Interquen y Committee on water Resources as well as the BB are quite consistent with the practices of the Corps and the SCS. The BB will always find.1arger benefits from increased agricultural production than will the gross benefits as they represent the return to resources outside agriculture, on presumably mObile resources which have a positive opportunity cost not vastly different than the return l-" v. - w- l ,.: ..S . an“ " Lu‘ut U" a... .9,- - uhv‘ ‘4 v g . "O’ $3.125 a re: a . ,.;-::.". "fi..~ 0;, I a°~ . I}: aggf. it: «n m 8 '4": the -63- it earns in the project area. If gross secondary costs were taken into account by the ER, their results would not be very different from.the other agencies. Benefits From.Increased Use Qf_Nonagricultural Property, The BR applies a 2 7/8 percent interest rate to the estimated increase in the market value of land for residential use.9 The Corps estimates such benefits by applying the current average rate of return associated with the activity concerned to the increased capital values. Alternatively, they estimate the actual increase in earnings where observable. The SCS uses a rate between h and 6 percent to convert increases in capital values to an annual basis. As a result, the BR will, other things equal, have the lowest benefits in this area. There is no basic inconsistency :UIthe measurement objective of these agencies and.the only significant factor is the difference in the interest rate used. Flood Damage Benefits we Corps estimates these benefits as the reduction in land and.property damage (restoration costs or reduced value) plus net damage to crops, plus damage to commerce and trade due to its interruption. The SCS procedure is the same, while the ER is known to have adjusted the estimates of the Corps by their assumptions regarding price levels. The Inter-Agency Committee is slightly more comprehensive in their recommendat ions, while the BR and Senate Document 97 suggests explicit allowance for reduced loss of life. Navigation Benefits The Corps projects these benefits as savings 9Basic on the average rate on outstanding U.S. Government interest bearing marketable securities running for 15 years or more. The recent determination by the Treasury Department in August 1962 has fixed the average at 2 7/8 percent. W“:fl°" Dov Ub'.‘ - < . many-x have“. - . -6u- over the cheapest alternative means of transport plus recreational value produced plus enhancement of land value from.use of dredged spoil. The BR uses the estimates made by the Corps after adjusting the price level projections. The Inter-Agency Committee and Senate Document 97 use similar procedures to those currently followed by the CrOps. Once again, the only difference results from.price level projections. Hater Sapply and Pollution Control Benefits All agencies measure these benefits by the cost of the most economical alternative, and where no such alternative exists the benefits are the value of the additional water to the consumer or the reduction in maintenance and operating costs fer pollution control. The Inter-Agency Committee recommends much the same. 0n.pollution control, they suggest that benefits include the cost of the most economical alternative, the decrease in cost of water treat- ment, and increased use of water due to increased quality and quantity. The first and second items are non-additive because it would be double- counting to first include the cost of the most likely alternative; and secondly, to include benefits for decreased downstream water treatment from either the project or the alternative. Fewer Benefits The BR accepts either the cost of the most likely alternative or the value of the power to users, whichever is lower, as the benefit of this function. The Corps uses estimates developed by the Federal Power Commission, where benefits are considered to be the costs of the most likely alternative, usually privately-financed steam power. The BB and Inter-Agency Committee recommend.practices followed ‘by the BR. Thus, significant differences between agencies will depend on how they determine the costs of the alternative and to the fact that -65- the BR includes secondary and indirect benefits when determining the value of the power to the consumer. Fish, Wildlife, 529. Recreational Benefits None of the agencies have developed sophisticated methods for estimating these benefits. For the most part, rough approximations are made and, hence, vary considerably from one agency to another. The United States Fish and Wildlife Service estimates these benefits for the Corps. The BR estimates fish and wild- life benefits by the expenditures of sportsmen on those activities and also on the gross market value of fish and fur for coxmnercial purposes. The benefits for small boat harbors are based upon the net return of similar craft on a for-hire basis, and other recreational benefits are computed on a value per recreation man—day parameter. The SCS estimates benefits only from commercial fishing and hunting and these are measured in the same way as the benefits from increased utilization of nonagricul— tural property. Co arison of Pu oses, and Financin Requgements Z a or inancigg Igencies Seven United States and international lending agencies, operating more than a dozen programs, directly or indirectly help finance exports and overseas investments. Their purposes, sources of funds and particular emphasis differ, ranging from the Export-Inmort Bank whose main function is to stimulate United States exports, to the International Monetary Fund which helps countries deal with foreign exchange and balance of payments problems. But all of them provide loans or other financial facilities which create expanded trade and increased economic activity in less developed countries. There is wide variation in the financing and ~66- administrative requirements of these agencies as shown in the brief summary below: (1) MM 3:25. This bank is the principal United States export financing agency. The promotion of exports, by direct lending or by guaranteeing loans from private capital sources, is its main.business. In the short—term field, EXIM Bank stands behind the Foreign Credit Insurance Association (FCIA), which provides exporters with comprehensive insurance covering commercial and political risks. For medium-term (1-5 years) transactions, which usually involve individual shipments or items of equipment, it offers both direct financing under its Exporter Credit Program and guarantees in conjunction.with commercial bank financ- ing. Longer term loans are made for larger projects, usually in conjunc- tion'with other lending agencies as part of an economic stabilization or development program. EXIM's credit facilities tend to follow commer- cial practices as to terms, but are nonprecourse. That is, the exporter is not liable in case of default by the importer. Minimum interest rate of 5 B/h percent is charged and fees vary by market and terms of credit. The period of maturity may vary from 8 to more than 20 years for develop- ment loans according to the nature of project. (2) égeggy for International.Development (AID). This agency administers the United States foreign economic assistance programs, a substantial part of which is in the form of development loans. There- fore; most AID loans are in countries where, despite the merits of the undertaking, conventional repayment terms are not feasible. For example, where foreign exchange prospects limit debt-servicing capacity. Loans are made to both governments and private enterprises, and -67- normally must be related to the development plans or needs of the country concerned. Terms of loans may be more liberal than for any of the other agencies. The period of maturity may be up to ho years, including a ten- year grace period, and with interest charges of 3/h to 1 percent. Based on.the nature of the project, however, interest rates up to 5 3/h-percent are charged. A recent directive by USAID specified that the limiting time of 50 years will be applied to all water and related water resource projects. (3) International Bank for