Agricultural Price Policy: A Practitioner's Guide to Partial-Equilibrium Analysis 9781501746376

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Agricultural Price Policy

Agricultural Price Policy A PRACTITIONER'S GUIDE TO PARTIAL-EQUILIBRIUM ANALYSIS

Isabelle Tsakok

Cornell University Press ITHACA AND LONDON

Copyright © 1990 by Isabelle Tsakok All rights reserved. Except for brief quotations in a review, this book, or parts thereof, must not be reproduced in any form without permission in writing from the publisher. For information, address Cornell University Press, 124 Roberts Place, Ithaca, New York 14850. First published 1990 by Cornell University Press. International Standard Book Number 0-8014-2363-5 (cloth) International Standard Book Number 0-8014-9596-2 (paper) Library of Congress Catalog Card Number 89-45978 Librarians: Library of Congress cataloging information appears on the last page of the book. § The paper used in this publication meets the minimum requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.48-1984.

DEDICATED TO THE MEMORY OF MY MOTHER AND MENTOR JOSEPHINE TSA WONG PO LIN

Contents

Foreword by G. Edward Schuh Preface

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1. Issues in the Analysis of Agricultural Price Policy The Levels of Price Analysis 2 A Guide to Analytical Techniques

5

2. Initial Analysis of Agricultural Price Policy Formulating the Policy Questions 9 The Domestic Price 12 Data Requirements 12 Farm-level data 13 Marketing data 14 Retail price data 16 Making Sense of the Data 17 Patterns of production 18 Patterns of consumption 22 Calculating the Average Price 24 The Border Price 27 Choosing the Appropriate Border Price 28 The Foreign Exchange Rate 30 Current and future disequilibrium 30 Interactive factors 32 The Exchange Rate Benchmark (ERB) 33 Different measures of the exchange rate benchmark 33 Calculating the shadow exchange rate 35 Advantages and disadvantages of using trade data 36 Using the shadow exchange rate 37 The Standard Conversion Factor 39 Alternative methods of conversion 39 Policy interpretation of the standard conversion factor 41

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Contents Efficiency Benchmarks for Imports, Exports, and Nontradables Adjusting the price of an import 41 Adjusting the price of an export 42 Adjusting for intermediary margins and "large" 43 country effects The efficiency benchmark for nontraded goods 44

41

3. Coefficients of Protection

48

Theoretical Framework 49 Efficiency 50 52 Efficiency Benchmarks: Border Prices and Shadow Prices Coefficients of Protection and Comparative Advantage: An Overview 53 The Nominal Protection Coefficient (NPC) 55 Adjusting the Data 57 The average domestic price 57 Adjusting the border price for imports and exports 58 Calculating Commodity-Specific NPCs 59 Calculating the NPC for maize 59 Calculating the NPC for sugarcane and sugar 62 Calculating the NPC for cotton 70 Calculating Sector-Level NPCs 77 Interpreting NPCs for Policy 77 The Effective Protection Coefficient (EPC) 79 Interpreting EPCs for Policy 80 Estimating Value Added 82 Corden and Balassa methods 83 Depreciation 84 Substitution among inputs 85 Calculating the EPC 86 Calculating the EPC for cotton 86 The relationship between NPCs and EPCs 88 Calculating the EPC for meat and beef cattle 90 95 Sector-Level Nominal and Effective Protection Coefficients The Effective Subsidy Coefficient (ESC) 95 The Producer and Consumer Subsidy Equivalents 96 (PSE and CSE) Interpreting the PSE and CSE for policy 98 Calculating the PSE and CSE for meat 98 Assessing Resource Use and Incentives 101

4. Coefficients of Comparative Advantage Calculating Shadow Prices for Primary and Intermediary Inputs Valuation of Land, Labor, and Capital 109 Identifying the next best alternative use of an input 109 Shadow price of land 109 Shadow price of labor 109

105 107

Contents Shadow price of capital: the demand approach 110 Shadow price of capital: the supply approach 110 Simplifying the valuation of inputs 113 Valuation of Services, Utilities, Credit, and Irrigation Water Shadow price of utilities 114 Shadow price of capital in formal and informal credit markets 114 Shadow price of irrigation water 116 The Domestic Resource Cost (DRC) 117 Interpreting the DRC for Policy 119 Calculating the DRC 120 The Net Economic Benefit (NEB) 126 Efficiency and the Development Process 128

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5. Market Analysis: Getting Started

131

Theoretical Framework for Market Analysis 132 The Perfect Competition Model 132 Using the Perfect Competition Model 135 The restrictive nature of the analysis 136 The scope for price interventions 137 Measuring Economic Response: Conceptual Aspects 139 Large versus Small Economies 139 From Economic Theory to Empirical Measures of Market Response 144 The Range of Specification Issues 145 Relevant time period 145 Defining a product 145 Variable versus fixed factors 146 Exact functional form 146 Relevant basic decision units and their constraints 147 Specifying a relevant sample 147 From Functional Forms to Empirical Measurement 148 Estimating parameters 149 Estimating response 150 Measuring Economic Response: Practical Aspects 151

6. Single-Market Analysis: Calculating the Impact of Price Policy Calculating the Effects of Price Policies 158 Tariffs on Imports of a Food Commodity 159 161 Government revenues Calculating the impact of a tariff 162 Efficiency 164 Welfare 164 Disaggregating the analysis 166 Spillover and feedback effects 170 Import Subsidy on a Food Commodity 170 Export Tax on an Agricultural Commodity 171

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Contents 174 Overvaluing the Domestic Currency Linkages among Markets: Multi-Market and General-Equilibrium 176 Analyses

APPENDIXES

A. Summary of Analytical Techniques, Data Requirements, and Sources B. The "Large" Country Case C. Computing Protection Coefficients and Selected Policy Consequences Using Spreadsheet Methodology on a Personal Computer D. Econometric Estimates for Use in Agricultural Analysis E. Calculating the Efficiency, Welfare, and Revenue Effects of Price Policies: Single-Market Analysis F. Price Indexes in Agricultural Price Analysis: A Note on Their Interpretation G. The Purchasing Power Parity Approach to Estimating the Equilibrium Exchange Rate Bibliography Index

183 200

229 249 266 277 288 291 299

Foreword

Economics continues to be a vital and vigorous discipline. In recent years the tools of economic analysis have been extended to cover the economics of social institutions, such as the household and marriage, and such phenomena as human fertility, crime, and suicide, topics once viewed as the proper domain of other social scientists. New perspectives on rational expectations have raised major challenges to the field of macroeconomics. Progress in quantitative techniques has made it possible to quantify general-equilibrium models for the empirical analysis of large economies and, by the use of vector autoregressive techniques, to capture relationships among economic and other variables in order to make predictions about the future in more efficient ways. In addition, economics is increasingly merging with political science into a field that is generally referred to as political economy. Analysts have discovered that there are large economic rents to be reaped when governments intervene in national economies, and those who reap such gains have a vested interest in keeping them. Thus, those interested in changing economic policy have discovered that they must first understand the political processes involved and that economics and economic policies often drive these processes. It is proper that much of the "action" in the economics profession is in these frontier areas of the discipline because that is how our knowledge expands. However, many problems in society can be analyzed with the more modest tools of the profession. These problems are faced by policymakers as they struggle to encourage their respective economies to move in the right direction, and to induce a configuration of investments that will lead to more rapid economic growth. Policymakers in both developed and developing countries have frequently xi

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ignored the precepts of basic economics. Those in developing countries in particular have stressed import-substitution industrialization policies, in the process neglecting almost all principles of comparative advantage as well as their agricultural sectors. They have cried foul about purported deleterious shifts in their external terms of trade while choosing to neglect the effects of their own policies on the domestic terms of trade. The result has been much economic wastage, slow growth in employment despite rapid increases (for a time, at least) in industrial output, inefficient industrial sectors that cannot compete in international markets, a poorly performing agricultural sector, and the sacrifice of a great deal of potential national income. At a lower but no less significant level, cost-of-production pricing policies are widespread in developing countries, as if demand simply did not matter. This problem is exacerbated by the widespread perception that estimating costs of production is something that almost anybody can do, with the result that basic elements of production theory are ignored. The petroleum shock of the 1970s had the potential to drive national policymakers to a more rational use of their natural resources. But the international community's recycling of the flood of petrodollars enabled many developing countries to avoid their day of reckoning. Instead of undertaking the major policy reforms needed with such a significant shift in their external terms of trade, they chose to borrow resources from abroad to cover the deficits in their balance of trade. The debt they accumulated during that period is today's international debt problem. It took a second external shock to bring the need for major policy reforms to a head-the significant change in U.S. monetary policy at the end of 1979. To halt a precipitous decline in the value of the U.S. dollar, the U.S. Federal Reserve stopped monetizing the large amount of debt the U.S. Treasury was issuing to cover the deficit in the U.S. federal budget. This decision led to a rapid and large rise in U.S. interest rates. In effect, the U.S. budget deficit was to be financed from savings, not from the emission of money. Because Americans save little of their earnings, many of these savings had to be attracted from abroad. The inflow of capital to the United States caused the value of the U.S. dollar to rise precipitously for an extended time. Developing countries were hit with a double blow. First, their debt, which was largely financed with short-term instruments, had to be refinanced quickly at much higher rates of interest. Second, the U.S. dollars needed to service their debt had to be acquired with much larger quantities of domestic resources because the dollar was worth more. The costs of past errors in economic policy-the failure to undertake proper economic adjustmentswere indeed high. Economic policies now had to be rationalized and discrimination against agriculture reduced. The process of economic reform makes it clear that

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agricultural policy is largely trade and exchange rate policies. Distortions in exchange rates, especially the widespread use of overvalued currencies, causes domestic agricultural prices to be significantly lower than border prices evaluated at equilibrium exchange rates. Added to this distortion there is usually an ample array of export taxes, confiscos, and quantitative limitations on exports. The reverse occurs on the industrial side. That sector benefits from the overvalued currency in acquiring raw materials and intermediate inputs from abroad while at the same time receiving high levels of protection for its final product. The main premise of Agricultural Price Policy is that the tools of partialequilibrium analysis can contribute importantly to the analysis of the myriad policies that affect the agricultural sector in most countries. If policymakers and their staffs use these basic tools, economic policies will improve, to benefit not only the individual country but global welfare as well. The combination of large subsidies to agriculture in developed countries and severe taxation of agriculture in developing countries has contributed to major losses in resource efficiency in the global economy, with a corresponding sacrifice in global income. In its early incarnation, this book was referred to as a manual. That still characterizes its content in the sense that it is very much a "how to" book. What perhaps most differentiates it from a simple compendium of techniques, however, is the analytical framework it provides for the procedures it details. Moreover, the limits of these highly analytical procedures are carefully described. The analyst is thus provided with a sound basis for understanding why the various procedures are needed, a detailed discussion of how to use them, and knowledge of their limits. The material herein was prepared for policymakers and their staffs, but it is also appropriate for courses at the level of intermediate economics. Budding economists will benefit from this material because it makes abstract principles come alive and shows how they can be useful. Professionals, too, will consult this book when they need a refresher on how to do particular analyses. Agricultural Price Policy represents a great deal of effort by an accomplished economist. Its social product in terms of more rational economic policies should be high. G. EowARD SCHUH Dean, Humphrey Institute of Public Affairs University of Minnesota, Minneapolis

Preface

Agricultural price policy has been increasingly recognized as vitally important to the economic development of poor countries. Yet what constitutes good policy is highly controversial among policy analysts and policymakers. Although economic theory and techniques do not provide definitive answers that resolve the controversies, they can be used as effective tools to develop insights of great value to policymakers. The purpose of this book is to show practitioners and students how to use basic techniques of economic analysis as tools to help design effective policies. It presents the basic procedures for analyzing the economic impact of price policy on the agricultural sector and discusses the value and limitations of various policies. Throughout the book, the terms practitioner and analyst are used interchangeably. This book was written primarily for officials who use their analytical insights to guide policymakers. These officials serve in development institutions and government agencies throughout the developing world. Educational background, traditions, and terms of reference on the job necessarily vary among them. The most important unifying element in this diverse readership is the desire to gain basic skills in agricultural price policy analysis. This book offers practical guidance for extracting key economic information with the help of basic techniques. The book's focus is not on prescriptions for policy reform but rather on the policy-relevant information the analytical techniques can yield. The book presents relatively simple approaches to help clarify key issues in agriculture caused by price structures, to suggest how price interventions should be redirected to achieve policy objectives more effectively, and to identify when further analysis may be necessary. These techniques do not involve complex modeling and sophisticated quantitative methods, but they are directed to policy analysts who are familiar with basic economic theory, XV

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both macro and micro. The techniques draw on basic concepts and paradigms in economics and enable the analyst to show the costs and benefits of various price interventions. Agricultural price policy is a complex and controversial subject, and it can be analyzed from different angles and with varying degrees of technical sophistication. This book refers to but does not review the range of techniques in the field of agricultural price policy analysis. It provides guidance on how to conduct partial-equilibrium analysis, discusses the kinds of relevant information this analysis can yield, and indicates when the results need to be supplemented by further analysis. The analyst is a problem solver who must simplify in order to enlighten and guide. To make progress toward feasible solutions, the analyst starts with a set of questions that relate to the assessment of policy in terms of objectives, instruments, and consequences. The first task of the analyst is therefore to identify the questions needed to guide analysis. The questions may be of a broad sectoral nature or specific to the operation of selected markets, or both. The analyst needs a framework to help identify the main questions, develop a feel for how markets operate in the short and long run, and formulate and link the many components of a complete agricultural price policy analysis. C. Peter Timmer's Getting Prices Right: The Scope and Limits of Agricultural Price Policy sets out the partial-equilibrium framework for price policy analysis, illustrates the range of policy questions it can illuminate, and provides guidance on when the partial framework should be extended to capture linkages across markets and over time. I have adopted Timmer's approach, and most of this book presents analytical techniques and discusses their value and limitations in practical settings. The second task of the analyst is to decide which techniques to use. Analysis of agricultural price policy involves two fundamental considerations: (1) defining the structure of incentives and their role in agricultural performance, and (2) assessing the consequences of a price change for a given market on production, consumption, the government budget, foreign exchange earnings, welfare, and efficiency. This book seeks to help the analyst choose specific techniques at an appropriate level of disaggregation and then assess the major impact of policy qualitatively and quantitatively. The payoff in completing this stage in the analysis is a sharper focus on the important issues. Since policy analysis is action oriented, the third task is to make a case for better policies. The challenge here is to combine the optimal with the feasible. Sound policy advice is an art, and there is no established methodology for bridging the gap between positive and normative economics-the gap between what is and what ought to be. The analyst has to draw on insights derived from long years of experience and interaction with a given system or other comparable systems. It is necessary not only to analyze but to synthe-

Preface

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size. A considerable body of literature assesses the development experience of past agricultural interventions, and the major works are listed in the bibliography. Several of these are useful companions to this book. In What Price Food? Paul Streeten reviews a wide range of experience and the dilemmas policymakers face. A 1987 FAO publication, Agricultural Price Policies: Issues and Proposals, sets out experiences in both developing and developed economies and emphasizes the need to develop effective international trade rules for agriculture. To the extent possible, the analyst should draw on the insights offered by these works to gain some perspective on the current situation. In a world of uncertainty and conflicting interests, analysis does not automatically translate into decision making. This book does not offer specific guidance on how to proceed from the results of analysis to recommendations. But analysis should lay bare the key causal relationships and the important features in the economy that will influence policy's impact on economic behavior. Analysis and experience can jointly suggest more fruitful approaches to stubborn problems. The tools and the range of insights presented here should enable the analyst to provide better information to policymakers. No particular ideological position with respect to greater market orientation or government control is advocated. Analysis can shed light on the gains and losses from specific intervention structures whatever the organizational structure of the economy. The fullness of analysis is often constrained by time and data availability. Consequently, before investing any effort analysts want to know whether a technique is appropriate and what kinds of insights can be derived. The book is structured so that relevant sections can be easily identified. These correspond to the logical progression of inquiry, which proceeds from the key issues for agricultural price policy in developing countries to the basic principles and concepts economists use to understand the impact of price policy on the complex process of economic development. The book introduces the related analytical techniques and discusses their value in practical settings, details the process by which analysis becomes more focused, and discusses specific computations. The focus is on price analysis. To say that prices matter is not to say that only prices matter. One does not have to be a price fundamentalist to focus on prices. The focus arises from three related considerations. First, microeconomic analysis is oriented largely toward prices. Economists are concerned about the operation of markets and the interaction of prices and quantities as producers, consumers, and intermediaries grope toward the achievement of their objectives. Prices mean costs and incomes. Prices work through incentives to affect resource use and thus shape economic development itself. Second, agriculture is a decentralized system of decision making

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par excellence, with myriad households all responding to prices as they assess risks and expected returns. Third, governments in many developing countries have relied on price adjustments as major instruments for raising revenue and transferring welfare. In short, prices are powerful signals and powerful policy instruments. Markets, however, do not operate in a vacuum. Factors other than prices interact in complex ways to affect the operation of markets and the prices that emerge. Key among these are the political and cultural systems, the distribution of power, knowledge, and assets in institutions, and the intangible but powerful aspirations ofleaders and nations for a good life. The importance of such factors places the contribution of price analysis in a broader context. The insights derived must be integrated with these broader considerations before definitive reforms are proposed. This book therefore does not advocate any definitive conclusions from the use of techniques. Such concreteness is neither possible nor desirable. The emphasis is on developing an approach to understanding and assessing the problems and using price analysis as an aid to decision making. The value of partial-equilibrium analysis goes far beyond the technical results obtained. It can improve the quality of the debate over policy. Over time, it can strengthen institutions responsible for formulating and implementing policies that will influence the development process itself. In my view, agricultural price policy is at the heart of economic development strategies-hence the excitement of analyzing it and communicating the results. I hope this book imparts the excitement of the subject and contributes to effective analysis. This book builds on the results of an earlier program of research carried out by the World Bank. The program was initiated in 1976 by Marto Ballesteros and Colin Bruce, who set out to investigate the application of protection analysis to the problems of agricultural price policy that the World Bank frequently encounters in its operations. The main results of this research program were summarized in "Methodologies for Measuring Agricultural Price Intervention Effects" by Pasquale L. Scandizzo and Colin Bruce. Pasquale Scandizzo gave me invaluable guidance and encouragement in my initial efforts to develop a practitioner's manual. I am grateful to Graham Donaldson, who as Chief of the Economics and Policy Division of the World Bank supported the project. Alfred Field and Dennis Appleyard of the University of North Carolina worked as consultants to develop the numerical examples and detailed derivations. Robert Weaver of Pennsylvania State University assessed the usefulness of elasticity estimates for price policy analysis. I am indebted to them for their substantial contributions to the book. In addition, Professors Field, Appleyard, and Weaver all gave generously of their time in discussing many aspects of the book. I also thank participants to

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the Workshop on Agricultural Price Policy Analysis and colleagues in the Bank who used early versions of the book; their comments helped me understand the kinds of questions of most interest to my readers. I am very grateful to colleagues in the World Bank who read and commented on drafts of the book, especially Tariq Husain, Gerald O'Mara, Garry Pursell, Neil Roger, G. Edward Schuh (now at the University of Minnesota), Paul Streeten (now with the World Development Institute, Boston University), Lyn Squire, Jack van Holst Pellekaan, and Larry Westphal, and to J. P. Mcinerney, University of Exeter. Their comments helped clarify key points in the theory and practical application of these techniques. I extend special thanks to Colin Bruce and J. Price Gittinger of the Economic Development Institute of the World Bank for guiding and supporting the project. On the final drafts I worked closely with Carol Timmer and C. Peter Timmer, Harvard University, on structure and presentation. Their help came at a particularly difficult stage in the writing of the book. To them I owe an enormous debt. Sanjay Pradhan, now at the World Bank, also made very helpful comments, and I thank him. Financial support from Vijay Vyas, Nicholas Wallis, and Anand Seth enabled me to complete the revisions at a time when the final inch seemed a thousand miles long. Continued support and encouragement from G. Edward Schuh, Jack van Holst Pellekaan, and Vijay Vyas, from J. Price Gittinger and Nicholas Wallis of the Economic Development Institute of the World Bank, and from the Timmer team kept the project alive right through publication. To the extent the book succeeds in guiding practitioners, we all have them to thank. I thank David Bates, Wonhee Lee, Jane Lee, and Mark Michalski for the long hours they spent studying voluminous documents for relevant information on the impact of agricultural price policy. Myron Scheuremann developed the instructions for computing coefficients with spreadsheet methodology and was very helpful in improving other aspects of the computations. Suzanne Kon Kam King ably typed the early drafts and efficiently conducted the necessary administrative work. I thank all the secretaries for the many hours spent on successive drafts of the book. Morris sa Young skillfully carried the main burden of typing the successive drafts and the final manuscript. Her adeptness at juggling the maze of inserts was just wonderful. I cannot thank her enough for her commitment to a seemingly endless task and for her cheerful and competent help right through to the end. Carol Timmer and Morrissa Young kept me sane during the worst episodes in the writing of this book. I also thank Pensri Kimpitak and Elizabeth Dvorscak of the Bank's Graphics Department for their skillful transformation of my clumsy-looking graphs and their excellent help throughout. The World Bank graciously gave me permission to use material from their publications. The sources of the borrowed information are cited in the text. My greatest debt is to my family. To my husband, Bill, and my three

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children I owe a happy family life that went on even when the book seemed to be going nowhere. The family has had to share many hours with the book and did so with much tolerance and understanding. "The Manual" (as the book has long been referred to) became the fourth "child" in the family. I particularly appreciate Bill's ability to struggle with his own book, juggle the demands of three young children, and help nurture a fourth! For unfailing support throughout these six busy years, thank you. ISABELLE TSAKOK

Washington, D.C.

