The proper use of Consumer Surplus for the evaluation of road projects in developing countries

Since Dupuit (Dupuit 1844) there is a consensus to measure the benefits and the willingness to pay of transport project users through the use of the concept of consumer surplus, calculated as the difference between what the users are willing to pay, which is expressed by the demand curve, and what actually are they paying. For road projects, both capacity expansions or infrastructure improvements (paving, repaving, etc.), this procedure is used as a standard, and is included in several widely available computer systems as HDM-4. This paper analyze in detail the use of consumer surplus for quantifying the benefits of transport projects and in particular distinguish between sensitive, financial and economic costs, to be taken into account. This work perform a review and critique of a number of inconsistencies that appear regularly in studies in this field and in particular in the application through the HDM-4 in which it was found that contradicts the theoretical foundations. The paper concludes with guidelines for the proper employment of the consumer surplus on the basis of appropriate microeconomic assumptions. The proper use of Consumer Surplus for the evaluation of road projects in developing countries Roberto Agosta Bruno Agosta 1Universidad Católica Argentina / AC&A, Buenos Aires, Argentina 2Massachusetts Institute of Technology / AC&A, Cambridge, Massachusetts, USA Email for correspondence: bagosta@mit.edu APPROACHES TO THE EVALUATION OF TRANSPORT PROJECTS The procedure for economic evaluation of a road project is based on the comparison of the resources utilized (construction and maintenance) with the benefits generated by the project to the economy as a whole. One of the main points that arise in this analysis is the problem of how to estimate these benefits in order to properly evaluate the project. As a first conceptual point, it is important to emphasize that any transportation project impact positively on the economic growth of the country, even if may be in different degree. In this line, it is important to properly assess the benefits of the project to correctly compare investment alternatives. The first approach is a purely economic standpoint: measure all the resources that the economy had “before” and “after” the project and calculate its difference in economic terms to estimate the value added. This process is described by Squire et al. (1975): "Whatever the nature of a project, its implementation always reduce the availability of inputs ("consumed" by the project) and increase the number of outputs ("produced" by the project). Without the project, the availability of these inputs and outputs for the rest of the economy would have been different. Examination of the difference in the availability of inputs and outputs with and without the project is the basis of the method to identify costs and benefits. " However, this procedure is difficult to realize in practice, so that from the article written by J. Dupuit in 1844 (Dupuit 1844) there is a consensus to measure these benefits and the willingness to pay of consumers, through the use of the concept of consumer surplus. PRICE, SENSIBLE COST, FINANCIAL COST AND ECONOMIC COST In the calculation of benefits from the economic point of view, indirect taxes (taxes other than income taxes) should be excluded in all prices since are additions to the economic value of the goods or services that do not represent real demand, but are just a transfer of resources between the beneficiaries of the project to the Government. There are other distortions in the pricing system such as subsidies or distortions caused by imperfect competition in some markets, which should also be excluded, since decisions on prices set by institutional forces can generate distortion in the results of the cost analysis. To solve these problems, we commonly use shadow prices defined as: Economic Cost = market price (financial cost) transferred charges (ie taxes) + effects of other distortions (ie subsidies). In the case of goods that are offered for imports and exports, prices must be taken at international prices, adding direct taxes minus costs of freight, insurance and transportation. Regarding labor costs, it must take into account the economic opportunity costs, considering the unemployment or underemployment rates. Having said this, we can argue that economic and financial costs may be very different, depending on the characteristics of the economies and may have very different behavior. We proceed analyzing the willingness to pay of consumers and it relationship with costs. THE WILLINGNESS TO PAY AND THE DEMAND CURVE As stated in the "User Benefit Analysis for Highways" manual (AASHTO 2003), "fortunately, economists have shown that people express how much they want something, demonstrating a willingness to pay for it," representing this a quantitative measure of welfare. This is the value perceived by the user that uses to make economic decision and is called sensible cost. Once is known the willingness to pay of users, we can define the demand curve as the mathematical representation of the relationship between willingness to pay (sensible cost) and the quantity demanded, keeping everything else constant. This curve has a negative slope, since quantity and price are inversely related (law of diminishing demand) primarily by the income and substitution effects. The vertical axis can be interpreted as the highest price a user or a consumer is willing to pay for an additional unit of good. The negative slope of the curve is also explained by the diminishing marginal returns of the utility of the good, as an additional unit is valued less by each consumer than the preceding unit. Since the demand curve shows the relationship between the market price of a good (willingness to pay) and the quantity demanded, it can be inferred that the areas below represent the total amounts spent or saved by the consumers. In a competitive market, consumers will pay the market price (P*), consuming an amount X*, so the consumer spending is P*X*, identified as the dark shaded area “A” in Figure 1. The net benefit for the consumers is calculated as the difference between the area below the demand curve for X* units (total area A + B) less the consumer spending (area A), represented in dark grey in Figure 1. This difference is defined as Consumer Surplus, since is the additional benefit for the consumers that were willing to pay a higher price than P* for the good, but since they are in a perfect market, they finally pay P*. To evaluate a transportation project from this approach, we should use the willingness to pay as a method to assess the benefits and the opportunity costs to measure the resources required to implement it. Changes in consumer surplus can be used in many cases to evaluate the benefits of a political decision, because they are a reasonable measure of the increase in benefits received by users. However, by definition, the calculation of changes in consumer surplus should be conducted on the demand curve, which means that prices or costs used should always reflect the willingness to pay of users in the market (sensible cost) and should not be used economic costs. SENSIBLE, FINANCIAL AND ECONOMIC COSTS IN TRANSPORT In the case of transport, to analyze any project, it is important to identify that the willingness to pay of users is given by the so-called "sensible" cost, which is the one perceived by the user to make his decision. The financial cost however is the cost actually incurred by the user (which may be different from the sensible, for example by the subjective assessment of the time as a function of the day of the week or the time of the day or because the user does not make his decision considering certain costs in which he actually incurred). Finally the economic cost is the measure of the consumption of resources of the whole economy used in transportation, Figure 1: Demand curve D P* X* Willingness to pay by the consumer