Reconstruction and Development (IBRD). The "Ubrld Bank" lends for economic development, mainly to member govern- ments. "Infrastructive" projects such as electric power, transportation facilities and irrigation predominate. The period of loans averages about 15 years but some are made up to 25 years. The Bank obtains its funds principally through the sale of bonds, and interest rates on its loans reflect those prevailing in the capital markets where the bonds are sold. Currently, the interest rate is 5 3/h percent, plus 1 percent for commissions and i-percent for administrative costs. (h) International Development Association (IDA). This agency was established in 1960 to meet the problem of financing sound, much-needed economic development projects in countries too poor to assume the foreign exchange debt on the conventional terms required by IBRD. The IDA supplements IBRD by lending for very long periods, up to 50 years with 10 years grace period and graduated amortization. Neminal interest rates or "service charges" of 3/h to 1 percent are assessed. The IDA cannot lend when private capital is available on reasonable terms. (5) Inter-American Development Bank (ADB). This, as its name , \./ -68- indicates, is a regional institution. The United States and all Latin American countries except Cuba are members. Loans may be granted for 10 to 20 years in ”ordinary" operations and for 10 to 50 years in "special“ operations. Depending on the situation, irrigation projects may qualify as a special operation. Currently, interest rates of 5 3/L percent are charged for "ordinary operations" and about h percent for 'special operations", repayable in currency of the borrower. IADB lends to both governments and private enterprise; procurement must normally be in.member countries. IADB also administers, on behalf of the United States, the Social Progress Trust Fund. Its projects are mainly for economic overhead and social development, water supply, sewerage, housing, and land settlement and reform.programs. Periods of maturity range from 15 to 30 years with interest rates of 1% percent to 2 B/h percent, payable in local currency plus a 3/h to 1 percent per annum service charge, payable in dollars. Samma£y|8tatement Considerable differences in procedures and practices to evaluate projects among the various agencies are apparent. It is obvious that the fate of a particular project may be determined by use of techniques acceptable to one agency but not another. The divergencies are due, in.the main, to differences in assumptions regarding secondary benefits, interest rates, prices, salvage values, taxes and time periods. The benefit-cost ratios computed by techniques of different agencies for the same project obviously would not be comparable nor would they mean the same thing. The interpretation of these ratios‘would be even more -69— contorted if they referred to different projects. Differences in financial requirements among the various financing agencies are also considerable. A.particular project may be financially feasible under terms of one agency but not another. The various financing agencies have distinctive purposes and.spheres of activity which tend to supplement and complement each other; however, it is possible for a partic- ular project to qualify for financing from several agencies. Seldom do the project investigators know the exact source of financing prior to conducting the feasibility study. Consequently, various assumptions re- garding interest rates, time period, salvage value, etc. must be made which frequently do not conform to the requirements of a particular agenqy from which the loan is requested. This adds to variations in the results of feasibility studies and is a major source of contention to the project investigators. It may be concluded that if benefit-cost analysis is to provide meaningful comparative guides for decision making, evaluation practices need to be uniformly applied. Uniform standards across all projects and functions may not always be practical but would facilitate within and between agency'reviews as well as public investment comparisons. While each of the agencies may firmly believe their own financing requirements and regulations are sound, there is no apparent reason for large differ- ences for similar type projects. It is left for Chapter IV, the more rigorous and complete discussion of the implications of differences in evaluation practices, alternative recommendations, considerations, and development of a consistent set of criteria and evaluation procedures for economic evaluation of projects in under developed countries. —-—.—-w———— CHAPTER IV CONCEPTUAL FRAEEWORK FOR EVALUATION OF WATER RESOURCES PROJECTS Thg’Criterion The evaluation of a water resource project is simply an attempt to determine all the beneficial effects to be expected, wherever they may arise, and conversely to consider all the nonbeneficial aspects. To systematically compare the many diverse services and costs connected with a project one must attach monetary values; that is, to attempt to assess in money the value to a nation of services produced and resources used. Hence, we may consider benefits analogous to the gross sales or receipts of a private business and commodities given up by a Nation in lieu of project services. The manner of comparing these two values is the criter- ion of evaluation, and if the benefits to whomsoever they may accrue are in excess of the estimated costs the project is economically justified. The presently accepted format for economic analysis of investment in water resource development is the benefit-cost analysis. But the broad phrasing of the sole criterion for project evaluation of “if the benefits to whomsoever they accrue are in the escess of the estimated costs" can lead to several interpretations of the manner in which the overall criter- ion for project justification can be applied in addition to the convene tional benefit-cost ratio. Assuming an evaluation of intangibles is avoided, it may be more .- a! ' ix -- o. ‘i‘. v . . U 3?: z I l ‘\A-. 'c- a v .'O‘ -.a, ‘5‘! A '~~.v 5‘: ', I.-. ‘;-‘ “a: U. A- I -71- desirable to summarize a project in terms of the net tangible benefits an- ticipated; i.e., total tangible benefits minus total costs, or in terms of the rate of return on invested capital, which is simply the ratio of annual tangible benefits minus annual operating costs to the invested capital. If it is desirable to rank projects such that they will be undertaken in the optimal order, it is clear that the net benefit criterion will prove unsatisfactory since it gives no consideration to costs. The pro- ject with the greatest net tangible benefits may have the greatest costs as well, and if the same costs were distributed among several smaller projects where the average net benefits per dollar of costs were higher, the net benefits from the set of smaller projects will be larger and consequently more socially desirable. Ranking by the rate of return criterion ensures that the present value (all future benefits and costs discounted back to current values) of available resources is maximized; that is, no substitution in the order of projects could improve the present value of current resources. The project with the highest rate of return on invested capital would be placed first in the ordering. On the other hand, the benefit-cost ratio criterion tends to maximize the returns on all costs, not just the capital costs. For a given set of projects, the ranking accorded by the rate of return criterion is, in general, different from.benefit-cost; the difference being due to the differences in the amount of capital relative to other inputs. The bene- fit-cost criterion is biased towards projects where the amount of capital costs to operating costs is higher. This is because the higher the capital costs relative to a given sum of net benefits the lower the rate of return whereas the sum.of all costs (capital and operating) is constant in the benefit-cost analysis. Asp!