Agricultural Price Policy

CHAPTER

1

Issues in the Analysis of Agricultural Price Policy

Agricultural price policy is a major instrument of government intervention. Governments intervene in the operation of agricultural markets in countries at widely different stages of economic development, in both market-oriented and socialist economies. They want agriculture to supply the surplus in food, industrial raw materials, labor for industry, tax revenues, and exports that earn foreign exchange. A focus on industry-led growth has been a major theme of economic development strategy since World War II, and governments have looked to agriculture to play a central, though supporting, role in the development process. In their efforts to stimulate growth, many developing countries overtaxed and underinvested in their agricultural sectors, guided by the theories that agricultural taxation would not significantly hurt agricultural production and that the surplus should be transferred to industry, the prime engine of growth. But the reality was different: in the long run the growth of both agriculture and industry was undermined. The mechanism used to extract and transfer the agricultural surplus was price policy. The disincentives generated by unfavorable output prices were not reversed, however, by limited input price subsidies. Moreover, the macro environment and the trade regime further reinforced the bias against agriculture. In many countries problems in the agricultural sector spilled over into the rest of the economy and contributed to crises in industry, the trade balance, and the government budget. It became increasingly clear that a weak agriculture could not support a strong industry, and many governments had to reassess their entire development strategy. Policymakers in attempting to design more effective agricultural policies can profoundly affect economic development. In developing countries agriculture is typically a large share of the domestic economy, and it contributes on average as much as 30 to 45 percent of gross domestic product (GOP). Its

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Agricultural Price Policy

share drops to 20 percent in lower-middle-income countries and to 10 percent in upper-middle-income countries. The percentage of the total labor force in agriculture is even higher. For low-income countries it averages 60 to 70 percent, and in lower- and upper-middle-income countries it drops to 50 and 30 percent, respectively. 1 Because agriculture is a major sector in most developing countries, governments use it to contribute to their major objectives. They will continue to intervene extensively in the operation of agricultural markets, both directly through sector-level instruments and indirectly through macro and trade policies. Agricultural price policy strikes at the heart of the development process by altering relative prices facing individuals, households, and the sector as a whole. Because prices are both costs and incomes, individuals respond to them in their roles as producers, intermediaries, and consumers. Their responses to incentives induced by price policy inevitably shape the process of economic development and the distribution of incomes and welfare. 2

The Levels of Price Analysis Agricultural price analysis can help policymakers examine the consequences, intended and unintended, of specific price changes on agricultural markets and assess the broader implications of these market-specific responses for the viability of the overall development strategy. Such analyses emphasize the trade-offs between different objectives and different measures, and policymakers can use this information to debate the pros and cons of alternatives. The prices and markets selected for analysis can vary greatly depending on the question and on the resources available. Since agricultural price policy is an integral and key component of overall macro and trade policy, a wide range of prices can be examined: macro (exchange rate and interest rate), trade (export and import), and sectoral (output and input). The analysis can be single market, multi-market, sectoral, intersectoral, or macro; partial or I World Bank, World Development Report 1983, and World Development Report 1984 (New York: Oxford University Press for the World Bank, 1983 and 1984). 2 For further information see Theodore W. Schultz, ed., Distortions of Agricultural Incentives (Bloomington: Indiana University Press, 1978); World Bank, "Agricultural Prices, Subsidies and Taxes: A Summary of Issues" (Washington, D.C., Economics and Policy Division, Agriculture and Rural Development Department, February 1979; processed); GeorgeS. Tolley, Vinod Thomas, and Chung Ming Wong, Agricultural Price Policies and the Developing Countries (Baltimore: Johns Hopkins University Press for the World Bank, 1982); Ramgopa1 Agarwala, "Price Distortions and Growth in Developing Countries," Staff Working Paper no. 575 (Washington, D.C.: World Bank, 1983); and Margaret Biswas and Per Pinstrup-Andersen, eds., Nutrition and Development (New York: Oxford University Press, 1985).

Issues

3

general equilibrium; static or dynamic. These different types of analyses are not mutually exclusive. For example, one can combine the analysis of several single markets with more informal assessments of linkages among them within the overall macro context. The key distinction here is between formal and informal analysis. Formal analysis quantifies causal relationships, whereas informal analysis is qualitative. They can be combined to yield valuable insights. Agricultural pricing issues are development issues. The specific techniques presented here are a subset of macro and project techniques to analyze development, and they serve to complement rather than substitute for the use of these other techniques. Indeed, Schuh has argued that agricultural policy must integrate micro, sectoral, macro, and external trade considerations. Failure by analysts and policymakers to go beyond the sectoral can be extremely costly. 3 Given these complementarities, the partial-equilibrium techniques of analysis discussed here should be viewed as only one of several approaches to the economic analysis of agriculture. Partial-equilibrium techniques are the essential starting point in a full-scale analysis of agricultural price policy. The full-scale analysis is set out as a logical sequence of inquiry at different levels of aggregation (see Table 1. 1). Starting at the national, or macro, level, which establishes the economic environment within which an agricultural sector operates, the analysis characterizes the economic context in terms of economic growth, output and employment, savings and investments, trade structure and balance, price levels, and inflation. At the second level of inquiry the focus is on intersectoral linkages and balance, and at this level general-equilibrium models are used to analyze intersectoral flows. The third level is sectoral analysis, which examines the performance of agriculture in terms of growth and the changing structure of output, and in the context of resource endowment, weather fluctuations, price variability in international markets, and available technology. At the fourth level, subsectoral analysis looks at markets within the sector for outputs and inputs and major linkages among them. The fifth and final level is micro analysis proper of disaggregated groups within the market, such as different groups of producers or consumers. 3 The importance of the macro and external trade environment on agriculture and the design of agricultural policy is discussed at length by G. Edward Schuh in "The New Macroeconomics of Agriculture," American Journal of Agricultural Economics 58, no. 5 (December 1976), pp. 802-811; "New Directions in Agricultural Policy" (paper presented at the Annual Meeting of Minnesota Wheat Growers, Moorhead, Minn., December 13-14, 1982); "Trade and Macroeconomic Dimensions of Agricultural Policy" (paper presented at a conference on Alternative Agricultural and Food Policies and the 1985 Farm Bill, sponsored by the Giannini Foundation of Agricultural Economics, University of California and the National Center for Food and Agricultural Policy, Berkeley, Resources for the Future, June 11-12, 1984).

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Table 1.1.

Major levels of economic analysis

Level of analysis

Focus of analysis

l. Macro

Performance and structure of economy: output, employment, level of key macro price indicators-namely, foreign exchange, interest, and inflation rates Structure of major output and input prices-e.g., as between agriculture and nonagriculture or industry-and terms of trade between sectors Impact of agricultural sector policy on resource allocation, income distribution, national growth, and overall sector performance Impact on output and input markets Submarket groups of producers, consumers, or intermediaries

2. Intersectoral balance 3. Sectoral: agriculture

4. Subsectoral: selected markets 5. Submarket: selected economic groups

This five-level approach to analysis broadly corresponds to an increasingly focused assessment of the role of agriculture and its policy options and constraints. The logical sequence of inquiry is roughly as follows: What is the macro context within which agriculture functions? What are the key linkages between agriculture and the rest of the economy? What are the major production and consumption activities within the sector and how do they jointly contribute to the performance of the sector? What are the major output and input markets within agriculture, and what are the interactions among them? Within each market, what are the significant subgroups in terms of income levels, production and consumption response, asset endowment, and so on, and how do they interact? The concerns of policy range from the macro to the micro, hence the need for different levels of analysis and focus. The policymaker needs to understand the changing context for agriculture to define as concretely as possible the specific objectives for the sector and the rationale for government intervention. Agricultural pricing issues typically combine concerns for taxation, production, consumption, welfare, and political stability. Precisely because agricultural price analysis is multifaceted, it is important to define at the outset, as clearly as possible, the key questions that will guide the inquiry. These issues guide the initial analysis, but typically they are reformulated as the study progresses. Indeed, a major value of price analysis is a quantitative assessment of the important problems in need of policy attention. Agricultural pricing issues have all the drama of development. The scope and focus of price policy analysis may change, but its major purpose does not: policy analysis solves problems. The process begins by asking some basic questions. What is the system of taxation and subsidization implied by agricultural price policy? What is the structure of incentives generated by such a system? Is the structure consistent with the sector's comparative

Issues

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advantage and conducive to the achievement ofthe country's goals for development? What is gained and what is lost by the current system, or a proposed change in it, in terms of furthering private and social interests? All policy questions have two aspects: they look backward and forward and thus assess past and current experience to guide future decisions. These basic questions generate the host of secondary questions that are outlined in the next section. A particularly important issue for agriculture is the extent and manner in which international prices and markets should be allowed to affect domestic prices of exports and imports. Analysts need to look at international prices to guide domestic prices, but at the same time they need to determine how food consumption and government revenue needs are to be met. To answer difficult questions such as these, analysts of agricultural price policy need to have detailed information that is specific to the country, which is beyond the scope of this book. The analytical techniques presented here focus on the role of prices within the wider development context. A Guide to Analytical Techniques Policy analysis informs, enlightens, and guides. It informs because it focuses on the major consequences, intended or unintended, of policy. It enlightens because it identifies key problems and emphasizes major tradeoffs among objectives-the costs and benefits of policy. It guides because it suggests more promising directions for policy to pursue. But it does not give definitive answers in the sense of specifying how conflicting choices should be balanced. Nor should it, for good policy has to balance conflicting objectives and interests and forge effective compromises. Policy analysis should aid but not substitute for decision making. The analytical techniques described in this book address different, though related, questions and therefore yield different kinds of information relevant to policy-making. All of them should be viewed as complementing standard macro and micro (project-related) techniques of analysis. The initial analysis of agricultural price policy, which is described in Chapter 2, provides an understanding of the role of price policy in promoting or inhibiting specific types of economic activities within the economic development process. The initial analysis identifies price ratios or trends and relates them to quantity changes. By juxtaposing price and quantity data it suggests hypotheses with respect to the impact of policy. It is assumed that prices are important economic signals and that resources are mobile in response to these signals. The initial analysis relies on existing macro, micro, and other sociopolitical studies already undertaken, and from these it extracts

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Agricultural Price Policy

potentially significant price and quantity relationships. The initial analysis can never serve as a basis for policy recommendations, however, because at best it can only suggest important causal relationships. It should be preliminary to other techniques and should help develop sound intuition with respect to key relationships that need to be explored further. The richness of the insights derived, of course, depends on who is interpreting existing information. Once domestic price data are assembled, analysts compile data for prices in international markets and adjust them according to the techniques outlined in Chapter 2 so that they can compare domestic prices with their equivalents in the international market. The world price of a commodity converted into domestic currency at a rate that correctly reflects its scarcity value to the economy is the border price. This price represents the opportunity cost to the economy of producing the commodity. According to the concept of opportunity cost, the value of a commodity or resource is what it could earn in the next best alternative use. The value to the economy of a commodity that is exported or imported is given by what the economy can earn by exporting it or must pay in importing it, and thus foreign trade opportunities set the value of the commodity to the economy. This focus on the use of opportunity cost as an efficiency benchmark against which price policy is assessed is the essence of the economic approach and the main contribution of the analytical techniques presented in this book. Official or market prices that do not reflect opportunity costs create inefficiencies. If the basic principle of opportunitycost pricing were adopted in price policy, it would greatly improve the rationale and determination of much official pricing because it forces analysts and policymakers to consider what alternatives a given course of action precludes and to balance this cost against the benefits of that given course. Chapters 3 and 4 present the analytical techniques that enable analysts to systematically compare the domestic price for a commodity with the price that reflects the relative scarcity of the commodity to the economy. This comparison of official or market prices to scarcity values emphasizes the taxation or subsidization implied by the official system and the divergence in incentives induced by official and competitive market systems. The price comparisons illustrated in Chapter 3 are termed protection coefficients because they indicate whether producers, intermediaries, or consumers are protected from the market system by the official system. The protection can be positive (a subsidy) or negative (a tax). Coefficients of comparative advantage, which are demonstrated in Chapter 4, indicate which activities are efficient earners or savers of foreign exchange. They compare the domestic cost of producing a commodity to the net returns in foreign exchange (if an export) or to the net savings in foreign exchange (if an import substitute). These coefficients have been referred to as

Issues

7

cost-benefit ratios: the cost is the value of domestic resources needed, and the benefit is the net earnings through export or net savings through domestic import substitution. Thus they can be used to identify where public investment should be undertaken and which private incentives should be promoted. Inconsistency between incentives and efficiency is suggestive of efficiency problems caused by policy. Chapter 5 introduces market analysis, which explicitly connects price changes with quantitative response within a market framework. The initial analysis and computation of coefficients of protection, with their emphasis ' on incentives, implicitly connect prices with quantities-incentives imply an economic response. To make an explicit connection between changes in prices and quantities, however, analysts need data on the responsiveness of market agents to price changes. When these price elasticities are known, the impact of a change in a commodity's price on production, consumption, government revenue, foreign exchange earnings, efficiency, and welfare can be calculated. More often than not, empirical estimates of elasticities are not available for the particular set of markets being analyzed. If practitioners decide to "borrow" them from other settings, it is essential that they understand the limited applicability of the borrowed estimates. Chapter 5 discusses key practical considerations in using estimates of elasticities. Chapter 6 illustrates the techniques of single-market analysis and disaggregates the economic impact of price changes on producers and consumers at different income levels. Market analysis uses empirical estimates of the responsiveness of producers and consumers within a given market to assess the consequences of a price change for the following types of variables: (1) quantities: production and consumption; (2) incomes and expenditures: producers' incomes, consumers' expenditures, government revenues, and foreign exchange earnings in the case of a commodity traded in the world market; (3) welfare: transfers of surplus between producers and consumers; and (4) efficiency: net gains and losses to the economy as a whole due to changes within the market. The single-market model is the basic building block within an analysis; it can accommodate interactions among markets, both domestic and foreign. If quantitative information is not available on the strength and direction of these interactions, analysts should still try to assess their likely importance in an informal fashion because informal assessments can suggest further analysis of important market linkages. Analysts can use quantitative estimates of impact to assess which consequences are problematic. Market analysis is a basic technique in microeconomics, and by analyzing single markets for various commodities, the practitioner will identify paths for further analysis. These may encompass spillover effects into other markets, sectoral linkages, and dynamic and general equilibrium effects of price changes.

8

I Agricultural Price Policy

At the sectoral level, the terms-of-trade index between agriculture and industry, which is presented in Appendix F, is a useful indicator of intersectoral incentives. Terms of trade usually refer to changes in the relationships between the average price of a country's exports and the average price of its imports. These external terms of trade differ from domestic (internal), or intersectoral, terms of trade in that the latter refers to the changing relationships between the average price of agricultural outputs and the average price of industrial inputs used in agriculture. Simply put, the index is a changing ratio of prices received over prices paid by farmers, and it can therefore indicate the relative profitability of agricultural vis-a-vis industrial production. A comparison of the index and relative growth performance of agriculture and industry can suggest the broad resource pulls of agricultural price policy. Agricultural price analysis is eclectic: it combines micro, macro, and trade theory. The initial analysis is essential because it begins the process of forming a consistent view of the role of prices. Coefficients of protection and comparative advantage are useful in assessing relative incentives and efficiency and their importance in the economic environment. These price comparisons can reveal important features of the environment because they are derived from a consistent view of how markets operate. Thus it is necessary to understand the key concepts and logic of this consistent framework if collecting and combining data are not to be mechanical processes. Market analysis is useful for focusing on specific markets. The analytical techniques can be used in succession as the inquiry becomes more focused. These techniques yield partial, though relevant, policy information: partial because the information should be supplemented or strengthened by other data and techniques, relevant because the techniques identify and suggest the magnitude of a problem caused by policy. In combination with each other and with other techniques, they inform policymakers about the role of prices and incentives in agriculture and the broader economic environment. The main payoff to analysis is a sounder assessment of what price policy should pursue and at what cost. The payoff to sound policy is the hope of a better world for ourselves and our children.

CHAPTER

2

Initial Analysis of Agricultural Price Policy

The initial analysis allows us to understand the major ways in which current policy affects agriculture, to identify the important issues, and thus to initiate a policy dialogue aimed at improving the policy environment. At the outset, the motivation on the part of both analyst and policymaker engaging in such a policy dialogue is to understand the consequences of current intervention, to determine if they promote or undermine major objectives, and to design and implement more effective policies. Improving the policy framework is a continuous process, and the analysis itself should be viewed as part of a continuing, iterative process that facilitates the policy dialogue. An initial analysis is the crucial first step in the process of improving the policy environment. Its central task is to identify the major policy issues to be addressed and several key features of the policy context, including the role and performance of the agricultural sector, the macro and trade environment within which the sector operates, the government's current objectives for the sector, the system of market intervention in place, and the extent to which the objectives are being achieved. Central to this effort is understanding the structure of domestic and international market prices.

Formulating the Policy Questions A thorough initial desk review provides a sense of direction-a better feel for the problems at hand, the contribution of price policy to them, and the dynamics of the interactions between policy and economic performance. One then can progress from a general statement of the problem to more specific formulations. The general formulation is often a variant of the following questions: Why has agricultural price policy been so ineffective, and how can

9

10

I

Agricultural Price Policy

it be restructured to improve efficiency and dynamic growth without unduly straining budgetary and administrative resources? The more specific formulations focus on the role of incentives and recurrent areas of conflict. What has been the role of price incentives in undermining the growth in production of specific commodities? How can farmers' incentives be improved without ruining the budget and adversely affecting the consumption of basic foods by urban consumers in the short run? For what commodities should incentives be promoted so that the country can exploit lucrative export markets without becoming unduly dependent on and vulnerable to foreign markets? This initial stage of the analysis develops an intuitive understanding of agricultural price policy's contribution to problems that currently strain the economic system. The manifestations of this strain are well known: financial crises in the budgets and the balance of payments; stagnating agricultural output; low productivity employment; and continued widespread rural poverty spilling into an overcrowded, underperforming urban sector. It is important to determine whether these result from misdirected priorities (or hopelessly conflicting ones) or the wrong policy instruments. The most damaging effects, even if unintended or indirect, must be identified. This very broad set of questions then needs to be formulated in more specific terms. Economic theory is helpful in organizing information-determining meaningful indicators of economic performance and understanding market interaction-and suggests which aspects of comparative experience are relevant. Analytical techniques need to be viewed as applied theory, and an initial analysis of agricultural price policy should reveal some key empirical dimensions of specific policy in terms of their nature, context, persistence, and the broad structure at macro and sectoral levels. Analysis is more than merely collecting data. As a first step, the analyst tries to place the problem in its broadest economic policy and political contexts. Agricultural pricing problems tend to combine several aspects of development-production, consumption, taxation, welfare, political stability-and relevant information thus spans macro and micro levels. Specifically, the analyst looks for levels and trends of growth of the economy, of the agricultural sector and its exports, and the country's imports of specific commodities. To assess where the inadequacies lie, the analyst can compare performance with objectives and intended consequences of policy, with growth potential given the quality and quantity of resource endowments, and with experience during a previous policy period or with experience elsewhere under comparable endowments. The problems to be addressed can be described as growing imbalances between supply and demand-problems that are manifested in the finances of the government and the economy's balance of payments, in the spread of black markets, and in the proliferation of marketing and quantitative controls in official markets.

