Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

ANNEX DTHE PROJECT’S IMPACT ON EMPLOYMENTAND THE OPPORTUNITY COST OF LABOURLabour, like all other project inputs, is valued in the financial analysis with the price to be paid for its use, i.e. thewage. In the economic analysis, however, we should consider the social opportunity cost of labour. The differencebetween the two values lies in the specificity of the labour market that may overrate (less frequently underrate) theopportunity cost of labour, because of specific market features: legal minimum wage, real wage rigidity, taxes andsocial contributions, subsidies, monopsony, unionisation, etc. The use of shadow wages accounts for the social costof using labour, net of all the benefits derived from additional employment and, in principle, no further assessment isnecessary of effects in secondary markets.The social opportunity cost of labour is its alternative use without the project. This means valuing the substitute useof labour time in a particular region. According to the state of the labour market, job seekers and employees willreact differently (leave previous employment, take leisure, work on the black market, etc.) and consequently thesocial opportunity cost will change.Choosing the appropriate shadow wage then means understanding the social opportunity cost of labour, whichdepends upon the peculiarity of the local labour market. This is why different types of unemployment imply differentformulas for estimating shadow wage rates (SWR).Competitive labour marketsEven under full employment and in competitive labour markets, shadow wages may differ from market wagesbecause of the social cost of displacing workers from one activity to another. These costs also lead to ‘frictional’unemployment. For example, in the Lombardy region, the unemployment rate is 3% and typically it is short-termunemployment. The latter comes mostly from the time needed to find the desired post. The labour market functionsrelatively well and only small corrections are necessary due to project-specific transport, training, relocation andother costs not captured by the wage. Even if these data are project-specific, an average can be inferred from theobservation of past projects in the same region. In the case of skilled worker or unskilled worker displacement (i.e.new and former activities are similar), the shadow wage can even be assumed equal to the financial wage. Theconversion factor used in Lombardy will be a figure very close to one (e.g. 0.95).SHADOW WAGES IN IRELANDIn 1999 the Community Support Framework Evaluation Unit (CSF Evaluation Unit, 1999) suggested the use of a shadow price for labour incost-benefit analysis in Ireland equal to the market wage. Even when a different approach is advisable, the minimum shadow wage applicable is80% of the market wage. This decision is supported by literature (e.g. Honohan 1996, Honohan 1998) and conditions of full employment (lowunemployment and immigration as labour supply). Even if several years have passed, these guidelines are still relevant and, in fact, the Irishlabour market now fits even better the conditions necessary for a conversion factor equal or near to one.Markets with informal activitiesIn some regions there is both a formal and an informal labour market, often related to urban and rural markets.Informal labour markets can exist also in an urban context with activities in construction or self-employment inmicro-business and some illegal jobs. Self-employment in the informal market comes from a lack of opportunities inthe formal sector. In these sectors, there are often no formal labour contracts, and unionisation and legal protectionof labour are weak. Public projects, in contrast, need to comply with regulations about safety, minimum wage, socialcontributions, etc. This is the reason why the formal sector usually pays higher salaries.The lost annual output m of hiring a new employee in a public project can be assessed from the average daily incomeand number of workers per day in the previous informal occupation. A conversion factor c is then necessary,especially in the rural sector. In fact, CAP (Common Agricultural Policy) keeps domestic prices for some agriculturalgoods higher than EU border prices. Hence, this conversion factor will be smaller than one. Additional costs oftransferring workers (training, relocation, etc.) z are subjected to conversion factor d, which will probably be basedon a standard conversion factor. A very simple formula is:SWR = mc + zdIt is important to remember that informal activities often hide unemployment, particularly in the rural areas.213