- ‘ u t‘ n‘. ..I 1"“. ““J .72- maximization of the present value of currently available resources is recognized as the optimal means of allocating these resources among competing users, one use being investment for future income; if present value is maximized, there exists no way of reallocating the resources currently available such that the welfare of the society can be improved in goods and services (for given relative prices and income distribution). However, it has been argued that if capital rationing exists, the benefit- cost ratio criterion becomes the optimum solution.1 The argument is that the government behaves as if it were subject to capital rationing; that is, it cannot obtain.all of the capital at the going rate of interest which it can profitably invest. Given this restraint, one considers not only specific merits of a project but also the extent to which it will jeopardize future projects by consuming funds for operating costs which therefore cannot be invested. The capital rationing case may be strong- est if one assumes a fixed budget for water resources development over time,2 which will eventually be totally exhausted by operating costs, leaving no funds for investment, regardless of the attractiveness of the 10tto Eckstein,‘Water Resource Development, Harvard University Press, Cambridge, 1958, Chapter III. 2This situation is representative of conditions in most less developed countries where 3 or 5 year development plans call for expen- diture of fixed sums of national budgets. . fih: ...- :94 0&- a; 'uv w- w in. .73- project.3 Therefore, benefit-cost analysis which favors projects characterized by low operating costs will be superior to the rate of return criterion as the former aims to maximize total benefits on.§ll expenditures on water resources, both present and future. If it is, in fact, necessary to rank the projects (which implies capital rationing) the benefit-cost ratio analysis is desirable. If water resource investments are not restrained by capital rationing, the choice between the alternative criteria becomes an academic question. Application of either criterion can satisfy the legal requirement that benefits exceed costs, and the only question is the economic feasibility of a project; no ranking is required. Further- more, any project which has a benefit-cost ratio of unity or greater, evaluated at the relevant interest rate, will have a rate of return equal to or greater than that rate of interest. The proof of this follows: 3There is an implied assumption in this argument that needs em- phasis. If benefit-cost ratio analysis is to maximize the return on total government expenditure, it can do so only if the relevant interest rate does not change over time. Suppose that the interest rate relevant to the project is five percent; that is the rate used to determine the capital intensity of a project, given the trans- formation function between capital goods and operating goods and relative prices of those goods. Since the procedure outlined by Eckstein maximizes the rate of return on all expenditures in water resources, it assumes that the interest rate relevant for transforma- tion between future capital goods and future operating goods will also be five percent, in this example. Whereas with the present value method we allocate only current goods, with the current interest rate; the benefit-cost ratio method essentially allocates future goods (between capital and non-capital uses) by the current interest rate. The same assumption is also implicit concerning relative prices of capital and non-capital goods; they will be the same in the future as today. Neither of these assumptions are necessary to the present value analysis. -714- Let K equal capital costs, B and Ct equal benefits and operating t costs, respectively, in year t, and r equal the interest rate. The present value of the benefit stream is T 520 6+5" T K+c<_:__ Ct t; t : O (I + r) the present value of costs is the benefit-cost ratio is T 333% T K42, c t : 0 (I f r)b , which is unchanged if converted to annual equivalents. If the ratio equals unity, then T T Z Bt =K+ 2. Ct :o W t=0 rm” If the rate of return is also equal to r, then T By rearranging terms, we see that: T T T .:EE B -’C = :EE:; B :3 :EE::. Gt 3 ‘K t: afirt t=o TIL—”rt t=0 (fr—1m and T T 2% fiat‘“ fit‘fh Hence, the two criteria converge and any project admissible by the requirement that the benefit-cost ratio be unity or greater will also be admissible by the parallel requirement that the rate of return be equal or greater than the interest rate used. Thus, if capital rationing is not a reality, the importance of this criterion is vastly reduced; other . . Mm“; Uan"‘ 3% all? ‘ A. ’Q q- is .‘u. .. (3"3“ UH“; a VV. 9» 61.. ‘ -75.. considerations must dictate the actual method selected. In the United States, there is fairly clear evidence that Congress has been willing to appropriate funds for projects of a very marginal nature and it is not unlikely that funds are available for projects not economically justified.h This is true also of the agencies which finance projects in less developed countries, and of the governments of the less developed countries in cases where they have provided their own financing.s Several projects in West Pakistan and in Uruguay have been built in advance of economic feasibility studies. The bases for justification in these instances were to promote national unity by "doing something” for isolated areas and for other humanitarian purposes. If we can expect Congress, international financing and other govern- ments to continue to authorize and appropriate funds to all justified projects, it matters but little whether we use the benefit-cost ratio or the rate of return method, either can be designed for simple interpreta- tion. The straight-forward rate of return method (where the discount rate which equates the present value of net benefits to capital costs, hFor instance, data on 13 existing projects by the Corps of Engineers showed benefit-cost ratios varying from 1.07 to 3.17 (Appendix Table 2). Only one benefit-cost ratio was in excess of 3, and five were less than 1.25. Similar data on projects by the Bureau of Reclamation and Soil Con- servation Service show numerous cases where funds have been appropriated with benefit-cost ratios of less than 1.1. Considering also that benefits are overestimated on these projects, as argued later, because of unduly low interest rates, the correction for which would further reduce the benefit-cost ratio of projects already executed, raises question that the assumption of capital rationing is realistic. 5As stated by officials of the IBRD and USAID, funds have been ad- vanced for projects which they felt were of a very marginal nature; 1.e. benefit-cost ratios of barely 1.0. 0.1:! O-- i l'.‘ ¥§ I“ ’71- (P '1- -76- also a present value) does have the advantage that the computed rate of return is the maximum interest rate which leaves the project barely justified. The formula would be: m :EE B§ - Cg : K given Bt, Ct, and K solve for r. t: +rt This method would satisfy criteria of all international financing agencies. Regardless of the interest rate charged by each agency at the time of the loan or if the rate changes between the time of evaluation and actual decisions, no additional calculations are required to bring the analysis up—toadate. Further, no adjustments in criteria are needed regardless of the agencies from which loans are sought. 0n the other hand, the ratio of the net discounted benefits to the capital cost is convenient in that, like the benefit-cost ratio, any rates of unity or higher just- ifies the project (at the assumed interest rate).7 The merits of both alternatives can be combined if that ratio is computed for several inter- est rates in the expected range of the relevant rate at the time of the decisionpmaking. This is recommended as the most desirable method of summarizing the merits of a given project for subsequent financing from several alternative agencies each with different rates of interest and other criteria. 