Initial Analysis

I 11

The analyst goes on to characterize the policy structure that has contributed to these problems in terms of economic and political objectives. Many objectives of economic development seem to be similar across countries; when broadly stated, many of them sound innocuous, but it is important to distinguish between nominal and actual objectives, because actual objectives require resources, whereas nominal objectives are pure rhetoric. One must probe further to discern the actual priorities driving the system and those objectives that are sacrificed when budget constraints tighten. Some objectives, such as food self-sufficiency, are subject to differing interpretations and have widely differing implications for development strategy. Under trade autarky, the aim of food self-sufficiency, irrespective of financial and opportunity costs, might be domestic production of all food to eliminate reliance on food imports. For a trade-oriented government, food self-sufficiency might refer to production of all crops that have a comparative advantage and can generate lucrative export earnings. Food imports are then paid for entirely by agricultural exports. In a third interpretation the entire economic system is designed to mobilize adequate foreign exchange earnings (through agricultural, industrial, and other exports) to pay for food imports. The autarkic and trade-oriented interpretations demand different development and trade strategies. Similarly, to achieve objectives such as equity or welfare, the government may simply intend to subsidize the urban sector, or it may plan to change the distribution of assets and the access of different income groups to social services. The practitioner needs to differentiate between rhetoric and action. This exercise also is valuable for identifying important sources of potential political resistance or support vis-a-vis proposed reforms. The politics of intervention can override any other economic or financial considerations. To make this differentiation, analysts need to go beyond official statements and review major price and nonprice instruments, including budgetary allocations, thereby deriving insight into the forces that shape the system of administered prices, including taxes and subsidies. In this analysis it is useful to distinguish between macro and sector-level prices because of the important interactions between macro and sectoral strategies. The distinction between macro and sectoral identifies the different levels of policymaking involved in a reform of agricultural policy. One important implication is that operating only at a sectoral level can be totally ineffective. 1 Nonprice instruments must be considered as well because price and non1ln a recent analysis of agriculture in Colombia by Vinod Thomas et al., Linking Macroeconomic and Agricultural Policy for Adjustment with Growth: The Colombian Experience (Baltimore: Johns Hopkins University Press for the World Bank, 1986), the authors point out that though sectoral policy tends to be supportive, macro forces undermine the agricultural sector.

12

/ Agricultural Price Policy

price instruments jointly determine the terms of trade facing agriculture. These nonprice measures include a wide array of instruments, such as structural and institutional changes that affect the ownership of assets and their income streams; and public investments in infrastructure, education, and research which improve market flows, the available technology, and access to goods and services. Streeten has referred to them as the five/'s: incentives, institutions, innovation, information, and investment. 2 Many price controls require complementary controls on marketing in both domestic and foreign markets. The package of price and marketing measures is further reinforced (or undermined, as the case may be) by the level and composition of investments. Prices and investments jointly have a determining influence on relative incentives and accompanying resource flows. The terms-of-trade indices between agriculture and industry (domestic or intersectoral), described in Appendix F, can be useful indicators of these broad resource pulls.

The Domestic Price A focus on price instruments is the appropriate starting point in the analysis. Most of the analytical techniques presented in this book require that domestic prices for various commodities be compared with their equivalents in the world market. Analysts therefore need to thoroughly understand the functioning of the domestic market for a commodity and the elements in its price formation. The aim of this section is to discuss the different levels at which data are needed, the simple techniques that can be applied to extract economic information from them, and the major factors to be considered in adjusting data for highlighting economic and other structural relationships.

Data Requirements A major portion of the practitioner's time is likely to be devoted to identifying the necessary data, locating the usable parts, and adjusting and juxtaposing different sets of data to understand relationships and policy outcomes. Access to data and other economic information is likely to have a major bearing on the scope, depth, and relevance of analysis for policy reformulation. Existing sources of data should be exploited as much as possible. Key gaps in data can be highlighted through analysis, and steps can be taken to fill in the gaps by building the relevant institutions or technical units. In the short run analysts cannot but be constrained by the data available, but 2Paul Streeten, "Food Prices as a Reflection of Political Power," Ceres 16, no. 2 (MarchApril, 1983), pp. 16-22.

Initial Analysis

I

13

for the longer run they can initiate measures to build the necessary units to collect and process relevant data. Data gathering and processing are typically costly. The analytical techniques offered in this book not only help assess current policy but also highlight the kinds of data required. The practitioner needs data on cost structures, amounts marketed, and market responses to understand the production process and the marketing systems that define the production and marketing options of economic agents. The analyst is then in a position to assess which analytical techniques should be adopted for further analysis on the basis of well-formulated policy questions and a thorough desk review of available data. The goal is to characterize the functioning of selected economic agents within the constraints and opportunities of their economic environment. In addition to the production process, analysts should consider the subsequent stages up to market sales to domestic or foreign consumers. Policy operates by impinging on the constraints and opportunities to which economic agents respond, along the entire production-marketing-consumption chain, and by changing the costs and the benefits of their operations in the short run and changing the opportunities they face in the longer run. Farm-level data. Representative production or farm models need to be identified, ideally by drawing on recent farm surveys that indicate a typology of farming systems; for example, subsistence, irrigated, large, small, traditional, mechanized, and so on. One can also draw on an existing project analysis for the country or for another comparable one. Selection is usually on the basis of practical considerations-the availability of data and time. One therefore really does not know the biases in the sample or their significance. Farm budgets with data on the structure of costs and returns based on technological relationships are essential for analysis of agricultural price policies. They contain detailed information on cropping patterns, technologies used, and major costs entailed, as well as gross and net revenues. With respect to outputs, analysts focus on the major sources of incomes and the linkages among them (complementary or substitutes) in terms of resource use and riskiness of production. Similar interactions in the use of different major inputs should be explored. Analysts can use farm budgets to assess the relative private profitability of different activities. Policy typically changes the prices farmers receive for their outputs and pay for their inputs, and a comparison of returns based on financial and economic prices thus indicates the change in incomes and incentives brought about by policy at the farm level. These computations are discussed in Chapter 3. On the basis of the above desk review, practitioners can identify which outputs and related inputs should be included in the analysis. In situations

14

I Agricultural Price Policy

where production systems are sharply different in various agro-ecological zones and it is not feasible to include them all, practitioners can use their knowledge of more aggregated data-namely, sectoral, provincial, macro, or trade level-to identify the major systems. They look at a variety of indicators such as contribution over a given period to agricultural output, to sectoral GDP, to exports or imports, to employment, and to the budget. If possible, analysts should also consult an agriculturalist for an assessment of major production systems. Data sources for the different levels of aggregation are likely to vary and may come from provincial governments, marketing agencies, research institutions, central statistical bureaus, and ministries of agriculture. Given the variety of sources and different definitions and methodologies, discrepancies in data sets are common. The best solution to this common problem is to assemble a team with a mix of skills-agronomic, institutional, and economic-to analyze the main reasons for the discrepancies. Jointly, the team members can carve out of the available information a consistent data set that can be defended on agronomic, institutional, and economic grounds. Ultimately, the analyst selects a set of production systems to be used in analyzing relative incentives and efficiency. The biases that this set is likely to contain-for example, a bias toward larger farmers, or irrigated systems, or a specific geographical or agro-ecological region-should also be noted because these will enter into the interpretation of subsequent analytical results. Once basic farm models have been selected, it is useful to compare the output and input price ratios for various commodities within a farm type over time, or across farm types at a given point in time and over time. The comparisons can be suggestive of relative incentives at the farm level, although they must be complemented by information on yields and production. Output-to-output price ratios can indicate the relative attractiveness of different outputs that compete for the same land. Input-to-input ratios can indicate the relative costs incurred using different inputs. Output-to-input price ratios can indicate the relative attractiveness of using certain inputs for certain output. Analysts can look at these ratios over time and compare their movements with trends in output growth and input use. The insights derived, although only suggestive of causal relationships, should be pursued further by developing fuller farm budgets, with data on cropping patterns and related input use, to complement data on prices of output and inputs. Farm budgets show the relative returns from different crops and livestock activities and contain valuable information on the impact of price policy on resource use. Marketing data. Agricultural marketing enables commercial agriculture and modem cities to coexist and thrive. Marketing encompasses a complex set of related operations linking farmer to consumer: transport, storage, and

Initial Analysis

15

processing functions and transfer of ownership. Marketing is a service sector that does not fit Adam Smith's bias against unproductive labor. Intermediaries require information, capital, and managerial skills (including risk taking) and a physical, social, and legal infrastructure to operate effectively. The marketing chain can easily be the subject of an entire subsector study. The task here is much more modest. The practitioner needs to understand the major actors or economic groups within this chain, the major functions they fulfill, and the costs of these operations. This understanding is summarized in the data on marketing margins, which are then used to adjust either domestic farm-gate or border prices. Abbott and Makeham point out that there are three broad approaches to computing these margins. 3 In the first, representative samples of a given commodity are followed from farm to consumer. The prices and changes are noted at each stage, and averages are derived. In the second, the gross receipts and outlays of each intermediary along a marketing channel are divided by the quantity handled. In the third, prices at each stage from producer to consumer are averaged for a given commodity and quality over a period of time. The only difference between the first and second approaches is the data base. In the first, one starts off with the prices and margins at each major stage, per unit of quantity. These prices and margins are then averaged. In the second approach, these prices and margins are derived by dividing aggregate value of receipts and outlays by aggregate quantity. The distinction between the two approaches is computational, not conceptual. The first and third methods are the most commonly used; the second method is rarely used because it requires the collaboration of enterprises. The practitioner in the field may have the resources to undertake initial fieldwork and collect price and quantity data according to any of the above methods. If the analyst has to rely on published sources, there are several possibilities. In many developing countries both the private sector and public agencies are engaged in marketing. The public agencies are likely to have the following data: amounts purchased, transported, stored, milled or processed, and sold in urban areas; the prices and costs at which these operations were undertaken; and the amount of tax revenues generated or subsidies received over a given period of time and within seasons of a given year. If cooperatives are a significant channel, such data may also be available for the major branches. Such data are contained in their periodic (annual or quarterly) reports or may be found in consultants' reports prepared in the context of a loan proposal. If there is a significant parallel marketing system, it is often virtually 3John Cave Abbott and J. P. Makeham, Agricultural Economics and Marketing in the Tropics, Intermediate Agriculture series (Hong Kong: Commonwealth Printing Press, 1984), p. 49.

16

I

Agricultural Price Policy

impossible to obtain data on intermediary margins in published sources. Indirect evidence may be possible if rates of interest charged on loans to intermediaries in official and informal credit channels are known. These rates would indicate the minimum rate of profit intermediaries must obtain to remain in business. One also can obtain data on total margins from farm gate to consumer simply by comparing the two market-determined prices. A breakdown of this gross margin into the major stages, such as processing, transport, and storage, may be possible if additional piecemeal information is available on the complexity of the processing activity and related processing ratio, the distance between major production and distribution centers, and cost per mile or kilometer per volume transported. It is useful to have data for a comparable marketing structure in another developing country to add perspective to these rough computations. Timmer advocates the computation of three price ratios to gain a better understanding of the degree of the financial inducements to operate as intermediaries.4 The first ratio compares the average monthly high (preharvest) price to the average monthly low (postharvest) price. The second compares prices in rural markets to prices in major agricultural markets. The third compares prices of the raw commodity with prices of the processed commodities. These three ratios indicate the margins involved in bridging the gap between production and consumption over time (seasonal), over space (distance), and over form (processing). Nothing can be inferred from low (for example, ratios 1.1 to 1.4) to high (for example, 1.5 and above) ratios about the efficiency of market operations. A low ratio can result from low-cost operation and competitiveness, or it can be due to the government placing a lid on costs without actually promoting efficient operations. A high ratio need not indicate monopoly power; it may result from poor physical and legal infrastructures and attendant high risks. The analytical value of these ratios is twofold. First, it focuses on the margins involved for the key transformations performed through marketing. Second, it focuses attention on the major components that give rise to a high or low ratio and their implications for market structure. Questions raised by these ratios can initiate the start of a more detailed investigation of marketing structures. For the purpose of meaningful price comparisons, it is sufficient to identify the major actions and stages in the marketing chain and their associated costs. The tables in Chapters 3 and 4 show how prices should be adjusted once these margins are known.

Retail price data. The practitioner will necessarily include retail price data when gathering data on marketing margins. Often the data will include both 4C. Peter Timmer, ''The Relationship between Food Marketing and Price Policy," in Agricultural Marketing and Pricing Policy, ed. Dieter Elz, World Bank Symposium series (Washington, D.C.: World Bank, 1987).

Initial Analysis

\ 17

official subsidized prices in major urban centers and market-determined prices for commodities considered basic staples. In a dual-price structure it is important to find out what the rationing system is. Which economic groups in fact have access to subsidized supplies? Access may be determined by the location of ration shops, the quality of the commodity being rationed, the implicit costs in terms of time spent to purchase the commodity, membership within the bureaucracy, the military, the employed, or the school system, and the reliability of supplies in the past. These features suggest the scope of the official price relative to the market-determined prices. The practitioner may be fortunate in being able to draw on a study of the food distribution or delivery system for the country under study. Indirect evidence may be available in a recent nutrition study, possibly conducted within the context of the preparation of a population-healthnutrition project. Such a survey would indicate, among other things, the income levels of the vulnerable groups, their expenditures (in terms of absolute amounts or a percentage of budget spent, at given prices) on basic staples, their caloric intake and estimated deficiencies given their lifestyle, estimated age and gender structure, and the extent to which the intake has improved or deteriorated over a given time period. Sometimes the practitioner can cross-check the reliability of such information by using household budget survey data from the same period, although the latter may not constitute an independent source of information because the survey data were used in the preparation of the nutrition survey. Alternatively, government budget data can be used to estimate the volume rationed by dividing the total subsidy bill by the official price. (Handling costs have to be subtracted first.) Food balance sheets do not contain useful price information, and the estimated consumption per capita is too aggregative for the purpose here. These estimates of per capita availability are obtained as a residual from total production plus imports, minus all major leakages-namely, exports and uses on the farm for feed and food. If there are no published sources, the best option is the judgment of experienced and knowledgeable observers. For the longer term, the practitioner should consider hiring specialists to conduct surveys of price and consumption data in major consumption centers. The goal in gathering retail price data is to understand the major prices consumers face as a result of the delivery systems and their incomes, at a given point or at different points in time.

Making Sense of the Data The practitioner is likely to face two problems in the attempt to build the empirical basis of the analysis: incomplete data for a given item or a flood of figures that are hard to interpret. The task is to make sense of the available data and to identify what is needed but missing. Data make sense only when

18

/ Agricultural Price Policy

they are consistent with economic theory. Theory guides the practitioner in identifying relevant data and organizing them to highlight a feature of the economic structure or pf economic performance. Simple graphical techniques help to explore possible causal relationships between two variables. At the micro level the behavior of producers and consumers is explained in terms of prices, incomes, and tastes. To build an intuitive understanding of their behavior in a given context, the practitioner can juxtapose price and quantity data and incomes and quantity data for a given period and over time. It is not the juxtaposition that establishes causality; it is theory that suggests the causal relationship. Patterns of production. With respect to production, the practitioner can plot trends in amounts produced and marketed over a given period of time. Three simple methods can be used to highlight the trend. With the freehand method, the analyst simply pencils in a straight line that usually captures most of the points. This crude method also reveals the unusually high or low points. The practitioner can smooth fluctuations in a time series by dividing the series into two parts, computing the arithmetical average for each part, and connecting the two points computed. Alternatively, the analyst can compute moving averages and fit a trend line to these. To compute a three-year moving average the analyst groups the data in three-year units, adds the figures for the three years in each grouped unit, and computes the yearly average by dividing the total by three. These exercises provide insights into the key features of output performance, and the practitioner can proceed to explore causality by juxtaposing output data with prices. Is there a systematic relationship between the two? After analysts have used the simple methods above to identify trends, they must step back and consider the forces at work. In searching for an explanation, they identify additional relevant data. The complexity of determining causal relationships between output and price movements can be illustrated by a simple example of maize production (see Table 2.1A and Figure 2.1A). Three simple methods of highlighting trends are presented. The raw data show that maize output is subject to discrete three-year cycles, and, irrespective of the method used, the trend is definitely upward. In Table 2.1B the practitioner explores the correlation between output and prices. Higher prices are associated with higher output, as theory would suggest, but there are lags in response and declines in output at selected higher prices. Figure 2.1B shows the definite upward trend in the three-year moving average. The practitioner must consider other major forces that may have been at work. One possibility is a favorable output, or fertilizer-price ratio. In this example we assume that fertilizer is not subsidized or taxed but that maize output is heavily subsidized. The ratios in

19

Initial Analysis Table 2.1A.

Organizing data on maize production, 1967-77

Maize output (million metric tons)

Year

!}

1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

3-Year moving total

3-Year moving average

3 + 4 + 8 = 15

15/3 = 5

Method of semiaverages

5.6

4

+ 8 + 6 = 18

II

I~

14 } 12 11

11.2

6 7 8 9

21 24 27 30

10

33

II

36 14 + 12 + II = 37

12 12.3

c.i.f. (cost, insurance, and freight) and domestic prices presented in Table 2.1C and Figure 2.1C make it clear that the domestic ratio is much more favorable than the c.i.f. ratio and that the former improves dramatically from 1974 through 1977. These comparisons strongly suggest that domestic farmgate prices in relation both to competing c.i.f. maize prices and to fertilizer prices have encouraged maize output. But the cyclical nature of output per(million metric tons)

t

3-Year moving average method

12 10 Q

8 6

...JAit---------------J'--- Method of semiaverages

4

2

1967

68

69

70

71

72

73

74

75

Time

Figure 2.1 A. Maize output and trends

76

77

20

Agricultural Price Policy Table 2.18.

Correlation between maize price and output 3-Year moving average average

Year

Farm-gate price (rupees per metric ton)

Output (million metric tons)

Output

Price

550

3 4 8 6 7 II 9 10 14 12

5 6 7 8 9 10 II 12 12.3

550 550 573 585 595 605 621.3 621.3 646.7

1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

585 615 634 653

formance is still not correlated with output or fertilizer price improvements. If maize is normally grown under rain-fed conditions, weather fluctuations are likely to have a major bearing on performance. In addition to information on crop weather, the practitioner can also consider information on major institutional changes, such as land reform and consolidation, formation of producer and service cooperatives, completion of major access roads, and so Price per metric ton

t

Rs 670

I

I

I

/""" _ _J 3-Year moving

.. 3

4

5

I

I

I

'/

/

I'

/

/

, ...

... ~

/

/

average

-~

6

7

8

9

10

11

12

13

Q (million metric tons)

Figure 2.1B. Fann-gate maize prices and trends

14 -

Table 2.1C.

