Economic rate of return

What Is Economic Rate of Return?

The Economic Rate of Return (ERR) is a measure used in capital budgeting and project evaluation to assess the profitability of an investment project from a societal or economic perspective, rather than a purely financial one. Unlike financial returns that focus on profit to a specific entity, the ERR considers all benefits and costs to an economy, including externalities and indirect effects. This makes it a crucial metric within the broader field of financial analysis for public sector projects and large-scale infrastructure developments. It provides a comprehensive view of a project's worth by accounting for the true opportunity cost of resources and the value generated for society as a whole.

History and Origin

The concept of evaluating projects based on their broader economic impact, beyond just private financial gains, has roots in the development economics of the mid-20th century. As governments and international organizations embarked on large-scale infrastructure and development initiatives, there was a growing need for a metric that could capture the total societal value of these undertakings. Economists recognized that traditional financial metrics might not adequately reflect the benefits and costs that accrue to an entire nation. The intellectual lineage of return on capital, which underpins the Economic Rate of Return, can be traced back to classical economists such as John Stuart Mill and Karl Marx, who extensively studied interest and profits in their work. More recent academic contributions have built comprehensive datasets to analyze long-term trends in rates of return across various asset classes, providing a historical context for understanding how capital generates returns within an economy.⁵, ⁶, ⁷

Key Takeaways

• The Economic Rate of Return (ERR) evaluates an investment project's profitability from a societal viewpoint, considering all economic benefits and costs.
• It is particularly vital for public sector projects, infrastructure development, and programs with significant externalities.
• ERR calculations adjust for market distortions, such as taxes and subsidies, to reflect the true economic value of inputs and outputs.
• A project is generally considered economically viable if its ERR exceeds a predetermined societal hurdle rate or the social discount rate.
• ERR helps policymakers make informed investment decisions by highlighting projects that maximize overall economic welfare.

Formula and Calculation

The calculation of the Economic Rate of Return (ERR) involves identifying and quantifying all economic benefits and costs associated with a project over its lifespan and then finding the discount rate that makes the Net Present Value (NPV) of these economic cash flow streams equal to zero. This is conceptually similar to the Internal Rate of Return (IRR), but it uses "economic" cash flows instead of "financial" cash flows. Economic cash flows often require shadow pricing to reflect the true value of resources in the absence of market distortions.

The ERR is the rate ( r ) that satisfies the following equation:

Where:

• ( B_t ) = Economic benefits in period ( t )
• ( C_t ) = Economic costs in period ( t )
• ( N ) = Project's lifespan in periods
• ( r ) = Economic Rate of Return (ERR)

This formula seeks to find the unique discount rate at which the present value of economic benefits equals the present value of economic costs.⁴

Interpreting the Economic Rate of Return

Interpreting the Economic Rate of Return involves comparing the calculated ERR with a social discount rate or a target hurdle rate established for public sector investments. If the ERR of a project is greater than this social discount rate, it suggests that the project is economically desirable, as its societal benefits outweigh its societal costs over its lifetime. Conversely, an ERR lower than the social discount rate indicates that the project may not be a beneficial use of public resources when considering the opportunity cost of capital for the economy as a whole.

The higher the ERR, the more economically attractive the project is, implying a greater net benefit to society. This metric helps policymakers prioritize public works, development initiatives, and other large-scale capital investment projects by providing a standardized way to measure their overall economic welfare contribution.

Hypothetical Example

Consider a hypothetical government project to build a new national highway. This is a significant capital investment that will span five years of construction followed by 20 years of operation.

Initial Investment (Economic Cost):

• Year 0: $100 million (land acquisition, initial design)
• Year 1: $200 million (construction phase 1)
• Year 2: $150 million (construction phase 2)
• Year 3: $100 million (construction phase 3)
• Year 4: $50 million (completion and initial operation)

Annual Economic Benefits (from Year 5 onwards for 20 years):

• Reduced travel time for commuters and commercial transport (estimated at $25 million/year in value).
• Lower vehicle operating costs due to smoother roads (estimated at $10 million/year).
• Reduced accident rates and associated healthcare costs (estimated at $5 million/year).
• Increased economic activity in previously inaccessible regions (estimated at $15 million/year).

Annual Economic Costs (from Year 5 onwards for 20 years):

• Maintenance and operational costs (estimated at $5 million/year).
• Environmental impact mitigation (estimated at $2 million/year).

To calculate the Economic Rate of Return, a cost-benefit analysis would determine the net economic cash flows for each year. For instance, in Year 5, the net economic benefit would be ($25 + $10 + $5 + $15) - ($5 + $2) = $48 million. These net cash flows would then be discounted to find the rate (ERR) at which the sum of their present value equals zero, taking into account the initial investment outlays. If this calculated ERR exceeds the national social discount rate (e.g., 8%), the highway project would be considered economically justified.