7Here the formulation suggested is the ratio of the value of the net benefits discounted by the accepted interest rate to the value of the capital investment. T This ratio is greater than 45 B - C t = {E + rst K’ one only if the net benefits are positive. we“; fit.“ ‘ {1‘1 “y‘ 7‘" 3.6;; -77- Care must be made in interpolation of the rate of return for project design. Different rates of return are likely to characterize varying sizes of a project. It would be erroneous to attempt to design the project to maximize the rate of return unless that rate coincides with the relevant interest rate. Failing to expand the project beyond the point of maximum rate of return, if greater than the interest rate, results in additional investment foregone even though that increment will earn a return higher than the alternative use of the capital (as reflected in the interest rate). The project should be designed to equate the rate of return on the last increment of investment to the interest rate. Any increment to the project where net discounted benefits exceed costs is a superior use of resources than is presumably available elsewhere. ‘222 Economics gleenefits The benefits of any water resources project are a result of the pre- sumed lower price and the increased consumption to the project output. This is evident from the well established theory that the quantity deman- ded of any particular good or service increases as the price declines, other things equal. Abstractly, these benefits can be rigorously defined and in most cases quite closely approximated in actual practice for water resource projects. In order to do so, however, it is necessary to intro- duce the concept of consumer surplus. . Let us take a hypothetical demand function relating the quantity'of X that will be purchased in the market and the price of that commodity. This function may be depicted as Dx in.Figure I. For lower relative prices of X1, larger quantities are purchased and consumed. -78— Price Px2 \ PX2 Per Unit \ le C 7 A PXl ]\\\\\‘\.Dx D Xl Quantity'X Figure I The consumer satisfactions will be maximized at a quantity equal to X1 for the price le. Relative to prices of other goods, the satisfactions from the last unit of I are just sufficient to offset the losses in satisfaction offered by not expending that amount on other goods. For amounts of X greater than X1, the satisfactions of the marginal unit decline relative to those of other goods, and conversely for smaller amounts. The amounts of X between zero and.Xl are extra-marginal units, and satisfaction offered by each is greater than the satisfaction that could have been obtained by the marginal amounts of other goods foregone. 4A smaller quantity will be consumed if the relative price of X was Pxé, or higher than le. The difference between the price line, le, and the demand schedule, Dx, represents the consumer surplus gained by the individual because he is able to buy and consume varying quantities of X. If, on the other hand, he were offered the opportunity of buying X1 23 none at all of X, he would be willing to pay a price higher than le per unit. This is true because the sum of the satisfactions foregone by consuming 221x (total value equivalent to the area bounded .sq‘ {‘3 I M‘N‘ (vow v 83, Mi '5. :51 p) L) -79- by ABCOD) is greater than the satisfactions realized by consuming other goods, equal to the area ACOD. The consumer surplus, then, is the area ABC, and is equal to the difference between the maximum amount the individual would pay for the quantity X1 where he must take all or none of it, and the amount he will pay if the price is equal to le. The effect on consumer surplus of a reduction in price of commodity X is illustrated in Figure 2. If the price goes from.Px2 to le the quantity demanded increases from X2 to X1. Total satisfactions from B Price PX C A Per 2 Unit 2 X1 Quantity'X Figure 2 consuming X increases from ABCDOXZE to FABCDOXl, or by the area repre- sented by FAEXZXI. However, consumption of other goods increased by the area ACDE, and has been reduced by the area FEXZXI. Therefore, the net gain in consumer surplus is the area ACDEF. If, for example, sz represents the cost of producing electrical power by the cheapest alternative and le is the cost of hydroelectric power supply, in terms of consumer surplus, the net benefit of the power is the area ACDEF and is equal to the price differential times the quantity that would be consumed at the higher price. The gross benefit is the net benefit plus -80- the cost of producing the power or the area ODEFxl. The line Px2 is a cost line if it represents the cost of the resources required to produce a unit of power, and this cost is positive only because there are competing uses for these resources. If the power is produced, it follows that output of other commodities must be reduced, or fail to grow as fast as they otherwise would, and the height of the cost line, le, represents the value foregone in terms of these other commodities. No concept of cost other than that of alternative foregone elsewhere has any economic meaning, for if no alternatives are restricted, the resources employed must be abundant and free, and hence are not economic goods. In Figure 2, if we let le represent the cost per unit of Federal power, for example, in terms of other goods or services given up, and P12 the same for the private steam power alternative. There will be net benefits to the power project, only if the resources required to produce a given amount of power via the project have a lower total alternative value to society than to the resources required for the private alternative source of power. The cost function summarizes con- ditions of supply in that it indicates the value to society of what has to be given up in order to have more of a specific good, while the demand function reveals what people are willing to sacrifice in terms of other goods and services, in order to consume that specific good. The area between the two functions represents the excess over what they are 'willing to give up and what they are required to give up, or consumer surplus. The pertinent question is how well, in practice, is one able to ‘ V¥ .- (D 'r1 P:Iq 5...}.1 up 3 ’} J- a C , a. 1 >4, #1 o O '1! in ‘C. m I) e h «g: -81- measure benefits as increments of consumer surplus. The alternative cost approach is widely used in evaluations of hydroelectric power, navigations, and municipal and industrial water supplies. This approach will be a fair approximation of gross benefits (consumer surplus), if the demand function, relative to quantity demand, is in- elastic. If the demand is inelastic the relative change in quantity is less than the relative change in price and, therefore, the error is minor. Alternative cost will be a fair approximation of gross consumer surplus also if the differences in project and alternative source costs are relatively small. It is only an approximation because no allowance is made for the differences in quantities demanded under the true con- ditions of project supply and alternative supply. It is common procedure in evaluating projects to predict the quantity of the good or services that will he demanded and apply both project and alternative supply prices to this single quantity. This is illustrated in Figure 3. The cost of the alternative source is considered to be the Price le _D C B Per _ . Unit . l ”"t PX2 9E FA: A L E l O G X2 Quantity'X Figure 3 area OGXZABCDE, while that of the Federal hydroelectric power plant -82- would be OGXZAFE, with ABCDEF being the net benefit. This procedure results in net benefits being overestimated by the area ABC. The correct net benefit (consumer surplus increment is the area ACDEF. If, however, Dx is very inelastic so that 12 -'X1, relative to X2, is very small com- pared with le - sz, relative to le, the overstatement will be rela- tively small. Likewise, the larger is X2, given the differences in costs, or the smaller the differences in costs, given X2, the smaller the per- centage error will be. Two distinct situations must be distinguished in using the alterna- tive cost approach to estimate benefits. First, where the project product is used