Output-input price ratio: maize/nitrogen Price of nitrogen fertilizer (c. i. f.) per kilogram

Year

(I)

Rupees a (2)

1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

0.065 0.061 0.065 0.061 0.066 0.064 0.094 0.160 0.166 0.171

0.65 0.61 0.65 0.61 0.66 0.64 0.94 0.16 0.16 0.17

U.S. dollars

Maize/ nitrogen price ratioc

Price of maize per kilogram b C.i.f. (U.S. dollars) (3)

Farm gate (rupees) (4)

C.i.f. (5)

Domestic (6)

0.550 0.550 0.550 0.585 0.585 0.585 0.615 0.615 0.634 0.653 0.653

0.200 0.180

0.846 0.901 0.846 0.959 0.886 0.914 0.654 3.843 3.962 3.841

.013 .Oil .012 .012 .020 .027 .023 .020

0.181 0.187 0.212 0.168 0.138 0.116

•The exchange rate is 10 rupees per U.S. dollar. bMaize is a domestic import substitute. The domestic farm-gate price is well above the c.i.f. price. cThe c.i.f. ratios were obtained by dividing column 3 by column I. The domestic ratios result from dividing column 4 by column 2. Maize and fertilizer are in kilogram units. The domestic ratios are consistently more favorable than the c.i.f. ratios. The c.i.f. ratios declined against maize production, but the domestic ratios increased in favor of maize production. Crop/nitrogen price ratio

4.0 30 2.0 1.0

0.9

0.8 0.7 0.6 0.5

04 0.3

0.2 c.i.f

01

1967 68

69

70

71

72

73

74

75

Figure 2.1C. Maize/nitrogen fertilizer price ratio

76

77

Time

22

Agricultural Price Policy

on. The main point is that the practitioner uses theory and simple analysis to obtain an initial intuitive understanding of economic performance and the price and nonprice factors that have contributed to it. In this way it is possible to develop hypotheses about policy response. Patterns of consumption. Let us now take an example on the consumption side. An example for sugar illustrates the search process essential in the initial stages of analysis, a process that can give the practitioner a feel for how markets interact and which domestic prices are appropriate to use. The policy question is this: What prices do most consumers now pay for sugar and its domestic substitute gur, and how are consumers likely to respond to an end of the sugar subsidy? The government is currently subsidizing sugar; most of it is imported and distributed in ration shops located all over the country, but it is heavily concentrated in major urban centers A and B. Subsidized sugar is rationed at three kilograms per capita, and consumers supplement their rations with purchases of sugar and gur, an unrefined sugar, on the open market. The government is considering removing the sugar subsidy and freeing the licensing system for sugar imports. Through official publications and newspaper quotations, the practitioner has been able to collect price data for the two urban centers for three years (shown in Table 2.2A). All imports of sugar are consumed in the urban centers. The proportion of domestic production sold in cities is unknown, although it is generally believed that village residents consume mainly gur, and urban dwellers consume most of the refined sugar. Over this three-year Table 2.2A.

Sugar production, consumption, import, and price Retail price Border price

Urban center A

Urban center B

Domestic production

9.00 7.00 11.00 4.00

7.00 13.00 3.00

7.00 14.00 6.00

7.00 1S.OO 7.00

7.00 8.00 4.00

7.00 8.SO 3.00

12.00

6.00

Imports

(thousand metric tons)

(rupees per kilogram) 197S Official price Market price Market price of gur 1977 Official price Market price Market price of gur 1979 Official price Market price Market price of gur

Total consumption

Percentage of imports in total consumption

8S

100

IS

IS

79

100

21

21

92

120

28

23

Initial Analysis

23

Rupees 15 f14 f-

• B • Average (1977)

•A

13 f121----------,.-A"""v-e-ra_g_e-:-(1:-::9:=75:-o)--Barder price (1977)

•A

11 r10 f9

f - - - - - - - - - - - - - - - - - . -6-

Bcrder price (1975)

• Average (1979)

8f-

• A

7f6 1 - - - - - - - - - - - - - - - - - Border price (1979)

80

85

90

95 Quantity (1000 metric tons)

Figure 2.2. Domestic and border prices of sugar

period the official retail price has remained at Rs 7 .00, though the amount rationed has increased from 15,000 to 28,000 metric tons. If one assumes that the bulk of domestic supply is consumed in urban areas, then a crude assessment of the response of urban consumers to different prices is indicated by comparing market prices and quantities for these three years. Three approaches to plotting price and quantity data are shown in Table 2.2A and Figure 2.2. The first approach uses price data from center A, the second from center B, and the third from an arithmetical average of data from centers A and B. It is assumed that total domestic production is consumed in urban areas, since gur is preferred by rural consumers and is available primarily in rural areas. Rough estimates of price response are presented in Table 2.2B. These estimates cannot be used to predict precise response to price changes; however, they do indicate that the likely direction is negative and that probable demand elasticity is in the range of -0.3 to -0.4. The data suggest that when the price of sugar rises, consumers have to shift part of their sugar consumption onto the gur market, and the latter's price rises from Rs 4.00 to Rs 6.00. The market prices of both sugar and gur rose when the border price rose in 1977 and fell when it fell in 1979. The linkage is through imports. If the government liberalizes both imports and domestic retail pricing, domestic retail prices are likely to fluctuate more sharply. The fluctuations in border prices, however, are likely to be dampened at the village level by the avail-

24

Agricultural Price Policy Table 2.28.

Alternative rough estimates of market response

Alternative !A When P = 14 rupees, fall is 3 rupees; in percentage terms, 3/14 x 100 = 21.4%. When Q = 79 metric tons, increase is 6 metric tons; in percentage terms, 6/79 X 100 = 7 .59%. Thus a 21.4% fall in Pleads to a 7.59% increase in Q, and a 1% fall in Pleads to a 0.354% increase in Q. Alternative 1/A When P = II rupees, fall is 3 rupees; in percentage terms, 3/ II x 100 = 27.2%. When Q = 85 metric tons, increase is 7 metric tons; in percentage terms, 7/85 X 100 = 8.23%. Thus a 27.2% fall in Pleads to an 8.23% increase in Q, and a 1% fall in Pleads to a 0.303% increase in Q. Alternative IB When average P = 14.5 rupees, average fall is 2.5 rupees. When average P = 100 rupees, average fall is 17.24 rupees. When Q = 79 metric tons, increase is 6 metric tons. When Q = 100 metric tons, increase is 7.59 metric tons. Thus a 17.24% fall in Pleads to a 7.59% increase in Q, and a I% fall in Pleads to a 0.440% (=7.59117.24) increase in Q. Alternative liB When average P = 12 rupees, average fall is 3.75 rupees. When average P = l 00 rupees, average fall is 31.25 rupees. When Q = 85 metric tons, increase is 7 metric tons. When Q = 100 metric tons, increase is 7/85 x 100 = 8.23 metric tons. Thus a 31.25% fall in Pleads to an 8.23% increase in Q, and a 1% fall in P leads to a 0.263% (=8.23/31.25) increase in Q.

ability of the cheaper substitute, gur. The practitioner should now look for other studies of sugar consumption in developing countries with comparable income levels and cultural preferences for sugar and gur. The examples for maize production and sugar consumption show how practitioners can use price and quantity data to understand the operative causal factors with the help of simple graphical techniques, suggestions from economic theory, and an understanding of structural features of that particular development context.

Calculating the Average Price Frequently the practitioner has to make adjustments to domestic prices because there are multiple domestic markets and prices, and because the domestic price differs across locations within the country. Government policy might control the price of a commodity in market A but allow an uncontrolled price in market B. From the standpoint of protection to the domestic

Initial Analysis

I 25

producer, a weighting scheme that takes into account the shares of domestic output marketed in each city would need to be used to derive an average price for the commodity. If markets in different geographical locations are highly segmented, there is likely to be a significant disparity among prices that is not mainly a reflection of transport and handling costs. It is then more meaningful to talk about major regional markets. One can use either the prices of the major markets within each region or the prices of the central market within each region. Practitioners use their understanding of the relative importance of different markets to determine whether they should average or whether they should select the price of a central market as representative of the domestic price. If the latter, they are linking prices in other markets to the central market through transport and handling. The method of averaging is useful when several markets seem to be of equal importance. For example, if domestic output is 1000 units, and 600 units are sold in market A for Rs 22 per unit and 400 units are sold in market B for Rs 35 per unit, the weighted average price would be

or

pd =

(Rs 22)(600) + (Rs 35)(400) 1000

J>d

=

(Rs 22)(0.6) + (Rs 35)(0.4)

=

Rs 13.2 + Rs 14

=

Rs 27.2

More generally, I

Pf

=

L PfWi

i=l

Domestic price of commodity i

=

sum of domestic prices of commodity weighted by relative market share, Wi

For prices facing domestic consumers, the weights would be the share of total consumption (that is, national output plus imports) by each region in the total. The two weighted averages in either case are then a measure of the "average" domestic price in the country, but of course this price may not be the relevant price facing any particular consumer. Multiple domestic prices may arise not only because there are multiple markets separated by transportation costs and possibly by government intervention but also because there may be seasonal price swings in pre- and postharvest periods within any given market. These swings tend to be pronounced for fruits and vegetables and are common for most agricultural

26

[ Agricultural Price Policy

commodities. But these swings can be dampened or narrowed because of government intervention such as release of stocks, import or export management, or maintenance of minimum or maximum prices. Under these circumstances, the average price the producer would get in a given crop year would be the actual market prices at different points in the cycle weighted by quantities sold at these different points. The formula for computing averages can be used. The observed retail market price is correct if the focus is on the impact of protection on consumers. If the focus is upon producers, either the farm-gate price is used or adjustments have to be made for factors that lead to the observed retail price being different from the wholesale or on-farm price. These factors include indirect taxes, producer taxes or subsidies, processing margins, and transportation costs. The taxes and subsidies can be either ad valorem-namely, taxes or subsidies levied as a percentage of the value of the commodity-or they can be lump sums-namely, taxes or subsidies that are fixed sums per unit of the commodity. In either the ad valorem or the lump-sum case one tries to derive the price at the producer level from the observed price. It is preferable simply to obtain the price at the farm-gate level. When estimation is required, the following formulas are used: In the ad valorem case, pdomestic

pdomestic, estimated _ _ _ _ ____:o""b""se"-rv"'e,_d- - - producer, fanngate

-

+ indirect tax rate - subsidy + processing + transport

rate In the lump-sum case, pdomestic, estimated producer, farm gate

= pdomestic observed

tax

+ subsidy - processing - transport

The general point is that the practitioner must decide which economic group is of policy interest and select prices relevant to that particular group. This chapter presents the major steps involved in the initial stages of analyzing agricultural price policy. The process starts by formulating the major policy questions and using this tentative formulation to guide the practitioner in searching for data. Analysts use economic theory and simple graphical techniques to extract economic information from these data and build an intuitive understanding of the key features in production and marketing facing producers, intermediaries, and consumers. This entire initial stage is usually referred to as a desk review. Subsequent chapters discuss specific techniques for organizing price and quantity data, making inferences on

Initial Analysis

27

relative efficiency, and assessing selected consequences for market agents of price changes. The effective application of these techniques depends in part on the insights developed during the initial stage of analysis, when key domestic prices are identified. Analysts compare these prices with their corresponding international prices, which are appropriately adjusted according to techniques presented in the next section so that meaningful comparisons can be made. Analysts can then begin to understand whether the domestic price structure significantly diverges from values that would indicate that the country could be competitive in world markets and that it is an efficient domestic producer of a commodity.

The Border Price The analyst's task is greatly complicated by having to incorporate the influence of international commodity markets and foreign exchange rates into the analysis. World market prices represent the opportunity cost to the country of producing various commodities. Unfortunately, these prices cannot be taken straight from statistical sources. Analysts must first determine the price of a commodity that represents its long-run trend value-thus compensating for any short-term fluctuation in price-convert that price into the domestic currency equivalent using an appropriate foreign exchange rate, and adjust it for internal transportation and marketing margins. The resulting value is the border price, which is an efficiency benchmark. The border price represents the cost to the economy of producing a good and enables the analyst to determine if the country is an efficient producer of that commodity. According to the logic of the border-price paradigm, it is a waste of a country's resources to produce a good for which it has little or no cost advantage. Policy considerations other than efficiency may well come into play in the agricultural policy-making process, but this initial analysis serves as the essential starting point. There are three major considerations in computing the border price: sharp seasonal or yearly variations in international prices; the exchange rate, which must reflect the opportunity cost of a unit of foreign currency to the domestic economy; and the importance of the domestic economy in the foreign trade of particular commodities. The country may be a price taker, "small" in the world market, or it may affect international prices through the volume of its imports or exports; hence it is "large" in the world market. The basic reason for any adjustment is to obtain a border price that does indeed reflect the opportunity cost of the commodity to the economy and is relevant to assess the benefits and costs of a proposed economic activity.

28

I Agricultural Price Policy

Choosing the Appropriate Border Price

The f.o.b. (free on board) and c.i.f. (cost, insurance, and freight) prices for a given economy serve as reference prices because they represent what the commodity can earn as an export or what it costs the economy as an import. When the international, or world, price is translated into domestic currency at a given exchange rate, the resulting price is called the border price. The exchange rate can be the official one or any other market rate that is considered a better assessment of the scarcity value of the foreign exchange to the domestic economy. The practitioner can obtain the f.o.b. or c.i.f. prices from the country's trade statistics and from publications of international development organizations and private trade or business associations. A list of major sources is given in Appendix A. The appropriate world price is the export or import price the economy would receive or incur for its exports or imports. These prices tend to fluctuate sharply from day to day, month to month, and season to season. Which of these prices is relevant depends on the transaction being contemplated and the question being asked. Economists distinguish between short-run fluctuations and longer-run trends. In the context of policy analysis, the longer-term trends are more relevant because they are indicative of the broad movements in opportunity cost. The short-run, day-to-day prices are relevant if actual transactions are envisaged. The practitioner can compute a yearly average of prices for past years and then use these averages to identify trends. The discussion of Figure 2.1A presented simple methods for computing moving averages. The practitioner may have access to projected prices computed by the World Bank and other organizations. Since these projections are built on a global data base and related analyses, they are a valuable additional source of information. Given the uncertainties surrounding any projection, it is useful to use a range of alternative estimates. It is important not to allow the selection of border prices to become purely mechanical. The practitioner should consider the relevant time frame for the analysis, likely trends and developments in world markets, and the results of government attempts at price stabilization. The first of these considerations is the policy question being asked, and hence the time period relevant for the analysis. If past and current experience is of interest, past and current prices are used, and some method of averaging may be necessary. If the interest is to develop a medium-term floor price to guide domestic production and consumption decisions for approximately one to five years, projected international prices for this period and an understanding of the basic factors shaping these market trends are necessary. If the information is needed for long-term planning and investment purposes, it is customary to use projected long-term trends.

Initial Analysis

29

Whichever projected prices are used, it is useful to conduct sensitivity analyses with alternative prices. While one cannot be sure of the margin of error, it is fairly certain that there will be error. Sensitivity analysis allows the analyst to work through the implications of different price assumptions. If an actual investment decision is contemplated, a full cost-benefit analysis should be undertaken. The practitioner should use different sets of price data depending on the question. Trends rather than year-to-year prices should be used for analysis oriented to the future. The second consideration is to assess the importance of international trade developments for domestic price policy. The task here is not to estimate the opportunity cost benchmark per se but to consider the major ways in which international trade is likely to present opportunities and constraints to domestic agriculture. At this level one is going beyond simply using projections produced by experts in analyzing price developments for world markets to an understanding of the key empirical features of the models generating these projections and the major sources of instability. The practitioner may wish to enlist the services of a specialist in this area who can provide a critical assessment of these models and give a more meaningful set of alternative estimates to be included in the sensitivity analysis. The third consideration is to understand the motivation and consequences of past government attempts at price stabilization. The practitioner also may find it useful to have an overview of the problem and to survey past attempts at price stabilization in a worldwide context. The aim here is to consider how policy design can respond to volatility and what the potentially important considerations are. A recent analysis of price stabilization schemes has seriously questioned the net benefits of these schemes and has drawn important distinctions between stabilizing prices, incomes, and consumption. 5 An understanding of the major benefits and flaws of past attempts can help the practitioner in the overall task of policy design. It is important to develop contingency plans so that policy can be responsive to errors in estimation. In sum, volatility of border prices has been of recurrent concern to policymakers. Volatility is a fact of life, and the policy question is how best to respond to it in order to further welfare and production objectives. Pricing decisions should not be made in response to short-run fluctuations in international market prices. The approach suggested here is to move on three fronts: (1) to determine which period of analysis is relevant and to use trends applicable to that period; (2) to understand better the complex forces shaping 5David M. Newbery and Joseph E. Stiglitz, The Theory of Commodity Price Stabilization: A Study in the Economics of Risk (Oxford: Clarendon Press, 1981). The focus of the book is methodological rather than empirical. The beginning sections summarize the main policy insights derived from their new approach.

30

I Agricultural Price Policy

international markets and past attempts to respond to price volatility; and (3) to develop contingency plans. 6 Insights derived from these analyses can help the practitioner both in assessing the usefulness of projected trends and in designing policy.

The Foreign Exchange Rate Before meaningful comparison between domestic and border prices can be made, it is essential to choose the appropriate world price and then to convert that price at an appropriate exchange rate into domestic currency units. An exchange rate that either undervalues or overvalues domestic currency will correspondingly overprice or underprice the commodity to the domestic economy. Once the appropriate price-the exchange rate benchmark-is determined, analysts apply it in valuing the prices of imports and exports so that domestic prices for various commodities can be compared to their equivalents in the world market.

Current and future disequilibrium. Figure 2.3 illustrates the concept of overvaluation and undervaluation of the domestic currency. With the official exchange rate at 10 rupees per U.S. dollar, the domestic currency is overvalued because people are willing to give up 20 rupees per dollar, the market equilibrium. At the official exchange rate there is an excess demand for foreign exchange. This excess can be eliminated by rationing or quantitative controls, by imposing tariffs on imports (thus reducing domestic demand for imports), or by subsidizing exports (thus increasing domestic supply of exports). When domestic currency is overvalued, measures additional to the official exchange rate-for example, tariffs, licenses, restrictions, and controls-are necessary to maintain a precarious equilibrium between demand and supply of foreign exchange. The excess demand at the official exchange rate can also spill over into illegal trading, where the illegal market rates are well above the official rate. At the official exchange rate of 10 rupees per dollar, the illegal rate may shoot up to 40 rupees per dollar. If the official exchange rate undervalues domestic currency, there will be an excess supply of foreign currency instead, and it will show up in a low level of restrictions on imports. A fixed official rate can also progressively overvalue domestic currency because of differential inflation rates rather than explicit policy. If domestic 6C. Peter Timmer, Walter B. Falcon, and Scott R. Pearson, Food Policy Analysis (Baltimore: Johns Hopkins University Press for the World Bank, 1983), discuss use of border prices in price analysis; see pp. 187-88 in particular.