Practical Applications

The Economic Rate of Return (ERR) is widely applied in settings where the broader societal impact of investments is paramount, often in the realm of public finance and development. Governments, international development banks, and non-governmental organizations utilize ERR as a primary metric for evaluating public investment projects. For instance, the Millennium Challenge Corporation (MCC) uses ERRs derived from detailed cost-benefit analysis to assess the expected economic returns of projects in developing countries, requiring them to meet a 10 percent hurdle rate to be considered for funding.³

ERR is crucial for:

• Infrastructure Development: Evaluating projects like roads, bridges, power plants, and water supply systems, where benefits extend far beyond direct user fees to include productivity gains, health improvements, and regional development.
• Social Programs: Assessing the economic viability of education initiatives, public health campaigns, or sanitation projects by quantifying their broad societal benefits, such as a more skilled workforce or reduced healthcare burdens.
• Environmental Projects: Determining the economic return of conservation efforts, pollution control measures, or renewable energy initiatives by valuing improved environmental quality and public health.
• Policy Formulation: Informing fiscal policy and resource allocation decisions by providing a robust framework for comparing the economic efficiency of different public spending alternatives. This analysis helps ensure that public funds are directed towards initiatives that yield the greatest overall benefit to the economy.

Limitations and Criticisms

Despite its utility, the Economic Rate of Return (ERR) has several limitations and criticisms. A primary challenge lies in the quantification of economic benefits and costs, particularly those that are non-marketed or indirect, such as environmental impacts, social welfare improvements, or the value of reduced congestion. Assigning monetary values to these externalities can be subjective and prone to significant estimation errors. The choice of shadow prices, which adjust market prices for distortions like taxes and subsidies to reflect true economic values, also introduces complexity and potential for bias.

Furthermore, like the Internal Rate of Return (IRR), the ERR can suffer from issues such as multiple rates of return for projects with unconventional cash flow patterns, or it may not provide a clear ranking for mutually exclusive projects, especially when project scales differ significantly. Some critics argue that accounting rates of return, while distinct, have historically been used as proxies for economic returns, leading to potential misinterpretations due to inherent measurement errors and biases in accounting data.² The conceptual differences between accounting and economic rates of return have been a long-standing subject of academic debate.¹

The determination of an appropriate social discount rate is another contentious area, as it significantly impacts the calculated ERR and thus the viability of long-term projects. Choosing a rate that accurately reflects society's time preference and opportunity cost of capital is critical but often challenging. These factors underscore the need for careful judgment and transparent assumptions when utilizing the ERR in project evaluation.

Economic Rate of Return vs. Internal Rate of Return

While both the Economic Rate of Return (ERR) and the Internal Rate of Return (IRR) are metrics used in evaluating capital investment projects, they differ fundamentally in their perspective and the types of cash flows they consider.

The ERR focuses on the true economic impact on an entire nation or community, making it suitable for governmental or quasi-governmental project evaluation. In contrast, the IRR is a tool for private entities to determine the financial attractiveness of an investment project based on its direct financial returns. Although both calculate a discount rate that equates the present value of inflows to the present value of outflows, the inputs and underlying objectives are distinctly different.

FAQs

What is the primary difference between ERR and financial rate of return?

The primary difference lies in perspective. The Economic Rate of Return (ERR) assesses a project's profitability from a societal viewpoint, including all economic benefits and costs, such as externalities. A financial rate of return, like the Return on Investment (ROI), focuses solely on the direct financial gains and costs to the specific entity undertaking the capital investment.

Why is ERR important for public projects?

ERR is crucial for public projects because they often generate significant indirect benefits or costs that are not captured by direct financial transactions. For example, a new road might not generate direct revenue for the government, but it can lead to vast economic benefits through reduced travel times, increased trade, and job creation. ERR provides a comprehensive framework for project evaluation by considering these broader impacts, helping ensure that public funds are allocated to projects that maximize overall societal welfare.

How are externalities handled in ERR calculations?

Externalities, which are the uncompensated impacts of a project on third parties, are a key component of ERR calculations. Positive externalities (e.g., improved public health from a sanitation project) are included as economic benefits, while negative externalities (e.g., pollution from an industrial project) are included as economic costs. Economists often use various valuation techniques, such as contingent valuation or hedonic pricing, to assign monetary values to these non-market impacts when conducting a cost-benefit analysis.

Can ERR be negative?

Yes, the Economic Rate of Return can be negative. A negative ERR indicates that the total economic costs of a project outweigh its total economic benefits over its lifespan, even after considering all societal advantages. Such a project would be considered economically undesirable, suggesting that the resources could be better utilized elsewhere in the economy for a higher risk-adjusted return.