as an input to the production of a final product and the price of that product is not affected by the project. This situation may characterize irrigation, especially in the United States, where the effect on the price of the agricultural products by the increased output of the project land is negligible. In this situation, it may be assumed that the benefit of the project function will be capitalized into some factor specific to the project area. Second, we can assume that the final product is produced by the project, and that the price of the project product will be less than the alternative product. Hydroelectric power, in some cases, and recreational facilities are examples of this type of product. How- ever, these benefits are not necessarily easily identifiable in terms of capitalization into some fixed factor. Application 2: Economic Concepts _ip Determinipg Project BenefitE The alternative cost approach is a reasonable approximation of the Q" -33.. gain in consumer surplus and, therefore, an acceptable method for eval- uation of power, and municipal and industrial water supply projects. The alternative costs for these water uses will not be drastically differ- ent from the project cost of each function. Conceptually, at least, the alternative cost approach can also be applied to the determination of benefits derived from flood control, irrigation and recreational facili- ties. ElggdhControl The relevant alternative cost for flood control is the cost of pro- ducing the services of the land in areas other than on the flood plain. These services may range from.providing sites for residential housing and factories to agricultural production. Let us consider a case where a change in land use occurs as a result of flood protection. If the installation of flood control makes possible the shifting of waste land into higher value urban or agricultural uses, the benefits are reflected in increased rents or land values. The flood control is essentially an investment on the land which increases its productivity for higher value uses. Since the area of land in the flood plain is fixed, the returns to the flood control investment will be capitalized into that factor. The case where flood control involves no change in land use, but will result in reduced annual damage is quite similar. An example of this is a city partially located in the flood plain. The costs of pro- ducing the services offered by the land in the flood plain cannot be greater than alternative sources of those services elsewhere. Frequent flooding, which increases the cost of residential housing will result in If!” 1.. p n ... e::£pfi‘ i (at "qu . '9A‘I‘Ec -V‘V ' ‘l‘; ‘51 "an ‘JL 3“» ‘b-m “ r __J . AI- ‘ ‘ ' ‘N‘ .‘I. .v- ..., v.- ... m“, . \nn. : . ..p I... -8h- lower land values in the flood plain, so that the total cost is con- sistent with the cheapest alternative. Reduction of the flooding will increase the rents to the flooded lands, as it reduces the other costs of production but not the cost from.a1ternative sources. Because land is a fixed factor it is able to capture the benefits accruing from flood control. The non-rent costs of production are reduced, relative to costs from alternative sources, and this differential is capitalized into the land and is reflected in the increased rental value of the flooded land. In the case of no change in land use, the entire increment to land rents represent annual benefits to flood control.8 Benefits both from reduction in damage and changed land use will be reflected in changes in the value (or rent) of land in the flood plain as a result of flood protection. Care must be exercised, however, not to include the return to additional investments made on the land which may become feasible once flood protection is available. For in- stance, if the flood plain had no use before the flood control protection, but became a residential area thereafter, only the increase in the site value would be admissable as a benefit. The increase in value attribu- table to construction of housing, street, etc., would presumably have taken place elsewhere had the project not been executed, and therefore, 8Prices of factors other than land and fixed investment in land will be determined independently of reclamation investment since these factors are sufficiently mobile to have prices determined outside the agricultural sector. The mobility assumption with respect to pricing of non land factors implies that the returns from reclamation will either be capitalized into land value or paid in the form of construc- tion charges assessed against the use of irrigation water and uses of the land protected from.flooding. . - ‘1‘ ‘i $72" c. *‘ n: g I II We!" ....15». . T‘ ..ise aYh‘wa! Mums -85- is not a flood control benefit of the project. Irrigation Irrigation is similar to flood control in that it is essentially an investment specific to a given tract of land and the benefits of the project will be reflected as increases in the capital value of that land. It is essential here also that the return to nonproject investments be excluded. It is customary in evaluating potential projects to estimate the "repayment capacity" of the water user for the cost of the investment in irrigation. This would be a good measure of the benefit of the pro- ject, representing the whole of the value of the water to the user, if it included the entire increase in net income (apart from return to non- project investment). This value is derived by determining the maximum amount the farmer could pay for a given amount of water for each soil type on his farm. If this is properly done, the amount represents the entire area under the demand curve for water, and if it were actually collected from the farmer in return for water, his net income would be no higher than before irrigation. Thus, repayment capacity calculations offer a method of estimating the total consumer surplus available for given amounts of water. However, since different.prices are charged for the same product, price discrimina- tion is implicit in the calculations, and it is necessary that price discrimination be used also in the actual allocation of the water. But if the farm consists of several soil types with different productivities, and if the water is sold at a single price, the result will be that the farmer will choose to use less water than is expected, and repayment will . Ill-ta: u .4 Hunt. .- q‘fi‘. Use- . a A . _‘ 1.. 3:5“ 4... 4.. Cd ('1? -86- fall short of expectations. This is because, at the single price of water, some of his land is of sufficiently low productivity that it is not feasible to irrigate it; whereas the repayment capacity and hence the price of the water assumes a declining schedule of water value. The maximum repayment, then, should be a good estimate of the benefits attached to irrigation development, but are very likely to be optimistic of estimates of revenue to be actually received from the water users if the water is sold at a single price per farm. Egcreation Recreation facilities provided by a water resource project fall into a category of benefits of a final product nature. Any benefits attributed to this function must be a result of the price of the project output being less than that of the alternatives. The difference in costs 0f the project product and the alternative must be known to estimate these benefits. The area bounded by these curves and the demand curve f 01‘ the product will be equal to the benefits, in terms of consumer sur- Plus, of this function of the project. There are difficulties in estimat- 1113 these two prices or costs, even though it is possible to determine the increase in use. Assuming a linear demand function, the benefit would be equal to one-half the increased use of recreational facilities times the reduction in cost (this is strictly true only if utilization was Zero before the project). The way to approximate these benefits without having explicit krlc>‘wwledge of prices is suggested. If there is a real reduction in the c 0313 of obtaining recreation by the project, it will be worth an amount