31

Initial Analysis Supply

Rps: U.S.$

...__ _ Market equilibrium

Demond

0

U.S.$

Figure 2.3. Market for foreign exchange

inflation is persistently above the inflation rates of major trading partners, the prices of imports in domestic currency become progressively more attractive while those of exports become progressively less attractive. The demand for imports rises, whereas the supply of exports falls. The fixed rate implicitly subsidizes imports and taxes exports. The equilibrium price for foreign exchange rises-the opportunity cost rises-but because the official rate is fixed, it becomes overvalued. Numerous controls, high tariffs, and illegal markets are evidence of an overvalued domestic currency. Since these are quite prevalent in developing countries, the official exchange rate is not a good indicator of the opportunity cost of foreign exchange. The prevailing official rate may be market determined rather than fixed officially. Its current value can be considered too high or too low from the perspective of some longer-term benchmark. For example, it may be pegged to the value of a major currency, such as the U.S. dollar. If the value of the dollar appreciates, then the local currency automatically appreciates in international markets; if the dollar depreciates, the local currency also depreciates. Since the official rate is market determined, it cannot be said to be overor undervalued, because the terms over- or undervaluation are relative to market equilibrium. But experienced observers may judge that its appreciation or depreciation during the current market period is short-lived. The

32

I Agricultural Price Policy

current rate departs sharply from an expected longer-term and more sustainable trend value. From the perspective of this expected longer-term value, the current market equilibrium rate is too high or too low. The relevant market equilibrium to assess opportunity cost is not the current one but the one expected to prevail in the future. An analogous situation arises in the case of an oil boom. The boom temporarily lowers the scarcity value of foreign exchange. There may even be a significant surplus. The economy can afford a high level of imports, but it is not sustainable once the boom is over and foreign exchange earnings drop to their historical levels. Under such a situation, even if the official exchange rate were market determined, the current rate would not be indicative of longer-term opportunity cost. The time dimension in market operations is of major importance in assessing opportunity cost. Opportunity cost is given by market alternatives, and these change over time. In terms of Figure 2.3, the curves shift over time. Interactive factors. The practitioner has to consider not only commodity flows but also the joint effects of services (current account) and capital (capital account) on the market value of foreign exchange to the domestic economy. International capital flows can assume key importance in determining market value, as the sharp appreciation ofthe U.S. dollar in the mid1980s showed. High interest rates in the United States (relative to rates in other international capital markets) attracted foreign capital and thus raised the demand and market value of the dollar. The high dollar in turn made commodity exports from the United States less competitive and contributed to a major deficit on the U.S. trade account. Domestic fiscal and monetary policies (sizable U.S. deficit and tight money supply, respectively) determined the foreign value of the dollar through the joint mechanisms of interest rate and international capital mobility. In many developing countries the impacts of complex interactions between domestic macro, trade, and exchange policies on the scarcity value of foreign exchange are likely to be different but no less significant. A typical scenario involves substantial domestic inflation due to continuing massive government deficits, which erode the value of domestic currency vis-a-vis foreign currency. In the face of an unchanging official exchange rate, disincentives to export and incentives to import mount and further worsen the trade balance. The sad state of the economy dampens net capital inflows from official and private commercial sources. In this case, the current and capital accounts undergo similar strains. Analysts need to consider both current and capital markets for foreign exchange. This in turn calls for an assessment of how domestic economic management interacts with these external markets.

Initial Analysis

I

33

The Exchange Rate Benchmark (ERB) The practitioner must decide which exchange rate best reflects the opportunity cost of foreign exchange. This is referred to as the exchange rate benchmark, which is used in Chapter 3 to value a commodity traded in the world market in domestic currency units. The resulting border price is thus free of any distortions induced by the country's foreign exchange rate. Assessing the opportunity cost of foreign exchange thus requires extensive analysis of current and often future foreseeable market opportunities. It is not surprising that the search for the relevant benchmark is usually problematic. But it is precisely because the value estimated by the analyst reflects an understanding of macro, trade, and external developments that it can serve as an input in efforts to redirect current policy. The process of computation can be guided by first defining the relevant period of analysis and the decisions the analysis will help to clarify. In other words, the scope and depth of analysis depends on how important the exchange rate issue is judged to be. Different measures of the exchange rate benchmark. Analysts can use several alternatives to determine the exchange rate to use in estimating the border price: the first-best shadow exchange rate (SER), or the equilibrium rate; the second-best SER; the effective exchange rate (EER); the auction rate; and the parallel, or black market, rate. The first-best shadow exchange rate is the equilibrium rate in a situation of no distortion in trade policy and international capital markets. Although it is a utopian notion, it has the advantage of being clear and unambiguous. It is analogous to the competitive equilibrium of perfect competition. Since the real world is one of policy and market distortions, the concept cannot be used easily in practical computation. If it were computed, it could indicate the direction in which policy should move. The second-best shadow exchange rate can also guide policy reform and is the most commonly used. Unlike the first-best rate, it assumes that distortions are present. Under the prevailing structure of trade taxes, subsidies, and controls, the second-best rate indicates the additional units of domestic currency that must be given up (in the case of an import) or can be gained (in the case of an export) in exchange for an additional unit of foreign currency at the margin. Additional units refer to units over and above the units required by the official exchange rate, and they reflect the premium attached to foreign exchange. For example, if the official exchange rate is 10 rupees per U.S. dollar, and the premium doubles the value of the dollar in the domestic economy, the shadow exchange rate is 20 rupees per dollar. The higher cost of the dollar in terms of domestic currency is expected to eliminate excess

34

I Agricultural Price Policy

demand for dollars. This higher rate is often referred to as the shadow price of foreign exchange. Unfortunately, the same term also is used to refer to the first-best equilibrium rate. Generally speaking, it is safe to assume that it is the second-best shadow exchange rate (or second-best shadow price of foreign exchange) that is referred to in empirical, policy-oriented work. The terms shadow exchange rate, shadow price of foreign exchange, and equilibrium exchange rate are often used interchangeably, and they all refer to equilibrium in a second-best scenario. The effective exchange rate (EER) is similar to the second-best shadow price rate because it takes into account the distortions of the existing trade and exchange system. It refers to the total number of units of domestic currency required for an import or received for an export in exchange for a unit worth of foreign currency. This total number is the sum of what is required given the official exchange rate and additional payments or receipts involved in the transaction. 7 At the official exchange rate, for example, an import costing 1 U.S. dollar will cost 10 rupees in domestic currency. But if additional taxes are levied, it may cost 20 rupees, which makes 20 rupees per dollar the effective exchange rate. If there is a subsidy on an import, the good may cost 5 rupees, and thus the effective exchange rate is 5 rupees per dollar. Conceptually, the effective exchange rate differs from the shadow exchange rate in the sense that the former is an average concept whereas the latter is a marginal concept. In estimation, both use average trade data, and they are quite similar. In subsequent discussions, only the term shadow exchange rate will be used. The auction rate is an official rate that is not fixed but varies, usually on a weekly or fortnightly basis, to equate demand and supply channeled through the official auction system. The larger the volume of transactions that enter the official auction and the more sustainable the inflow of foreign exchange through the auction, the better the auction rate reflects the opportunity cost of foreign exchange. Conversely, the more restricted the access to the auction and the more unsustainable the level of inflow, the less the auction rate approximates the opportunity cost. Practitioners must fully understand the extent to which the auction is or is not officially constrained, and thus is not reflecting underlying scarcities. The important elements of information to be considered are as follows: the expected sustainable earnings of foreign exchange, rules of access and the implementation of these rules, expected major sources of demand from public and private sectors, weekly rates over extended periods, and trends in the 7See Anne 0. Krueger, Foreign Trade Regimes and Economic Development: Liberalization Attempts and Their Consequences (Cambridge, Mass.: Ballinger Press, 1978), appendix A, p. 301.

Initial Analysis

I 35

differentials between official and unofficial rates. Ghana, for example, instituted a weekly auction system in September 1986, and Nigeria has had a fortnightly system since September 1987. Cocoa exports have been a major source of foreign earnings in Ghana, and access to the auction has gradually widened. The weekly rates were roughly 130 cedis to 1 U.S. dollar in September 1986, 170 cedis by September 1987, and 210 cedis by July 1988. Knowledgeable observers estimate the unofficial rates at roughly 270 cedis, which represents a narrowing of the wide differential between official and unofficial rates. Although Nigeria, like Ghana, is dependent on one main source of foreign earnings (in this case petroleum), the Nigerian auction seems to have performed differently. The general point is that the operation of the auction, in particular the extent to which it reflects market forces, must be well understood before auction rates can be used as reliable estimates of opportunity cost. The greater the excess demand at the official exchange rate, the more likely the parallel rate, or black market rate, will be well above the official exchange rate. The first-best equilibrium exchange rate and the parallel rate are polar opposites because the former assumes no distortions and the latter exists precisely because of severe policy distortions. Analysts determining the appropriate exchange rate to use look at the parallel rate to indicate whether the official exchange rate significantly overvalues domestic currency. The parallel rate is likely to overstate the opportunity cost of foreign exchange because it reflects not only market scarcity but also the risks involved in illegal trading. In addition, the very existence of a parallel market may further divert exports and their earnings from the official market to an unofficial market where foreign exchange earnings are higher per unit of commodity sold. Parallel markets often thrive at the expense of official markets. In economies where the official exchange rate has been significantly overvalued-for example, Ghana and socialist Guinea in the 1970s-the illegal rates were many times above the official exchange rate. 8 Although in general these rates should not be used as the opportunity cost benchmark for foreign exchange, they can be useful for assessing the severity of the shortage. Calculating the shadow exchange rate. The relevant period of analysis can be the recent past, the near future, or both. In any case, one can start the analysis by computing the second-best shadow exchange rate implied by the current trade structure. The common approach uses trade data that contain Sfor a detailed discussion see World Bank, Accelerated Development in Sub-Saharan Africa: An Agenda for Action (Washington, D.C.: World Bank, 1981), pp. 24-27, 55-58 in the English version; pp. 21-26, 28-33, and 54-69 in the French version.

36

/ Agricultural Price Policy

information on two items: the total value of exports and imports in foreign prices, which, converted into domestic values at the official exchange rate, gives border values; and tariffs and subsidies applied to traded commodities. 9 If there are extensive quantitative controls, the tariff or subsidy rates may understate the difference between border and domestic prices. The domestic values of imports and exports should then be used instead. When deriving the total value of imports and exports at domestic prices, the weights to be used are the quantities of imports and exports, respectively. Comparing the value of traded goods at domestic prices to their border prices indicates the extent to which measures additional to the official exchange rate are necessary to balance demand and supply in commodity markets. The ratio is thus an indicator of the premium on foreign exchange. Although this term is used frequently, the premium is really on the traded goods that foreign exchange can buy. total value of imports and . . _ exports in domestic prices al . b d . Premmm on foreign exchange tota1 v ue m or er pnces

If there are extensive parallel markets, it is useful to get some indication of the premium in those markets, too. The shadow exchange rate is the official exchange rate adjusted by the estimated premium. Thus SER = premium x OER

The estimated shadow exchange rate can be compared with available data on parallel market rates. The latter can be interpreted as the upper bound of the opportunity cost value. The official exchange rate can be interpreted as the lower bound, and the shadow exchange rate lies between the two extremes. This comparison helps analysts to assess how quantitatively significant and sustained is the difference between the official rate and the benchmark rate. This empirical assessment is crucial for policy analysis, for it is not overvaluation (or overappreciation) per se that is significant for policy but the extent of the divergence and its persistence over time.

Advantages and disadvantages of using trade data. An advantage of this method is that it is relatively simple to apply because trade data are more readily available in many developing countries. It is also easy to interpret the 9Some use the term border value only when the opportunity cost benchmark is used. In line with common usage, the more general term is used in this book. The stricter definition is the correct one because it captures the concept of opportunity cost.

Initial Analysis

I 37

ratio of domestic to border values as indicative of the premium on foreign exchange. The higher the domestic value relative to the border values, the higher the premium and the higher the difference between the shadow rate and the official rate. There also are disadvantages to using trade data. It should not be used when quantitative restrictions prevail. A direct comparison of domestic and border values is more informative. The method relies solely on trade data, which are likely to contain various inaccuracies. Importers and exporters might over- or underinvoice (overstate or understate actual values used in the transactions of these commodities) to minimize taxes. Furthermore, there is a lag in the collection of trade data, which means that data may not be available for the most recent years, which are likely to be the most relevant. Net inflows in the capital account are ignored as well, which can make a substantial difference in the scarcity value of foreign exchange. If a country is "large" in international trade (its own trading actions affect the world price), the data may not take into account likely changes in unit prices for imports and exports. Adjusting border prices for a "large" country is discussed in Appendix B. This approach to trade data should not be mechanical. Analysts need to give thought to the longer-term equilibrium ofthe country's foreign exchange market. The task is both to understand the operations of the foreign exchange market, rather than provide a magic number, and to determine how domestic policy interacts with external markets for commodity, services, and capital flows. Understanding as the foundation to useful computations is further emphasized in the need for sensitivity analyses. Using the shadow exchange rate. The shadow exchange rate can be computed for specific groups of commodities or on an economywide basis. Though conceptually different, computed shadow exchange rates and effective exchange rates are similar. For exports, a SER > OER indicates that on balance they are taxed, and a SER < OER indicates net subsidies. For imports, the reverse is true. Thus a SER > OER indicates net subsidies; a SER < OER indicates net tax. The shadow exchange rate indicates the opportunity cost of a unit of foreign exchange in the limited sense that it shows what the actual total cost or benefit is in terms of domestic currency (given current distortions), whereas the official rate indicates only part of the total cost or benefit. The shadow rate can be considered a second-best equilibrium rate only if the structure of trade, trade policies, and related distortions are considered to be in equilibrium-that is, they are sustainable in the foreseeable future. There is nothing normative or desirable about the shadow rate. Relative to the firstbest equilibrium rate, it is itself a distorted measure of opportunity cost. It is

38

I Agricultural Price Policy

often used not because it is an ideal measure but because it is a practical measure. Comparing the official exchange rate and the computed shadow exchange rate is a first step in assessing exchange rate distortions. Additional steps may be needed, depending on the use to which the opportunity cost benchmark will be put. If it is to assess relative incentives of past and current price policy, these computed shadow rates suffice. If they are needed for planning purposes, then their use assumes that the future will be like the past, which is likely to be an unrealistic assumption. Alternatively, one must show that these shadow rates do incorporate expected policy and market changes such as projected prices and policy initiatives affecting the export orientation of the economy. It is important to consider whether a future-oriented shadow rate is likely to be significantly higher or lower. There are several indicators: developments in parallel market rates can indicate private perceptions of expected scarcity, which can become self-fulfilling prophecies; expected export growth in the light of current macroeconomic developments and projected world prices for the commodity and its closest substitutes; and import growth in the light of expected growth in the supplies of domestic import substitutes, population growth, and per capita income growth. In countries where services such as tourism or shipping are important sources of foreign exchange earnings, analysts may have to consider the economic growth prospects of the foreign countries from which the demand emanates. A recession in these countries thus indicates a decline in the absolute or relative growth of these invisible earnings. In other countries remittances from foreign workers can be an important source of foreign exchange, and in this case the growth prospects and absorptive capacity of oil surplus countries may become relevant to the analysis. As the analyst goes through the major accounts in the balance of payments, the set of considerations grows by leaps and bounds. Any of these markets can be the subject of a full and detailed study. The aim here is to identify major factors impinging on the shadow exchange rate. The practitioner may decide that a full-scale study of selected markets is advisable because of their importance to domestic policy concerns. If such a study is not undertaken, the practitioner can adjust the shadow exchange rate to reflect market conditions on the basis of best guesses of likely developments. Systematic consideration of developments in key external markets is likely to result in a range of plausible estimates for the shadow exchange rate, which can then be used in a sensitivity analysis. Plausibility is subjective and depends on one's understanding of the particular case in hand and experience in other contexts. The better this understanding, the sounder the judgments

Initial Analysis

I

39

one can make about plausible estimates. Good policy analysis requires good intuition and good techniques. As stated in C. Peter Timmer's Getting Prices Right, "Policy analysis will always be a process that is at least as intuitive as it is quantitative" (p. 132). Through sensitivity analysis, practitioners can explore the implications of these alternative rates for incentives, comparative advantage, and the extent to which official policy needs adjustment. The computation of the shadow exchange rate and its subsequent adjustments can be a major task. The practitioner is the best judge of how much effort to invest. Appendix C shows how spreadsheet methodology can be used to facilitate sensitivity analysis. To the extent possible, the practitioner should draw upon estimates based upon extensive analysis undertaken in local universities or development institutions. The analytical resources in these research and development institutions are likely to be more adequate to undertake these extensive analyses.

The Standard Conversion Factor

The shadow exchange rate is a summary indicator of the trade-related distortions, and it is used to adjust for distortions in the official rate. Likewise, the standard conversion factor (SCF), which is the ratio of the official exchange rate to the shadow exchange rate, is used to adjust for distortions introduced by the trade regime between the border prices of traded goods and the domestic shadow prices of nontraded goods. The adjustment is needed because an overvalued official exchange rate understates the border prices of traded goods in local currency, and, conversely, an undervalued official rate overstates them. For example, if the official rate overvalues the domestic currency at 10 rupees per U.S. dollar, an import that costs 1 dollar would cost 10 rupees in local currency. With a shadow exchange rate of 20 rupees per dollar, the good should have cost 20 rupees instead, and the prices of traded goods in local currency are thus too low relative to the prices of nontraded goods. With an official exchange rate that undervalues domestic currency, border prices of traded goods are too high. Without the adjustment the two sets of prices-border prices of traded goods and domestic shadow prices of nontraded goods-are not comparable. Alternative methods of conversion. Foreign prices can be converted directly into local currency at the shadow exchange rate rather than the official exchange rate. Alternatively, the official rate can be used to convert foreign prices to border prices, and then the domestic prices are adjusted with the standard conversion factor.

I

40

Agricultural Price Policy

As previously noted, SER = premium x OER . _ value of traded goods in domestic prices P remmm - va lue of traded goods m · border pnces ·

where

Border price

= foreign

price

X

official exchange rate

The standard conversion factor is defined as the ratio of the official exchange rate to the shadow exchange rate. Thus

SCF

= OER

and

SER

=

1 SCF

Therefore

1 SCF

=

. premmm

or

SCF = ---,--premium

or

SCF

SER

=

x OER

value of traded goods in border prices value of traded goods in domestic prices

The alternative methods for adjusting the border price can be demonstrated with a simple example. The domestic shadow price of a nontraded good is 10 rupees per U.S. dollar, and the border price of a traded good at the overvalued official exchange rate is I 0 rupees. The price of the latter should have been 20 rupees because the shadow exchange rate is 20 rupees per dollar. At 10 rupees the traded good is too cheap relative to the nontraded. A shadow rate of 20 rupees per dollar implies an SCF = 10:1120:1 = 112 = 0.5. To make the two prices comparable, analysts can convert the foreign price in dollars directly into a border price of 20 rupees using the shadow exchange rate. Alternatively, the border price of 10 rupees can be adjusted by the SCF = 0.5. Thus 10 rupees is divided by 0.5, and the border price becomes 20 rupees. Either method yields the same relationship between the two-a border price of 20 rupees to a domestic price of 10 rupees for the nontraded good. The relationship is 2: 1 under either method. Domestic shadow prices of primary resources and nontraded intermediary inputs that are adjusted by conversion factors are referred to as border equivalent prices. The term also is used for adjusted border prices. Chapters 3 and 4 illustrate the use of the standard conversion factor in adjusting border prices.

Initial Analysis

I

41

Policy interpretation of the standard conversion factor. When SCF < 1, it means that domestic currency is overvalued, but it does not necessarily mean that exchange rate policy is the problem. Overvaluation results in SER > OER, which implies SCF < 1 by definition. Overvaluation can occur when the official exchange rate is fixed by policy, and when it is determined by market forces. In the first case, exchange rate policy is the problem. In the second, it is not. The forces at work are generated by the complex interactions of domestic macro and trade policies, on one hand, and international trade and capital movements, on the other. The current market value is overvalued because it is considered unsuitable over the longer run. The adjustments required are fiscal and monetary rather than in exchange rate policy. The standard conversion factor is one of a class of conversion factors. Conversion factors can be calculated for specific groups of commodities. The most commonly used commodity-specific conversion factors are the consumption conversion factor (CCF) and the capital conversion factor (KCF). The consumption conversion factor is the ratio of a typical or representative bundle of consumption goods at border prices to its value in domestic prices. Similarly, the capital conversion factor is the ratio of a typical bundle of capital goods at border prices to its value in domestic prices. They are used in precisely the same way as the standard conversion factor. The CCF is applied to the shadow wage of labor to obtain a border equivalent value of the opportunity cost of labor. Similarly, the KCF is applied to the shadow price of capital to obtain the border equivalent price. If these commodity-specific conversion factors are not available, the standard conversion factor is used to convert domestic shadow prices to their border equivalent prices. Efficiency Benchmarks for Imports, Exports, and Nontradables Once the international price for a commodity is converted at an appropriate exchange rate into domestic currency, the border price must be adjusted further to make it comparable to the domestic price. By adjusting the border price for all margins, the analyst determines the border price the farmer, intermediary, or consumer would have faced if there were no specific intervention.