e qua-1 to that reduction in order to use the nearby project reservoir -87- rather than go elsewhere for an alternative body of water. That is, one will pay a rent in order to use the reservoir. If there is com- petition for the exclusive use of the water, (e.g., frontages sold on the open market), one will be willing to pay an amount for the frontage equal to the cost reduction to him of not having to go elsewhere. The rent on a particular frontage will depend upon the extent to which other costs are less there than for the alternative, whether the alternative be on the same reservoir or on another lake. Frontage which is able to earn no rent will have no benefits, as the absence of rent indicates that it has no advantage over alternatives 3 people are indifferent between using that frontage or going elsewhere. Rents earned by frontage property, then, are a reasonable estimate the benefits to the recreational aspect of a project, however, A rough approximation A of estimation of these rents is not an easy task. may be made by determining frontage values of similar reservoirs. more sophisticated approach would be to take into account the effect °f differences in population, income, availability of substitutes, and quality of the reservoir on the price of the frontage in a cross sectional analysis. No evaluation method based upon benefits being equal to alternative 008 ts can be accepted unless identical treatment is given to interest and taxes foregone for both the project and the private alternative. That is, the government project should not be given a preferred status with respect to these items. If the alternative is privately financed, the resources it would utilize would essentially be producing two pro- duc ts. For example, in the hydroelectric power case, the private alter: ‘ sew-i V usng has u up“; 4 1‘." .o‘ —’J' VB ,. far: ‘1.“ H; Li? a. ... “a U. . (J ,4 0’ 'r1 7- 32- uy“. ‘- ; 1. (D 3!. "\ .1 -88- alternative will produce power as well as government services in the The public project will pay negligible taxes; form of tax payments. Unless tax pay- hence its output is, for practical purposes, all power. rents foregone are included as a cost of the project, or taxes are re- moved from the cost of the alternative, we will be comparing dissimilar items, and the analysis will be biased in favor of the public project. .Aliernatively, if the costs of the alternative are to be reduced by taxes to put it on a basis comparable to the non-paying Federal project, all taxes should be removed. Likewise, treatment of interest costs must be comparable for the project and the alternative. The effect on evaluation 0f projects, using different interest rates is treated in detail in the next section. Critique 9f Secondary Benefits The concept of primary benefits accruing to a water resource pro- Ject is generally obvious, even though their exact nature and the proper me thod of measuring them may be difficult to ascertain. Likewise, it is equally obvious that secondary activities in the area of the project will L18‘L‘lally be stimulated and expanded as a result of the primary resource development. The extent of the "area" cannot be precisely determined, for it is pOasible for the effects of the project to ice felt throughout the whole ecchow. If we assume that these secondary effects can be identified the question, then, becomes whether there is anything inherent in this additional commercial and industrial activity, such that the welfare of 1uation 18 increased in this particular use of pr0ject resources. If -89- so, then it is clearly desirable to include some measure of this bene- ficial aspect in determining whether to proceed with the project. Con- versely, if these secondary aspects are undesirable, there is less reason to adopt the project. The argument to this point is essentially that if net secondary benefits to the economr do exist, they should be eval- uated as carefully and precisely as primary benefits. Granted their existence, they are just as real and important to the evaluation of the project as other benefits and they should not be viewed ambiguously, as a class of benefits for which only partial consideration be granted. _S_gcondary Benefits - Practical and Analytical 171.211 The general view of secondary benefits has been to consider their net value; that is, the gross secondary benefits have to be offset by Secondary cost, the exact composition being somewhat in dispute. There are certain implication of this point of view relative to benefit-cost ratios which have not been clear, and has not been used correctly in many project evaluations. If the particular value of a benefit-cost ratio has any relevance other than whether it is greater than unity, the manner in which second- az'y' benefits are included in the calculations can lead to different For example, assume that the following estimates are determined I‘esiults. for a water resources project: Annual primary benefits $150.00 Annual primary costs 100.00 B/C ratio 1.50 Annual secondary benefits 100.00 Annual secondary costs 75.00 B/C ratio (Secondaries only) 1.33 25.00 Net annual secondary benefits It is seen that the benefit-cost ratio on the basis of primary benefits -90.. and costs is 1.5. If net secondary benefits are added to primary benefits, the ratio becomes: 150 + 25 = 1.75 '—'66"'1 Calculating in this manner 1m13t increase the benefit-cost ratio as long as there are net secondary benefits -- the opposite is true if there are net secondary costs. If the ratio is calculated by adding the gross secondary figures to the primary benefits and costs the ratio is: 150 4' 100 I 1J13 m Here the ratio is reduced from the original 1.5 and is much less than (1.113 to 1.75) using simply net secondary benefits in the ratio. In general, where the ratio of secondary benefits to secondary costs is less than the ratio of the primary estimates, then the composite ratio will be less than the latter and marked by less than the ratio using only net Secondary benefits. The extent of this divergence will depend on the SiZe of the secondary estimates relative to primary benefits and costs. For example, let the secondary benefits and costs be three times as large as before, then, the figure would be: Annual primary benefits $3150.00 Annual primary costs 100.00 B/C ratio 1.50 Annual secondary benefits 300.00 Annual secondary costs 225.00 B/C ratio (Secondaries only) 1.33 Net secondary benefits 75.00 Calculating the benefit-cost ratios we get the following results: Primary benefits only £558 = 1,50 .E. .3 .T. .3 .l Ii > rt. III flail! -91. Adding net secondary benefits 150 + 300 - 1.38 Two important points are noted. First, by increasing the relative size of secondary benefits and costs, the composite ratio for the pro- ject is reduced from 1.h3 to 1.38. Second, just adding net secondary benefits to primary benefits the ratio increases to 2.25 from the pre-- vious 1.75. It is argued here that the logical procedure is to add the additional benefits and costs to primary benefits and costs, respectively, before calculating the ratio. The results of not doing so is obvious. If pro- jects with identical total benefits and costs, but with a different division between primaries and secondaries, were being analyzed, the project with the relatively greater secondaries would produce the greater ratio where net secondary benefits are added to primary benefits. It would be ridiculous to give a higher rating to one project when it has the same overall effect on the economy. 5 The difficulty in this approach of secondarylaenefits lies in estimating the secondary costs. The question.is what allowance should be made for the net secondary benefits which would have been realized if the project resources had been used elsewhere. That is, if the project was not undertaken, we can assume that the resources intended for it would be used elsewhere in the economy, and be expected to generate pri- mary and secondary benefits in these alternative employments. Hence, the use of resources in a particular project means that the possible alter- native benefits are given up - the cost of the project in.a real sense is the value of these foregone benefits. -92- It is sometimes assumed that the value of fill foregone benefits are included in the market price of the project resource and hence, only the costs of resources in the secondary activities need be con- sidered. In other words, no allowance need be made for the foregone secondary benefits which would arise from the alternative use of the project alternatives. But, suppose the situation is reversed, what would be the price required of the alternative investment to bid these resources away from the project? Clearly, this would be determined by the value of the goods and services rendered by the project resources; essentially the gross primary benefits of the project. The pricing process is reversible, and so it would be inconsistent to claim that the market price includes the value of secondary benefits. The value of goods and services is determined by demand and supply within their relevant market. Secondary Benefits From Project in Less Developed Countries The usual explanation of how secondary benefits arise is that otherwise unemployed resources will be used or some resources will be utilized more efficiently. But under conditions of full or near full employment of resources, there is no evidence or presumption that this problem is more crucial than in the area from which project resources are drawn. That is, we do not know how inefficiently employed resources are distributed throughout the economy, if in fact such a situation does exist. Consequently, in this situation it is recommended that secondary benefits not be included in the evaluation to determine whether or not a project should be built. The question of chronic unemployed resources, such as is the usual -93.. case in less developed countries, is somewhat clearer. Here, the unemployed resources are less mobile and cannot be absorbed elsewhere over time and other public policies and programs are less appropriate and efficient. The scope for economic development is limited by the pressures for consumption and, hence, by the difficulties of providing resources for investment, by institutional framework, and by lack of skills. The unemployment or under-employment is persistent and food shortages and low levels of living are the usual case. It is contended that the secondary effects of water resource projects are relatively more important in less developed countries than, for example, in the United States. A brief discussion of the principle concepts involved follows. Most of the economic writings on the theory of resource develop- ment argue that investments in developmental projects such as water , resource programs are of the nature of autonomous investments with powerful induced investment potentials. That is, the original invest- ment in putting water on the land is only the beginning of the total investment process. Houses and farm buildings must be constructed, roads and railroad facilities must be extended into the area, additional processing plants and marketing facilities are needed, etc. and the full impact of such developments results in a total investment of many times the original one. However, the degree of induced investment which would accrue to the general economy from autonomous investments in water resource projects are greatly influenced by the true shape of the investment program and the conditions of the economy. Under certain conditions the investment may be highly beneficial but, under other -9h- conditions it may be positively harmful. This is because all autonomous investment has within itself an element of development and an element of competition as it affects the entire economy. If the competitive influences are the more pronounced the result of the investment will be deflationary in its effect. If the competitive influence is less pronounced than the developmental elements, the effect of the investment on the economy as a whole will be inflationary. Whether the deflationary effect of a sudden increase in production unp accompanied by a large autonomous investment is beneficial or not depends upon the conditions of the economy at the time the production increase occurs. If a sudden increase in production occurs at a time when auto- nomous investment is weak or even.decreasing, the increase in production and accompanying decline in prices will lead to a decrease in national income, and will even worsen an otherwise weak position of the economy. It is contended here that water resource projects in less developed «countries would, in most instances, have maximum beneficial influences orleconomic development of the economy. The initial investment occurs Ilsually'under conditions of widespread underemployment and low utili- zamion of resources. In the construction operation itself serious taompetitive effects are not as likely to be experienced.by the economy. Isabor is put to work which otherwise would be unemployed and.new skills étre learned in constructing and operating projects that would otherwise Iwemain unskilled. Resources are used which otherwise would go unused. The multiplier and accelerator effects of the investment will raise EEmployment and incomes generally without serious detriment to any Skirticular sector of the economy. Finally, new production occurs where -95- there is a scarcity of agricultural commodities so that the effect will keep prices from becoming inflationary. Under these favorable conditions, which are met, for the most part, in less developed countries, the benefits of irrigation and other water uses are maximized. Because of these conditions it is contended that greater consideration to secondary benefits from water resource projects in less developed countries is warranted, and should be included in pro- ject evaluations. This would justify government subsidization of feas- ible resource projects which are not financially feasible because of incapacities of subsistence type agriculture and inabilities of peasant farmers to assume responsibility for reimbursement of project costs 'within the limits specified by international financing institutions. Interest Rate Considerations, Implications ans Recommendations The interest rate, as a cost of capital, used in investment decisions 10 Ireflects the preference of lenders for current over future consumption, ‘the alternative uses of the resources, and risk premium.to cover varia- lrility of expected returns inherent to an investment. It fulfills two IIrimary and related roles in project evaluation, first, it distinguishes EHmong projects, with respect to the time shape of the costs and benefits amid the level of those benefits relative to capital inputs. Secondly, 10This is the concept of time preference which is defined by the reaction of an individual of perpetual life (and income stream) to a zero iIIterest rate. If that person has zero time preference, he will consume tile same amount each period, that amount being equal to his average income. 