Adjusting the price of an import. The border price of imports is usually recorded as the c.i.f. price (inclusive of the cost of insurance and freight) in international statistics. This is the desirable form because the c.i.f. price captures the landed price at port of entry to the recipient country. If the specific price data are not provided, unit-value calculations can serve as

42

I Agricultural Price Policy

proxies. A unit value is the total value of imports in the particular commodity category divided by the quantity of goods imported. The calculation of the adjusted border price depends on where in the production-through-marketing chain the domestic producer competes with the import. The two extreme points are at the farm and at the port of entry. If the point of competition is at the farm level, the c.i.f. price is adjusted upward. The costs of transport, handling, processing, and marketing are added to the c.i.f. price because these are the costs incurred to bring the commodity to the farm level. If the point of competition is at the port of entry, then the c.i.f. price is not adjusted. Instead, the domestic farm-gate price is adjusted upward, because costs are incurred to bring the commodity to the port of entry. Sometimes the point at which the import and the domestic import substitute compete is the wholesale market. In that case one can choose between two equivalent adjustments: first, one can adjust the c.i.f. price only; second, one can adjust both the c.i.f. and the farm-gate prices up to this common intermediate point. In the first case, the costs of handling from port of entry to the wholesale market are added to the c.i.f. The next step is to subtract from this "c.i.f. plus" price the costs of handling from farm to the wholesale point. This second step is necessary because the c.i.f. plus price would overstate the price the farmer can get. The farmer does not get this c.i.f. plus price because of the costs incurred in bringing the commodity from the farm to this wholesale point. Adjusted or estimated border price

=

b d h dr transport costs b 0 dserve. + an mg costs + from border or er pnce at the border to market

+

marketing margins from border to market

transport costs from farm to market

processing and marketing margins from farm to market

In the second case, the c.i.f. price is adjusted upward to the wholesale point. The farm-gate price is also adjusted upward by the costs of handling from farm to the same wholesale point. It is necessary to make these upward adjustments to both prices because costs are incurred in moving the commodity originating from opposite points to a common point. Adjusting the price of an export. The border price of exports is recorded as the f.o.b. price (free on board), which is exclusive of insurance and freight charges. This is again the appropriate price (or unit value) to use because the figure gives the price received for the provision of the domestic good to the point of export.

Initial Analysis

I 43

When a country exports the commodity, the analyst makes the following adjustments to the f.o.b. price of the commodity: Adjusted border price

observed border price

handling costs at the border

transport costs from farm to border

processing and marketing margins from farm to border

Notice the asymmetry in the adjustments for the export and import case: for exports, all intermediary margins are subtracted; for imports, if an intermediary point is of interest, then all are added up to the point of the wholesale market, whereas costs from the farm to that market are subtracted. Border prices are adjusted for all costs incurred from border to farm for both exports and imports. For the export, one subtracts the margins, because the farmer would have had to incur these costs to bring the commodity to the border. For the import, which would be sold domestically at the wholesale market level, costs from border to wholesale market are added, because the domestic farmer would be competing against this import plus price. The domestic farmer, however, would not receive this import plus price because costs are incurred in bringing the commodity from the farm to the wholesale market. These adjustments result in the price the farmer would get for the sale of an export, given the f.o.b. price, and for the sale of an import substitute at the wholesale market, given the c.i.f. price.

Adjusting for intermediary margins and "large" country effects. The practitioner may not have data on intermediary margins. For landlocked regions far from centers of foreign demand and supply, there is an a priori reason to think that these intermediary margins are substantial. In these cases data may be available for marketing and transportation costs in some neighboring country with similar conditions with respect to location and infrastructure, and analysts can obtain some factor for relating border price to its adjusted equivalent; for example, pb =-:.,.--,..--,-

padjusted

=

a

This factor can be used to adjust the border price being estimated. If there is no possibility of transferring data, one must simply ignore the margins and remember that the coefficients that are discussed in Chapter 3 overstate protection in the case of imports and understate protection in the case of exports. A major consideration in using the border price relates to the importance of the economy as a trading nation. A "small" country is by definition a price

44

I Agricultural Price Policy

taker in international markets, and border prices are treated as given. But if a country is a major trading nation and can affect the level of an international price by entering or leaving the international market (is "large" in the world market), it should not consider the border price for the commodity as given. Instead, a large country should assess the likely impact of its trading decisions on the international price. In other words, a large country is by definition one that does not passively take a price as given. Its actions influence the market because it commands a major share of the market, and its trading decisions help to set the market price. By contrast, the small country cannot set the market price because it has a small market share. In the extreme, a large country is a price setter if its trading actions totally dominate the market and determine the price, as the United States does in wheat and corn. The border price for a large country still reflects opportunities offered by foreign trade. But the price has to be estimated using information on market share and the likely response of foreign supply and demand to a change in trading volume by the large country. Observed border prices have to be adjusted for the likely impact of the country's exports or imports on border prices. In the large country case the adjusted border prices are referred to as marginal export revenue and marginal import cost, respectively. For exports, information is needed on the response of foreign demand; for imports, information is needed on response of foreign supply. These responses of quantity to price changes are discussed more fully in Appendix B. The efficiency benchmark for nontraded goods. The ultimate purpose in obtaining a border price-that is, converting the world price of a commodity to its domestic equivalent-is to determine the social opportunity cost of producing the commodity. The border price of the commodity serves as the efficiency benchmark for comparison with the domestic price. But where commodities are not traded in the world market, some other efficiency benchmark must be found to enable policymakers to know if production of the commodity is an efficient use of domestic resources. This efficiency benchmark may be available domestically, for example, if a country has a system of parallel markets in which one market is controlled by government policy and the other is a competitive market. The official domestic price is then compared with the competitive domestic price. In a dual-market system, in which the official market coexists with the unofficial one, the official procurement price must be lower than the unofficial price; otherwise farmers would sell all of the commodity to government purchasers. The government procurement itself reduces supplies available on the unofficial market and thus tends to increase the equilibrium market price. The latter price thus tends to overstate the social opportunity cost of producing the commodity. Given the distortions introduced by government marketing, it is

Initial Analysis

45

a second-best efficiency benchmark. The undistorted market-equilibrium rate is likely to be lower than the distorted equilibrium and higher than the distorted official level. In addition, market prices are likely to vary from market center to market center and from season to season. Therefore the practitioner needs a set of cross-section and time-series data to compute an efficiency benchmark for a given period. If the official market monopolizes all trade, the efficiency benchmark can be found in one of two ways. Competitive market prices in another country with comparable structural characteristics-for example, the Indian and Pakistani Punjabs-may provide the appropriate price for comparison. Alternatively, analysts might use the prices of a close substitute that is tradable in the world market. Suppose sorghum is a nontradable good, but maize, a close substitute in consumption, is tradable. At given world and domestic prices, consumers are willing to exchange two units of sorghum for one unit of maize. Maize, the imported substitute, is twice as expensive as sorghum. The efficiency benchmark for sorghum thus can be set at half the price of a unit of maize. This approach is likely to underestimate the opportunity cost of sorghum, however, because the market price would likely be higher if the government did not intervene. Indeed, it is precisely because of this higher market price that the government imposes controls on procurement and sale. By suppressing market operation, the government is also losing valuable information on opportunity cost or scarcity values. It is important for analysts to make a distinction between tradable and nontradable goods when using the analytical techniques presented here, for they have different opportunity cost benchmarks. Strictly defined, a tradable good is a commodity or service that can be imported or exported, and a nontradable good is one that cannot be imported or exported. The essential difference is the extent to which a commodity's domestic price formation is influenced by the world market for that commodity (or for a close substitute). In classifying commodities into tradable or nontradable, the key consideration is the range of domestic or foreign market opportunities available during the period relevant for analysis. A good that is normally considered tradable, that is, it enters world markets, may not in fact be traded. Policy prohibitions such as export controls or licensing restrictions can tum a tradable into a nontraded item. In other circumstances a commodity may be both nontradable and nontraded, often because of the high cost of domestic transport. Local fresh milk, for example, is nontradable because it would be exorbitantly expensive to import or export. Maize is traded internationally, but it might be nontradable in a landlocked country with poor transport. In these cases domestic prices are either lower than marginal import costs or higher than marginal export prices. These nontradables benefit from natural protection from foreign trade because of high domestic costs. Sometimes a good is

46

I Agricultural Price Policy

nontradable because of quality differences. A domestic product may be of such inferior quality compared to the internationally traded version-for example, poorly processed, broken rice-that there is indeed no market for it. As an economy enters different stages of development and faces different trade options, the classification of commodities as tradable and nontradable is likely to change. As development proceeds, more and more commodities tend to become tradable as marketing and transportation infrastructures improve and domestic transport costs fall, as technology improves quality and quantity of outputs, and as policy becomes more outwardly oriented. Again, the distinction does not necessarily reflect intrinsic differences between commodities. Rather, it reflects different market opportunities, which are in constant flux. A clear distinction between tradable and nontradable requires two assumptions: first, that there is no major change in availability in the structure of production or consumption; and second, that the next best alternative use of a given commodity or resource is not likely to generate repercussions throughout the economy. In other words, only marginal (as opposed to major) shifts in resource use are considered, and these marginal changes in one market cannot disturb the operation of other related markets. The distinction between tradable and nontradable becomes blurred in the case of a major change in the availability of a nontradable good, particularly in a well-integrated economic system. The major change is likely to have multiple repercussions throughout the economic system, and ultimately it will affect availability and price of tradables. Under these circumstances, the value to the economy of this nontradable is given by some weighted average of the border prices of the tradables it substitutes for. For example, a major change in the supply of electricity may substitute for imported sources of energy and related equipment. The distinction is useful only so long as one can assume limited substitutability between nontradables and tradables within the time horizon relevant for the analysis. A nontradable may have no substitute or no tradable as a satisfactory substitute-for example, local transportation from farm to market, or repair and maintenance as opposed to purchase of new equipment. By contrast, if substitution were perfect, producers and consumers would switch out of the nontradable into a tradable and vice versa, depending on relative availability, costs, and returns. Local labor would be substituted for migrant labor in production, or fuelwood for kerosene in consumption. The opportunity cost of the nontradable would then be the border price of the tradable substitute. Along this continuum between goods that have no substitutes and goods that have perfect substitutes, analysts thus look for the degree of substitution between commodities and assess whether a nontradable commodity's price behaves similarly to that of a tradable substitute. The higher the degree of substitution between nontradable and tradable, the less

Initial Analysis

47

important is the need to distinguish beween them for the purpose of assessing opportunity cost benchmarks. The initial, or desk, stage in the analysis of agricultural policy enables practitioners to develop insight and intuition about the functioning of the key production and marketing systems. 10 After completing this initial stage, the practitioner has identified the important domestic and border prices and developed hypotheses about major determinants of these prices, including the impact of price policy. The analyst will have taken stock of the data available and that needed for further analyis and clarified the basic policy questions that will be addressed. The domestic and border prices identified serve as basic building blocks for subsequent stages of analysis. The following chapters discuss how to organize and interpret them to shed light on relative incentives and on the relative efficiency of resource use implied by the economic activities undertaken. Using empirical assessments of response to price changes, the practitioner can assess quantitatively the short-run impact of these price structures on production, consumption, welfare, the government budget, and foreign exchange earnings. Essentially, the practitioner is trying to understand the direction and magnitude of responses by key economic agents to price policy signals and assess the extent to which the responses advance or undermine the achievement of development objectives. IO'fo help participants of the Agricultural Price Policy Analysis Seminars at the World Bank develop insight and intuition about the functioning of key markets, the Economics and Policy Division of the Agriculture and Rural Development Department of the World Bank worked with Graham P. Chapman, now at the School of Oriental and African Studies, University of London, during 1982-83 to develop Exaction: A Policy Simulation Game. Exaction re-creates the drama of national development. It is a two-sector open-economy model, with government playing a key role. It is an extension of the well-known Green Revolution Game. Participants take on the role of poverty-stricken farmers in the rural sector, industrialists in the urban sector, trading intermediaries, and decision makers in government. Acting and reacting with each other in the face of an uncertain physical environment and a changing world economy, they struggle through several years at the edge of survival. Participants learn from their own actions and experiences. The game teaches through individual and collective experience and discussion rather than through lecture. Exaction was developed by Graham Chapman, in collaboration with me and the participants in the experimental World Bank sessions.

CHAPTER

3

Coefficients of Protection

Governments use agricultural price policy to pursue a variety of development objectives. Promoting efficiency is not an end in itself, but it is necessary to improve the economic opportunities available to the majority of the population on a sustainable basis. Efficiency considerations therefore cannot be ignored, for in the long run only the efficient survive. Thus the question for the analyst is how to assess the efficiency of the price system imposed or induced by agricultural policy. Prices contain two types of information that are central to the analyst's task. First, prices can reflect relative scarcity; they indicate the value of a resource to the economy. The value of a resource is what the economy must give up to obtain it or what it can earn by exporting it. Second, relative prices can indicate relative incentives to produce, market, and consume different commodities. Price policy affects the economic system by altering incentives and therefore the economic decisions that shape a system. The analyst can assess the efficiency of agricultural price policy by comparing the existing price structure with an alternative one that reflects efficient resource use. The comparison also indicates whether policy-induced incentives are likely to support or inhibit efficient resource use. In short, efficiency is assessed through price comparisons. As we saw in Chapter 2, the analyst first must define the alternative set of efficient prices, which will serve as efficiency benchmarks. These prices reflect opportunity cost. Such values when converted into domestic currency are termed border prices, which are the opportunity costs for commodities that are traded in world markets. Pricing according to opportunity cost reflects relative scarcity and is conducive to efficiency. According to the logic of the border-price paradigm, domestic prices that systematically diverge from border prices entail efficiency losses. 48

Coefficients of Protection

49

Coefficients of protection enable analysts to compare domestic prices to foreign prices. By calculating the various coefficients, they can determine both the implied structure of taxation and subsidization and the divergence between incentives that are generated by policy and incentives that opportunities for foreign trade would have provided. Complementary to coefficients of protection are coefficients of comparative advantage, which indicate the relative efficiency of domestic production for export or for import substitution. The opportunity costs of the domestic resources required in domestic production to earn or save a unit of foreign exchange are compared with the opportunity costs of foreign exchangewhat people are willing to give up in domestic currency to acquire an additional unit of foreign exchange at the margin. Coefficients of protection and comparative advantage allow analysts to determine whether incentives generated by price policy are supportive of efficient agricultural development and in what direction public investment and private incentives should be restructured to promote more efficient use of resources. The most important feature of these price coefficients is the systematic comparison of policy-determined prices with border prices, which reflect the relative scarcity of the commodities to the economy. Scarcity values are thus used as benchmarks to evaluate the desirability of official prices.

Theoretical Framework Opportunity cost is a powerful concept that guides much of economic inquiry. The core of economic analysis is the search for and assessment of alternatives. Precisely because resources are scarce, one must choose the alternative that best satisfies objectives. Scarcity imposes the need for choice, and opportunity cost captures the notion that relative scarcity is the foundation of value. The use of opportunity cost as a benchmark is the guiding principle in economic pricing. If very stringent conditions derived from the model of perfect competition hold, then market prices tend to reflect opportunity cost, resource allocation will be efficient, and the highest level of welfare will be attained, given the resource endowment, initial income distribution, preferences, and constraints. The model thus links opportunity cost to efficiency. Briefly, these stringent conditions specify the following: Suppliers and consumers are price takers. Individually, they have no market power, no power to influence the prices and other terms on which they sell and buy.

50

j

Agricultural Price Policy

There is freedom of exit and entry. This means that there are no legal or other impediments on individuals entering or leaving the market. There is perfect information, and resources are mobile in response to opportunities. Within such a market, competition will ensure that sellers do not make excessive profits, and least-cost methods of production will prevail. A key feature of this model is the causal link between opportunity cost and efficiency. Opportunity cost pricing leads to efficient resource use.

Efficiency

There are three distinct concepts of efficiency, but the central and unifying notion is simply that more output and welfare cannot be extracted from a given set of resources. 1 The three concepts are technical or engineering efficiency: choosing an input combination that enables one to be on the highest production function, given available technologies; economic efficiency: from a given set of inputs, extracting the maximum output, given the prices of inputs and outputs faced; and social efficiency: the impossibility of rearranging outputs and making some people better off without at the same time making others worse off. In other words, society is at a Pareto optimum point when increasing the welfare of some entails decreasing the welfare of others in the economy. The key difference between technical efficiency and economic efficiency is that the former involves only the technical relationships between inputs and outputs, whereas economic efficiency also involves the price relationships between inputs and outputs. Economic efficiency entails technical efficiency but not vice versa. In social efficiency a single input-output relationship is expanded to encompass the structure of all inputs and outputs, and the relationship of that structure to aggregate welfare. A more efficient use of resources means that one can produce more from what one has and attain a higher level of welfare. Increasing efficiency means reducing waste and unnecessary deprivation. This concept is important in the use of techniques, and two simple diagrams will help to clarify these basic notions. The production function is the relationship between input levels and maximum output levels using a given technology. As shown in Figure 3.1, once on the curve of production function 2, the precise level of output will depend on relative prices of input and output. In Figure 3.2, the situation can be improved by moving away from point Y 1 to any point within the shaded area. For example, point Y2 has more of output Yb, without less of output Ya, than point Y 1 . Point Y3 has more of Ya, without less of Yb• than point Y1 • Point Y4 has more of both Ya and Yb. This production

1The concept of efficiency is discussed at length in most introductory economics textbooks. SeeR. G. Lipsey and P. 0. Steiner, Economics, 6th ed. (New York: Harper and Row, 1981); Paul A. Samuelson, Economics, 9th ed. (New York: McGraw-Hill, 1973).

y2~--------------------~

Production function (1)

Output Y

Input X

Figure 3 .1. Technical efficiency

t

OutputYb

Any point within this shaded area is more efficient than Y1

Production possibility frontier

/

OutputYa

Figure 3. 2. Improving efficiency

52

I Agricultural Price Policy

possibility frontier sets the limit to the total combinations of Ya and Yb one can have with a given resource endowment. In the perfect competition model, market pricing leads to the highest level of output and welfare attainable with given resources and initial endowments. The model emphasize the key role of market prices as signals to induce private responses that further both private and social interests. But the model is an idealized abstraction-a first-best world. Most markets are imperfectthe world is second or third best. The need for policy analysis arises precisely because the world is not first best. The gap between the world of perfect competition and the real world raises many difficult questions in the application of the theory to policy advice. Efficiency Benchmarks: Border Prices and Shadow Prices

Once the principle of opportunity cost pricing is established as an efficiency benchmark, observed prices that diverge from opportunity cost values are said to be distorted, and they contribute to inefficient resource use. Distortion therefore refers to the divergence between the observed price and prices that reflect opportunity cost. Implicit in the argument is that the divergence must be systematic and persistent, not purely temporary. These chronic price distortions generate inefficiency. If a domestic market is competitive, market prices reflect relative scarcity and can serve as efficiency benchmarks. If a market structure is dominated by monopolistic elements, market prices themselves may be distorted because they reflect collusion rather than scarcities. If externalities exist, government intervention is required to improve on market signals that do not lead to efficient resource use. Externalities that generate social costs should be taxed. Government intervention may then reduce price distortions by moving prices closer to scarcity values. Market prices may be distorted, whereas official prices may be closer to efficiency prices. In the case of public goods such as the provision of public infrastructure and information, government intervention is needed to improve the competitiveness and efficiency of market operations. The key consideration when assessing whether distortions exist is not whether the prices are market or government determined. The key question is, What is the next best alternative market for the use of this resource or commodity? This alternative provides the benchmark value. This next best alternative may reside in international or domestic markets. The opportunity cost of a tradable commodity is the border price-the price of an export or import converted into domestic currency at a given exchange rate. 2 If an export, the border price is the domestic price at the 2Some use the term border price to refer to foreign price converted into domestic currency at an exchange rate that correctly reflects its scarcity value to the economy. The more general definition is adopted in this book, and the more restrictive use of the term will be indicated.

Coefficients of Protection

53

point of export, free on board the carrier (the f.o.b. price). If an import, the border price is the domestic price at the national border, inclusive of cost, insurance, and freight (the c.i.f. price). The relevance of border prices as efficiency benchmarks is not dependent on the competitiveness of international markets. International prices do not have to reflect efficiency of resource use at the global level. The international prices a given country faces may be the result of dumping or cartels or some other form of market power. However they are determined, they represent what the country would have to pay or would receive if trading internationally. The important consideration is not whether international markets are competitive, but whether the prices a given country faces are likely to prevail during the period of interest to policymakers. The opportunity costs of nontradable commodities are domestic shadow prices. The efficiency value of a nontradable input is given by its contribution to output in the next best alternative use. As we saw in Chapter 2, this efficiency benchmark is the domestic shadow price. If there is no alternative use, the shadow price is zero. If the contribution of the nontradable input in the alternative use has a higher value than in its current use, then the shadow price is positive and greater than its actual observed price. If the market is purely competitive, the market price is equal to the shadow price. For a nontradable output, the competitive benchmark is estimated by adjusting the price of a close substitute that is tradable. Coefficients of Protection and Comparative Advantage: An Overview There is an important similarity between policy analysis using protection coefficients and project analysis using shadow prices. Price coefficients compare observed prices (given price intervention) to the efficiency prices that would prevail in the absence of intervention and domestic market distortions. Cost-benefit project analysis compares the with-project stream of expected costs and benefits to the without-project situation evaluated at observed and shadow prices. 3 In both cases the systematic comparison reveals the economic differences that policy and project introduce. Both methods use efficiency values as the basis for comparison, and concepts and procedures familiar to the project analyst are easily transferable to policy analysis. Protection coefficients compare domestic prices to border prices. These price ratios indicate the extent to which domestic price policy protects domestic producers from the direct influence of foreign markets and in the process generates incentives to domestic production or consumption. The 3The usual term is "financial" prices. Since this has not been defined, the term "observed" has been used. The basic point is the distinction between prices at which transactions usually take place-hence observed or financial-and prices that reflect scarcity and economic worth-hence shadow or border prices.

54

i Agricultural Price Policy

protection or incentives can be positive or negative and, as such, are suggestive of the likely impact of policy-induced incentives on the way resources are used and the efficiency of that resource use. There are three levels of inference involved: (1) from price ratios to relative protection; (2) from protection to relative incentives; and (3) from relative incentives to resource use. The economist is interested in prices precisely because they are powerful signals to decision makers allocating their resources. The three levels of inference clarify the channels through which prices permeate the economic system. Protection coefficients can thus characterize the policy setting in broad quantitative terms. They are diagnostic and prescriptive. They are prescriptive, however, only in the sense that the divergence between a domestic price and the system of reference prices has efficiency implications. At the simplest level, nominal protection coefficients consider only output or input prices. At a more sophisticated level, effective protection coefficients consider returns to the productive activity. As shown in Figure 3.3, the measurement techniques expand to include input prices as well to capture protection on the entire productive activity: Nominal protection coefficients (NPCs), which relate to only output or input prices Effective protection and effective subsidy coefficients (EPCs and ESCs), which further consider returns to major nontraded and primary inputs Producer subsidy and consumer subsidy equivalents (PSE, CSE), which consider input subsidies and indirect taxes, in addition to domestic and border price of the output, and the total quantity marketed.

The choice of the most appropriate coefficients depends on which indicator of incentives is considered most suitable to both the policy environment and production structures. Specifically, if government policy manipulates output prices only and leaves input prices to be largely market determined, then NPCs are likely to yield sufficient information about the policy-induced incentive structure. Alternatively, if policy affects input prices as well, but traded inputs constitute a small fraction of total costs, then NPCs may again be sufficient. But if policy significantly changes output and input prices and if traded inputs are major cost components, the information content of EPCs may be different from that of NPCs. EPCs are always better indicators of incentives than NPCs, because EPCs consider returns to the entire productive activity, not just output or input prices. The practical suggestion here is to consider when EPCs are in fact likely to be significantly different from NPCs. From an assessment of the pattern of incentives one should proceed to consider the direction the pattern should now take. One major consideration in structuring incentives is the sector's comparative advantage, that is, the international competitiveness of its productive activities. What should the

55

Coefficients of Protection The Border: Import/Export

J

r- Transportation Handling Consumer level

(5) CSE

Transportation and retailing Intermediary level: processed output

Output: Productionprocessingmarketingconsumption chain

Transportation Processing Handling Other miscellaneous handling margins

(1) NPC

(4) PSE

(3) ESC

L...

The Farm Gate: Output/Input Traded inputs [

(2) EPC

(6) DRC (7) NEB

Fertilizer. pesticides FueL lubricants Miscellaneous: seeds, manure. etc.

Nontraded [ intermediary and primary inputs

Labor The services of capital equipment Land

The structure of production from farm gate to border

The structure of coefficients encompossing farm gate to border

Figure 3.3. Schematic representation of coefficients of protection and coefficients of comparative advantage

sector be encouraged to produce and with what technology? From an efficiency point of view, the sector should produce those outputs for which it is internationally competitive and for which a sufficient demand exists. Estimates of domestic resource coefficients can help the analyst make an initial and rough assessment of comparative advantage. These coefficients do not, not,however, consider size of demand and whether increased output can be absorbed. Figure 3.3 shows the range of items included in different coefficients. For example, the shorter bracket for the NPC indicates that the information content of the NPC is less than that of the EPC. The schematic representation also shows the relationships among different coefficients in terms of what items each includes or excludes. Each coefficient is discussed in detail in subsequent sections.

The Nominal Protection Coefficient (NPC) The nominal protection coefficient of a commodity is the ratio of its domestic price to its border price. The border price is defined as the price in

56

I Agricultural Price Policy

the international market converted into local currency using an exchange rate. Thus (1)

or

. 1 . ffi . G ross nomma protectiOn coe ICient

where

pb =

J>d =

i

=

=

domestic price . . h ore1gn pnce x exc ange rate

£

border price-namely, foreign price X exchange rate; thus the border price is the foreign price in domestic currency domestic price commodity i

The exchange rate may be the official rate, but it should reflect the opportunity cost of foreign exchange to the economy. If it does, the NPC is called net NPC as opposed to gross NPC. The formula is then (la)

where pbb is the border price, using the exchange rate benchmark (ERB). The same relationship can be expressed as the nominal rate of protection (NPR). Thus (lb)

which is equivalent to (NPC - 1) x 100. The NPC can assume a range of numerical values. If NPC > 1, domestic producers or intermediaries are receiving a higher price after intervention than they would without intervention. This is called positive protection. Note, however, that NPC > 1 for a consumer denotes negative protection. Consumers have to pay a higher price given intervention than they would without it. The conflict of interest between producer and consumer in the short run is apparent in the interpretation of the NPC. If NPC < 1, then the reverse structure of protection is in force. Protection is negative. The producer or intermediary is being discriminated against, while the consumer is being favored. Finally, if NPC = 1, the structure of protection is neutral. Producers, intermediaries, and consumers are facing domestic prices that are equal to the border prices they would have faced without intervention. In sum, the greater the divergence of the NPC from unity, the greater the effect of policy on altering price structures and the incentives to produce or

Coefficients of Protection

57

consume the product. Whatever its numerical value, an NPC is indicative of rel;:ttive incentives among crops and changes in relative incentives over time. As we have seen, it is not absolute prices that matter but relative prices. Similarly, it is not the absolute level of incentives that NPCs highlight but their relative structure among crops and over time. As such, NPCs are summary indicators of the relative incentive structure generated by policy, across crops and across years. Adjusting the Data

For NPCs to be indicative of the protective structure of policy and changes within it, the domestic and border prices used must be representative of the prices decision makers actually would have faced with and without intervention. Otherwise the comparison would be meaningless. There are two basic considerations in estimating meaningful NPCs. First, what are the major production and consumption activities one should select given the policy issues and the resources (including time) at one's disposal? Second, for these commodities, what prices have or would have acted as signals in decision making affecting resource use? The selection of commodities and prices cannot be mechanical; it should instead be guided by prior understanding of policy issues and the functioning of markets for key activities. The average domestic price. Often it is not obvious what prices to select. One reason is the multiplicity of domestic prices for any given commodity, although agricultural commodities are more homogeneous than manufactured ones. Typically there are numerous domestic prices for a single commodity. For a single market, there are different prices for each season. There are different locations for producing and consuming regions. Furthermore, there are different groups of decision-makers to consider: broadly, producers, intermediaries, and consumers. The length of the production-marketingconsumption chain means that there are significantly different stages at which a commodity can be evaluated. This multiplicity of markets, seasons, locations, interest groups, and stages in the life of a commodity requires that price data be adjusted in various ways. One must first decide which economic group one is interested in, and then all the adjustments are made relative to that group. In adjusting, one is essentially computing averages across geographical locations and markets and across seasons. The weights are the quantities produced, marketed, or consumed in these various locations and time periods. Since NPCs can be interpreted as tax rates on a given commodity for different economic groups, one can get the same information if one has data on tariff or tax rates and if quantitative restrictions are not imposed. If no data on tax rates exist, or if quantitative restrictions are

58

) Agricultural Price Policy

widespread, then direct price comparisons are necessary to yield measures of taxation rates. Adjusting the border price for imports and exports. Whether a commodity is imported or exported affects the adjustment of the border price. If an import, the c.i.f. price for the commodity must be adjusted for internal transportation and processing margins. The adjustments make the border price comparable to the estimated domestic price that the farmer receives because both refer to the same stage in production. If an import is to be adjusted to the farm-gate level, the internal margins must be added to the c.i.f. price. This adjusted c.i.f. price is called the "c.i.f. plus" price: it is the price farmers could have received if they were allowed to compete freely with the import substitute. Often it is useful to adjust the c.i.f. to the major consumption point within the country to assess incentives to consumption and the intermediary stages of processing and marketing rather than local production only. If an export, the f.o.b. price for the commodity must be adjusted downward, because farmers would not have received the full f.o.b. price since they must incur the cost of internal margins necessary to deliver the good at the border. This adjusted f.o.b. price is called the "f.o.b. minus" price. In sum, the adjusted border price is "c.i.f. plus" for an import and "f.o.b. minus" for an export. See Chapter 2 for information on how to incorporate these adjustments. The border price must also be adjusted for over- or undervaluation of the domestic currency. Note that in formula 1 the exchange rate is not necessarily the official rate. If only the official rate were used, the extent of protection would be over- or underestimated because the exchange rate at which foreign prices are converted into domestic prices alters the price of the commodity. The official exchange rate (OER) is itself a major form of policy intervention that affects incentives through prices. The use of an overvalued exchange rate means that the value to the economy of imports and exports is undervalued. Imports are encouraged and exports lose their competitiveness in world markets. In the reverse case of undervaluation of domestic currency-hence overvaluation of foreign currency-imports are too expensive and exports are too lucrative. Undervaluation thus discourages imports and encourages exports. While overvaluation is an implicit subsidy on imports and a tax on exports, undervaluation is an implicit tax on imports and a subsidy on exports. In assessing what the border price would have been in the absence of intervention, analysts must adjust for the under- or overvaluation of the domestic currency. NPCs adjusted for the extent of over- or undervaluation are referred to as net NPCs (unadjusted NPCs are often referred to as gross NPCs). The importance of the exchange rate policy as a source of price

Coefficients of Protection

59

incentive or disincentive is emphasized in comparisons of gross and net NPCs. Gross NPCs overstate the extent of protection given to tradables in the case of overvaluation and understate it in the reverse case of undervaluation.

Calculating Commodity-Specific NPCs The nominal protection coefficient (NPC) is a ratio of the domestic price decision makers face given intervention and the border price they would have faced in the absence of intervention. The numerical value indicates the positive, negative, or neutral structure of protection generated by policy. The selection of meaningful prices for the ratios requires an understanding of the prices that are important signals in decision making and that affect resource use and the adjustments needed to given price data. For actual computation, analysts need to keep in mind several considerations. Prices vary over location, time, and interest groups. Goods may be imports or exports. The official exchange rate may be over- or undervalued and thus embody a major form of policy intervention. Not only past but also projected prices may be necessary. The country may be a price contributor, or price maker, instead of a price taker in international markets. The following examples assume that the country is a price taker in world markets ("small"), but Appendix B shows how to calculate coefficients if a country's own trading actions affect the border price. 4

Calculating the NPC for maize. Table 3.1 shows how to calculate the NPC for a commodity whose market is subject to intervention. In this example maize is a staple food, and the government is concerned with protecting the food consumption of urban consumers and incomes of domestic producers. Domestically produced maize is more costly than imported maize, hence the government has a state monopoly on imports. To protect urban consumers as well, the government directly intervenes in two ways. First, the food logistics agency carries out forced procurement, which captures 60 percent of maize output at an official price. The official price is lower than the domestic market price of LE 142.5 per metric ton at the farm-gate level and higher than the unadjusted border price of LE 105 per metric ton (LE = Egyptian pound, the currency of Egypt). Second, the government provides a subsidy on transportation from farm to wholesale markets in urban areas. The relatively high domestic transport cost is a major factor that causes the domestic 4The following examples that show the calculation of the NPC for maize, sugar, sugarcane, and cotton were worked out by Alfred J. Field, Jr., and Dennis R. Appleyard, "Second Draft of Material Prepared for the World Bank Analyzing the Impact of Market Intervention in Agriculture" (Chapel Hill, N.C.: Department of Economics, University of North Carolina, December 1982; typescript), pp. 31-59.

60

Agricultural Price Policy

Table 3 .1.

Estimating the nominal protection coefficient (NPC) for maize Comments

Steps

Step 1. Calculating the average domestic price in the presence of a controlled price for maize per metric ton at the farm-gate level: 1. State-controlled price: LE 110 State-controlled share of output: 60% 2. Unofficial market price: LE 142.5 3. Domestic price: l1armgate

= 0.6(110) + 0.4(142.5) = LE 123

See Chapter 2, Calculating the Average Price.

4. General formula: I

P?=

2: i=l

The market price at the farmgate level. See Chapter 2, Calculating the Average Price.

P?wi

Step 2. Calculating the adjusted border price: 1. Foreign price (c.i.f.) of maize: U.S. $!50/metric ton 2. Official exchange rate (OER): LE 0.70/U.S. dollar 3. Unadjusted border price: LE 105/metric ton 4. Handling charge from border to urban market: LE 4.4/metric ton 5. Marketing margin from farm to same market: LE 3.0/metric ton 6. Transportation charges from farm to market: LE 6.0/metric ton 7. Adjusted border price (economic farm-gate price): Ph = (unadjusted border price + handling charge) - (marketing margin + transportation charges from farm to market) = (105 + 4.4) - (3.0 + 6.0) = LE 100.4

See Chapter 2, Efficiency Benchmarks for Imports, Exports, and Nontradables. Using OER.

Calculation of "c.i.f. plus" price. Note that urban consumers pay only 105 + 4.4 = LE 109.4/metric ton.

Step 3. Calculating the NPC: 123 pd NPC = jib = 100 .4 = 1.225

Step 4. Adjusting for policy-induced distortions: I. Overvaluation of domestic currency (equilibrium exchange rate > official exchange rate): a. OER = LE 0.70/U.S. dollar b. EER = LE 0.85/U.S. dollar c. Standard conversion factor: SCF = OER = 0.70 = 0 824 . 0.85 EER d. Appropriate adjusted border price: pb Pb • d"J = SCF

. . - transportatiOn + handl"mg - marketmg

105 = 0 _824 + 4.4 - 3.0 - 6.0 = LE 122.8

Equilibrium or shadow exchange rate. Overvalued domestic currency; see Chapter 2, the Standard Conversion Factor.

Urban consumers would pay 105/0.824 + 4.4 = LE 131.83/metric ton.

Coefficients of Protection Table 3.1.

61

(Continued)

Steps

Comments

2. Transportation subsidy: a. Transportation subsidy: LE 6/metric ton b. Appropriate adjusted border price: pbadj = pb + handling - marketing - (transport + subsidy) = 105 + 4.4 - 3.0 - (6 + 6)

Transportation subsidy from farm gate to urban market.

= LE 94.4

3. Adjustment for overvaluation of domestic currency and the transportation subsidy: pb•di

= 01 ~;4 + 4.4

- 3.0 - (6 + 6)

= LE

116.8

4. Calculating the net NPC: a. Overvaluation of domestic currency: Net NPC

=

.pd

pbadi

=

123.0 122 _8

=

1.002

=

1.303

b. With transportation subsidy: pd 123.0 Net NPC = pbadi = 94 _4

c. With overvaluation + transportation subsidy:

Note the difference between the unadjusted NPC = 1.225 and the net NPC = 1.002. The unadjusted NPC overstates the degree of protection given to maize, an import substitute.

N t NPC = P?anngatc = 123.0 = I 053 e pbadj 116.8 ·

price to be higher than that of imports. The overvalued domestic currency helps the state trading agency and the urban consumer insofar as it reduced the domestic cost of imports, and it hurts domestic producers because it makes their commodities less competitive with an artificially cheaper import. Five separate policy instruments-overvaluation, import monopoly, forced domestic procurement, fixed official price, and a transportation subsidyhave countervailing effects on domestic producers and consumers. The NPC calculation enables the practitioner to assess whether the net effect is positive, negative, or neutral protection. Without any of the above interventions, the urban consumer price would be LE 131.9 per metric ton, and the domestic producer price of about LE 143 per metric ton would prevail only in rural areas. The high transportation costs between rural and urban areas would act as a form of natural protection for domestic producers. Maize as an import substitute would be competitive only in rural, not urban areas. The table first calculates the NPC and then adjusts it for policy-induced distortions-in this example, an overvalued domestic currency and a trans-

62

I Agricultural Price Policy

portation subsidy. The example for maize for the "large" country case is presented in appendix B. In Step 1 the average domestic price for maize at the farm-gate level is calculated. This country maintains a parallel marketing system for maize: an official market controlled by a marketing board and an unofficial private market. Using weighting techniques described in Chapter 2, analysts compute an average domestic price. In Step 2 the border price is calculated. To have a meaningful comparison between domestic and border prices for maize, the border price must be adjusted by the costs of handling, marketing, and transportation to the c.i.f. price. The resulting border price (c.i.f. plus) represents the international farm-gate price the farmer would receive given handling costs from port to urban wholesale market and marketing and transportation costs incurred in moving maize from the farm gate to the same point, namely, the urban wholesale market. In Step 3 the ratio of the domestic price to the border price is calculated to obtain the gross NPC. Step 4 adjusts this NPC value for policy-induced distortions, which results in the net NPC. In this example the gross NPC is adjusted for both a transportation subsidy and an overvalued domestic currency by using a standard conversion factor. In this example the government is pursuing the potentially conflicting objectives of protecting both producers and consumers. It is therefore useful to determine which, if any, of the objectives the government is furthering and to assess which of the multiple instruments have a dominant impact. The exercise reveals three mechanisms at work. The protection afforded to producers through the state import monopoly of competing imports is substantially eroded by the overvalued domestic currency. Urban consumers are the major beneficiaries because they would have to pay LE 131.83 per metric ton instead of the lower LE 109.4 per metric ton for imported maize because of overvaluation. The major instruments are overvaluation and a monopoly on imports. Thus the protection affecting producers is significantly affected by policy instruments outside the sector. Sectoral instruments can be of secondary importance, and practitioners should look beyond the sector to understand what policies shaped agricultural incentives. Calculating the NPC for sugarcane and sugar. Tables 3.2A and 3.2B consider a more complicated example involving a multistage production process. The problem is to calculate the NPC for sugarcane when a tariff has been placed on the final good, sugar, which is imported. A tariff on sugar increases its price and stimulates domestic production for sugarcane. As shown in Figure 3.4A, at the nonintervention price (world price) for sugar,

Coefficients of Protection Table 3 .2A.