1"VI-1th positive time preference, he would borrow so as to consume more; ‘Eith negative time preference he would save. -96... within one project, the rate of interest, together with the prices of capital and operating goods and the transformation function.by which we can technically substitute one for the other, determines the level of capital intensity. It was pointed out previously while the benefit-cost analysis allows the interest rate to allocate between capital and nonpcapital expenditures within a project, it favors capital intensive projects relative to a rate of return analysis. The result is similar to a sit- 'uation where one rate is used for decisions internal to the project, 'but another and effectively lower rate for choosing among projects. Opinion among authorities on the correct interest rate is divided. Cumment practices in the United States in terms of the choice of interest :rates for project evaluation is intended to approximate the borrowing irate on long term loans. That rate, by its very nature, contains no risk premium, as lending to the Government is riskless, apart from risks of changes in the price level. As one authority indicated, the (Eovernment through its power of taxation, has unlimited claim to the resources of the society and in effect guarantees each loan with these I'esources.11 Therefore, if the Government borrowing rate represents the tilue of these resources in alternative and riskless uses, it is an in- s'I‘L‘Eficient rate for application to a project where risk is not negligible. The same principles and arguments apply whether we are comparing differ- \ llArnold Harberger, Pa rs of Joint Economic Committees, "Federal Expenditure Policy for Ec—Em'f'ono c G'r'ow—EF—a iW, . . Government Printing Office, Washington, 1957, p. 239. -97- ences in rates between the United States Government and the private markets or between different international financing agencies for pro- jects in less developed countries. One authority argues that the correct interest rate is the "social rate of time preference" of taxpayers.12 He assumes that purchasers of Government bonds are not financing water resource development, and thus it is the taxpayers' rate of time preference (estimated to be between 5 and 6 percent) which represents the real social cost of capital for this use. However, it would be most difficult to determine who is financing water resource projects, whether domestic or foreign. One could argue that tax proceeds are used partially to retire Government debt, and pay interest thereon, and that proceeds of bond sales finance ‘water resource development, the implication being that the bond rate (plus risk premium) is the relevant one for these projects. This 12Otto Eckstein, water Resource Development, Harvard University IPress, Cambridge, 1958, Chapter III. While Eckstein believes the social time preference rate of taxpayers in the U.S. to be 5 t0 6 per— tzent, he feels that this rate is unduly high for Government investment Taecause; (a) a lower rate is relevant for Government than for private (decisions; (b) Government investment is at a disadvantage relative to jprivate investment since no depreciation allowances are available on ‘the former; and (c3 private decisions are biased towards relatively Short-lived investments. He offers these arguments as a rational lfor a compromise utilizing a relatively low interest rate but adding ‘the requirement that the benefit-cost ratios be well in excess of unity. 'Phis is questioned because if imposed, this scheme would clearly cause iin increased distortion within projects as compared to among them. IInternally, the inputs of a project would be determined by the 5 or 6 IDercent interest rate, while a lower rate would be implicit in choosing Etmong projects. It is contended that if a lower interest rate is called 1‘ or, it should not be nullified by requiring a high benefit-cost ratio ‘fhich at the same time distracts the project choice relative to the input irequirements. If the 5 or 6 percent were the correct one, it should be applied unequivocally. Therefore, this compromise does not appear to be acceptable. OM 0A.. -.a -98- argument is equally difficult to maintain. It is argued here that the long term Government borrowing rate in the United States represents the value of resources in riskless uses elsewhere in the economy and thus is clearly the rate to be used in drawing resources from these uses, after taking risk into account. EEEE t of Different Interest Rates The agencies that analyze various aspects of water resource projects in the United States, and international financing agencies use different interest rates, the particular rate depending upon the agency and the individual project in question. Changes in the interest rate for analysis by benefit-cost ratios and by rates of return have significant implication for evaluation of projects. An increase in the interest rate used in evaluation of a project has the internal effect of lowering the capital intensity of that project, 'the extent depending upon the transformation function of that project. In.general, a rise in the interest rate will be accompanied by substitu- tion.within the project towards lower capital intensity, assuming that in ‘the real world we have a condition existing between fixed proportions and perfect substitutability.” 'With respect to whether benefit-cost ratio or rate of return éunalysis is used for project evaluation, the effects internal to the IJroject of changes in the interest rate are the same. This may be 13That is, assuming that this condition is more usual than having 1?ixed proportions at one extreme, where the capital intensity is not EIltered; and, at the other extreme, where operating goods and capital Eioods are perfect substitutes and a range of interest rates over which ‘there will be no change in capital intensity, but beyond a certain point ‘fhere capital is completely replaced with operating goods. -99- demonstrated as follows: If we let B equal annual equivalent benefits; 0 equal annual operating costs, K equal capital investment and aiTK equal annual interest and amortization costs, we habe B/C = B/ (O +~a1TK) for benefit—cost ratio. The denominator will be minimized (the ratio maximized), when a transfer of goods from O to K can no longer reduce total annual costs of achieving the level of benefits, and that point depending on aiT,1h the relative prices of capital and operating goods, and the transformation function between 0 and K. Any change in the in- terest rate will change aiT’ thus indicating a reallocation of resources between capital goods and operating goods. In addition, changes in the interest rate will alter the scale of the project. Likewise, the present value of a project is maximized 'when.the last increment of benefit is equal to the last unit of cost (present values). If that benefit can be had at a lower cost by trans- fers between capital and operating costs, present value is maximized. Therefore, the scale and input combinations of the project are altered ‘until the condition is satisfied. The interest rate will thus affect both scale and combination of resources used. Changes in the interest rate can also affect the ranking of projects 'when ranked by benefit-cost ratios. If projects have about equal rates of substitution on the relevant portion of the transformation function 'but widely varying degrees of capital intensity, their ranking by jpresent value analysis will be unchanged over variations in the interest irate, while the ranking by benefit-cost ratios can be completely altered lhAs determined by'project life and the interest rate. -lOO- (assuming scale of project is altered but little, otherwise the present values may also be volatile and their ranking could be altered). Consider the case of fixed proportions within the project with respect to capital and noncapital inputs, but proportions which.vary widely among projects. Apart from scale considerations, the present value of net benefits are reduced by a rise in the interest rate but the amount of capital is unchanged. Further, the present value of all projects are reduced by the same percentage, so the original ranking is preserved (assuming similar time shapes of income stream). Now consider a highly capital intensive project and one also of the opposite nature. The benefit-cost ratios will change significantly, relative to one another. With a rise in the interest rate, the ratio for the capital intensive project will drop substantially, while the ratio for the opposite type of project will be altered but little. Hence, their rankings could be easily reversed. It is conceivable that one project with a ratio above unity at one interest rate could be 'below unity atla higher rate, while a second with a ratio below that of the first at the lower interest rate would remain justified at the higher rate. However, as was pointed out above, the rankings serve to aid decision making only if capital rationing exists, in which case the ‘benefit-cost ratio rankings are preferred. Elifferent Interest Rates for Benefits and Costs The manner in.which nonuniform benefit and cost streams are re—