63

Estimating the nominal protection coefficient (NPC) for sugarcane

Steps

Comments

Step 1. Estimating the average domestic price of sugarcane at the producer (farm-gate) level, with two major supply areas: I. Location A: Price: Rs 792/ metric ton Quantity marketed: 128,000 metric tons 2. Location B: Price: Rs 815/metric ton Quantity marketed: 261,000 metric tons 3. Total quantity marketed (A + B): 389,000 metric tons 4. Average domestic price of sugarcane: Pjlarmgate =

0.329(792)

+ 0.671(815)

=

Rs 807

5. Formulas: Specific: P official exchange rate): a. Official exchange rate (OER): Rs 16/U.S. dollar b. Equilibrium exchange rate (EER): Rs 18/U .S. dollar c. Standard conversion factor: SCF

=

OER EER

16

= T8 = 0.889

d. Unadjusted border price: Rs 8768/metric ton e. Adjusted prices: (l) Adjusted border price: 8768/0.889 = Rs 9863 (2) Adjusted input border price:

P~n~~~

= [(9863

f. Net NPC:

N t NPC

e

- 238 - 530)/11] - 27

Taken from step 2, item 3. Adjustment for overvaluation. Adjustment for internal marketing and processing margins.

= Rs 800 Domestic farm-gate price derived from step 1.

pd

= farm~te = 800 807 = I 009 badJ · pinput

2. Adjustment for domestic subsidies: a. Transportation subsidies: Sugar: Rs 12/metric ton Sugarcane: Rs 8/metric ton b. Processing subsidies: Rs 20/metric ton c. Adjusted input border price for sugarcane: [8768 - (238 + 12) - (530 + 20)]/11 - (27 + 8) = 689 Adjusted ex-factory cost - adjusted transport = adjusted input border price d. Net NPC: N t NPC e

=

pd fanngate pbadj mput

= 689 807 =

1.171

3. Adjustment for both domestic subsidies and overvalued exchange rate: a. Adjusted border price: [9863 - (238 + 12) - (530 + 20))/11 - (27 + 8) = 789 b. Net NPC: N NPC et

=

pd farm gate b adj pinput

= 789 807 = 1 023 .

Compare the 4 estimates. In step 3, NPC = 1.153; step 4, item f, net NPC = 1.009; step 4, item 2d, net NPC = 1.171, and step 4, item 3b, net NPC = I .023. Note all net NPCs are numerically lower than the unadjusted NPC. Among the net NPCs, an overvalued domestic currency functions as a tax on producers and lowers the NPC, whereas input subsidies to producers and an import tariff have the reverse effect.

Note: Sugarcane is a principal input when the final product, sugar, is protected by a tariff on imports. The main market for sugar, either imported or domestically produced, is at the border.

64

Table 3.2B. Estimating the nominal protection coefficient (NPC) for sugar when sugar is imported and a tariff is imposed Steps

Comments

Step 1. Estimating the average retail price of sugar when several major markets are present: l. Market A: Price: Rs 9827 /metric ton Quantity sold: 228,000 metric tons 2. Market B: Price: Rs 9643/metric ton Quantity sold: 320,000 metric tons 3. Market C: Price: Rs 9710/metric ton Quantity sold: 300,000 metric tons 4. Total quantity sold: 848,000 metric tons 5. Average retail price of sugar:

These market prices already incorporate the effect of the import tariff.

= (

pd

~;~:: ) (9827) + ( ~;~:: ) (9643)

+ ( 300,000) (9710) 848,000

=

Rs 9716

6. General formula:

Wi is the respective weight or quantity.

Step 2. Estimating the adjusted border price: l. Foreign price of sugar: U.S. $548/metric ton 2. Official exchange rate (OER): Rs 16/U.S. dollar 3. Unadjusted border price: 548 x 16 = Rs 8768 4. Handling charges from port to market: Rs 50/metric ton 5. Transportation costs (port to market): Rs 190/metric ton 6. Adjusted border price:

The adjusted border price is the price that the producers of sugar would have received if they were to compete with imported sugar in the absence of intervention. The c.i.f. plus formula is explained in Chapter 2.

P~u';'.!.. = 8768 + 50 + 190 = Rs 9008 Step 3. Calculating the NPC: NPC =

pd badi psugar

The NPC refers to sugar, not sugarcane. NPC is evaluated at the retail level.

9716

= 9008 = 1.078

Step 4. Calculating the net NPC: Adjustment for overvaluation: P badj suga< SCF

=

Net NPC

9008 0.889

SCF = l6/l8 = 0.889 taken from Table 3.2A, step 4. Without overvaluation, the import sugar price would be significantly higher than the domestic retail price. The implicit subsidy of the overvaluation counteracts the tariff, and consumers are positively protected.

= 10 132.7 '

= IO9716 132 7

=

0.95

65

66

I

Agricultural Price Policy A.

p

pd pb

D Q3

Q4

1-

Q2

imports at

pb

Qsugar

Q1

-j

f- --l imports at

B.

p

d'

s

pd

S'

d'

Qsugarcane

Figure 3.4. Supply and demand for sugar (A) and sugarcane (B)

pb, imports of sugar at the given world price match the excess of quantity demanded by domestic consumers (Q 1) over the quantity forthcoming from domestic suppliers (Q 3 ). The imposition of a tariff raises the domestic sugar price to J>d, reduces consumption to Q2 , raises domestic production to Q4 , and reduces imports of sugar to Q4 Q2 . Figure 3.4B shows that increased domestic production of sugar leads to increased demand for sugarcane as an

Coefficients of Protection

I 67

input to sugar production, shifting the demand curve for sugarcane from dd to d' d'. If the supply of sugarcane is not completely unresponsive, the price of sugarcane will rise to pct. If supply is completely unresponsive, the price of sugarcane will rise proportionately to the rise in the price of sugar, that is, the sugarcane price will rise to pd'. The NPC is calculated in Table 3.2A for sugarcane and in Table 3.2B for sugar, and it is assumed that the supply of sugar to the importing country is completely elastic-it is available to the importing country in unlimited amounts at the given border price. In Table 3.2A it is also assumed that the main market in the importing country is at the border. Appendix B looks at the same problem in the large country case-that is, the supply of sugar to the importing country is not completely elastic, and the quantity imported varies with the prices because the scale itself affects the prices of imports. Table 3. 2A is computationally more complex than the example for maize in Table 3. 1, but in terms of policy structure and instruments it is simpler. A more complex set of calculations is needed because the practitioner has to proceed from raw to processed sugar, which requires detailed technical and market information. The policy structure is simpler because there are no conflicting objectives; the government sets out to protect producers. The only instruments are a tariff and an overvaluation of the domestic currency. Table 3.2A will help practitioners deal with complex production, processing, and marketing structures rather than complex policy structures. Frequently protection or discrimination is applied to the processed rather than the raw commodity. Thus, in assessments of price policy structures and the incentives they generate, it is useful to identify where the source of complexity lies. If it is in the technical relationships, the practitioner should draw on technical expertise. If it is in the policy structure, then the economist has a larger input. Even in this simple policy structure, however, it is useful to note how policy instruments have opposite effects: the tariff raises protection for an import substitute; the overvaluation lowers it. Table 3.2B estimates protection at the retail level. Since it is not at the farm-gate level there is no need to consider complexities of processing and handling from farm to retail, and the estimation is much simpler. This example illustrates an obvious but basic point-the computational requirements of policy analysis may vary with the specific economic group of interest and the level of disaggregation that is called for. It is important to formulate as precisely as possible the specific groups and activities to be analyzed and their place in the long chain from production to consumption before quantifying the price structures. Much valuable time can be saved in the computation if a thorough initial analysis is undertaken (see Chapter 2). Table 3. 2C demonstrates the calculation of the NPC for sugar by first estimating the price of sugar and then comparing it to the border price. If the

Estimating the nominal protection coefficient (NPC) for sugar

Table 3.2C. Steps

Comments

Step 1. Estimating the domestic retail price, starting with sugarcane-from the supply-side (cost) perspective: l. Farm-gate price of sugarcane, P!'armgate: Rs 807/metric ton 2. Transport from farm to factory: Rs 27/metric ton 3. Processing ratio: I metric ton sugar per II metric tons sugarcane 4. Processing and marketing costs: Rs 530/11 metric tons sugarcane 5. Ex-factory cost : (807 + 27)(1I) + 530 = Rs 9704/metric ton sugar

6. Transport from factory to retail market: Rs 200/metric ton 7. Domestic retail price of sugar: p OER by assumption. If pct = 20 rupees, Pf = 1 U.S. dollar, OER is 10 rupees = 1 dollar, and SER is 20 rupees = 1 dollar, then gross NPC = 2, and net NPC = 1. Figure 3.6 illustrates the way the exchange rate enters into relative incentives and profitability. In many situations the agricultural sector supplies most of the exports, whereas both agriculture and industry contribute to the production of import substitutes. Figure 3.6A shows how an overvalued exchange rate lowers the price and hence the gross revenue that agriculture receives as a supplier of exports and import substitutes. Industry benefits because the overvalued rate reduces the costs of its agricultural purchas,es, as shown in Figure 3.6A and 3.6C. With an exchange rate that overvalues the domestic currency, the price pb prevails instead of the higher pbb, which would have prevailed if the rate had reflected the opportunity cost of foreign exchange. Part of the agricultural surplus is transferred to industry, a consumer of agricultural products. The overvalued rate also discriminates against industry as a supplier of import substitutes and benefits agriculture as a consumer of industry's output. In a development strategy that favors industry, however, industry is not left to suffer these adverse income consequences, and the government resorts to trade tariffs and barriers to protect industry and collect revenues. As Figure 3.6B shows, the terms of trade between agriculture and industry are influenced by both the exchange rate and the additional protective measures. The practitioner should also consider how the exchange rate can affect relative incentives in producing tradables (exports and import substitutes) as opposed to nontradables (services such as construction and bulky commodities with high transport costs). With an overvalued domestic currency, exports earn too little (in domestic currency) and imports are too cheap (also in domestic currency). This in tum means that prices of nontradable goods are too high relative to tradable goods. Producers produce too many nontradables relative to tradables. Consumers consume too few nontradables relative to tradables. Resources are thus wrongly allocated against the production of tradable goods and in favor of the consumption of tradables. In terms of the balance of trade, exports are too few and imports are too many. An exchange

I 03

Coefficients of Protection A Agriculture's supply of exports

p

pbb 1-l.,....__ _ _ _ _ _ ____,.'-------

Benchmark rate

pb ~----lo.--+----~ Overvalued rate

Industry's demand for agricculture's output Q

'\DI

Industry's demand for import substitutes Q

Figure 3.6. Terms of trade between agriculture and industry: overvaluation of domestic currency

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rate that overvalues the domestic currency therefore also enters into the terms of trade between tradables and nontradables, as in the following relationship: pnt pr x OER (- pb)

pnt

> pr x SER (- pbb) if OER < SER

where pnt denotes the price of a nontradable good, pr the foreign price of a tradable, pb the border price, and pbb the border price using the exchange rate benchmark. For an exchange rate that undervalues the domestic currency, the relationship is the reverse. Thus pnt pr x OER


SER by assumption

In sum, the exchange rate is a key price because it enters in the terms of trade between exports and imports, between agriculture and industry, and between tradables and nontradables. Distortions in the rate therefore permeate resource allocation throughout the economy. Where the official rate is market determined (hence the term distortion does not apply in the usual sense), the appreciation or depreciation of the rate may still remain a matter of concern to price policy if the market rate is believed to be short-lived, because the rate diverges from the longer-term expected benchmark value. Above all else, this discussion of protection coefficients shows that price relationships matter because they are signals for decisions on resource use. The key prices are the exchange rate at the macro level and the relationships between both domestic and border and between input and output at the sectoral level. In various combinations these price relationships determine the terms of trade facing producers and consumers, and their incentives to engage or withdraw from different economic activities. Incentives per se are of little interest except that they provide the driving force behind economic performance. The practitioner not only wants to know what the incentive structure is but also what it should be to promote development. A major requirement for sustainable development is efficiency. The next question is therefore: Does the incentive structure support an efficient agriculture? Chapter 4 discusses measures of efficiency.

CHAPTER

4

Coefficients of Comparative Advantage

The protection coefficients illustrated in Chapter 3 are measures of relative incentives, which have implications for efficiency. Coefficients of comparative advantage, on the other hand, are measures of relative efficiency, which have implications for incentives. The information content of coefficients of protection and coefficients of comparative advantage is complementary because policy-making combines considerations of both incentives and efficiency. Efficient domestic production of tradable goods-for export and for import substitution-is an important policy consideration for planning and investment purposes. An economy has a comparative advantage in the production of a tradable commodity if that production is efficient; if not, it has a comparative disadvantage. To assess comparative advantage, analysts employ the concept of opportunity cost. The assessment proceeds in four steps. First, the opportunity cost of foreign exchange-its scarcity value to the domestic economy-must be determined. This serves as a benchmark value for further computations and comparisons .. Second, value added in foreign and border prices is computed. This measure of value added indicates net earnings in foreign exchange (in the case of an export) or net savings in foreign exchange (in the case of an import substitute). The net earnings or savings indicate the benefit of domestic production in terms of foreign exchange. The benefit is also a measure of opportunity: what the economy can earn or save given foreign trade opportunities open to the economy. Third, analysts compute the cost of the primary factors or domestic resources used in production-the cost in terms of alternatives forgone. Domestic resources are valued in shadow prices, giving the domestic resource cost. Fourth, the domestic resource cost is compared to the net benefits. This cost-benefit comparison is the measure of efficiency. 105

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The term comparative advantage has two meanings. In the first sense the efficiency of production is being compared among two or more trading nations. Nations with the lowest opportunity costs are relatively more efficient and have a comparative advantage. They have a cost advantage in comparison to other producers, and they are internationally competitive, given prices of the tradable output and related inputs prevailing in international markets. Their international competitiveness is due to their higher productivity and their exchange rate, with one or several of the following factors operating: they use fewer traded inputs per unit of output, they use fewer domestic resources per unit of output, their domestic resources have lower opportunity costs, and the value of domestic currency is not high relative to other major currencies. A country has a comparative advantage when its opportunity costs are less than those of other producing nations. The second meaning of comparative advantage refers to the efficiency of different kinds of production within the domestic economy, which are compared in terms of earning or saving a unit of foreign exchange. The costs incurred for a given commodity are compared to the costs that would be incurred in an alternative domestic activity. The opportunity cost of foreign exchange is a good measure of this alternative activity because it indicates what the economy as a whole would have to give up in terms of domestic currency to obtain an additional unit of foreign exchange. The commodityspecific exchange rate is compared to the economywide exchange rate. If the former is less than the latter, that domestic production is a relatively efficient way to earn or save a unit of foreign exchange. The second meaning of comparative advantage is implied in the first one, and vice versa. If domestic production costs are less than in other producing nations, then the economy gains in efficiency terms in producing the tradable good. This gain is expressed in terms of foreign exchange because countries are considering what foreign trade options to pursue. The concepts of comparative and absolute advantage are often confused, but they are quite distinct. Absolute advantage refers to the differences in absolute cost levels in producing nations. Comparative advantage refers to the differences in opportunity costs among trading nations. It is possible for nations A and B to produce both commodities X and Y, which compete for the same domestic resources, and for nation A to have an absolute disadvantage in producing both X and Y. But nation A can have a comparative advantage in producing X if the amount forgone in Y is less than the amount forgone in nation B to produce X. The absolute disadvantage of nation A relative to nation B is less in X than in Y. Nation B has an absolute advantage in both X and Y, but a comparative advantage in Y only. The absolute advantage of nation B relative to nation A is greater in Y than in X. Specialization and trade would benefit both nations because world output (made up of

Coefficients of Comparative Advantage

107

the two nations in this case) would be greater if production took place where the opportunity cost is least. The point here is the importance of opportunity cost considerations as a basis for mutually beneficial trade. Nothing can be inferred about the potential benefit from international trade for a given economy merely from comparisons of absolute advantage. There are two measures of comparative advantage: the domestic resource cost (DRC) and the net economic benefit (NEB). 1 Both coefficients use the same information on prices and input use, but the DRC is more widely used than the NEB. Both techniques require that primary and intermediary inputs in the production process be valued in shadow prices. Through measures of comparative advantage practitioners can take an important step toward normative analysis. They begin to assess the efficiency implications of the incentive framework they have characterized through protection coefficients, thus extending their positive analysis to one major normative concern, namely, efficiency of resource use. Incentives by themselves are neither good nor bad. Their effects are judged according to the extent that they promote or undermine developmental objectives. Policy analysis is normative, but it builds on positive analysis. Within the partial-equilibrium framework, normative analysis defines the developmental objectives and builds on the previous price analysis (see Chapter 3) in two ways. The first is through assessing relative efficiency, as discussed in this chapter; the second is through assessing impact on production, consumption, welfare, efficiency, the government's budget, and foreign exchange earnings, as discussed in Chapters 5 and 6. The assessment of relative efficiency requires detailed information on production inputs and their markets; the assessment of the impact of prices requires empirical estimates of market response. The practitioner chooses one of the two methods based on the results of the initial stage of analysis (see Chapter 2): formulation of main policy questions, assessment of available data, initial hypotheses about the functioning of key markets, and allocation of resources for further work. The relevant considerations within the first method are detailed below.

Calculating Shadow Prices for Primary and Intermediary Inputs This section presents practical procedures for the economic pricing of nontradables, in particular, primary inputs or resources of land, labor, capi1The calculations shown in Tables 4.1, 4.2, 4.3, and 4.4 were worked out by Alfred J. Field, Jr., and Dennis R. Appleyard, "Second Draft of Material Prepared for the World Bank Analyzing the Impact of Market Intervention in Agriculture" (Chapel Hill: Department of Economics, University of North Carolina, December 1982; typescript), pp. 84-89.

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tal, and intermediary inputs such as transportation and construction services. There is a substantial literature on shadow pricing in the context of costbenefit project analysis. 2 From this literature it is clear that all the computed shadow prices are second-best shadow prices because they assume that the current policy structure and market distortions prevail. Other authors also have discussed why shadow prices are interdependent, and consequently why the assumptions with respect to policy and market opportunities for one resource must be consistent with the assumptions made in the context of assessing another resource operating in the same economic environment. Furthermore, shadow pricing values the contribution to objectives of resources at the margin. This means that no major change in the scale of use of the resource is contemplated; otherwise the entire structure of market opportunities may change. Future-oriented shadow prices are denominated in constant prices or in real terms. Finally, shadow prices can be estimated using linear programming modeling methods or informal techniques within the partial-equilibrium approach. It is important to remember, however, that shadow pricing is an attempt to go beyond a single market and capture the impact of broader market opportunities on the economic value of the resource or commodity. 3 In the project context shadow-pricing techniques help identify and measure the contribution of the proposed investment to the economic (and possibly social) objectives of the government. Observed and projected financial prices are not used in economic cost-benefit analysis precisely because of the distortions caused by policy and market imperfections. Distorted prices by definition do not reflect the economic value of the resource or commodity. In policy analysis the purpose of using shadow prices is different. Shadow prices are used as benchmarks against which the extent of distortions is assessed. To derive shadow prices that can be used as benchmarks, the 2Some well-known works in this area are Ian Little and J. A. Mirrlees, Project Appraisal and Planning for Developing Countries (London: Heinemann Educational Books, 1974); Lyn Squire and Herman G. van der Tak, Economic Analysis of Projects (Baltimore: Johns Hopkins University Press for the World Bank, 1975); Terry A. Powers, ed., Estimating Accounting Prices for Project Appraisal: Case Studies in the Little-Mirrlees/Squire-Van der Tak Method (Washington, D.C.: Inter-American Development Bank, 1981); J. Price Gittinger, Economic Analysis of Agricultural Projects (Baltimore: Johns Hopkins University Press for the World Bank, 1982); and Anandarup Ray, Cost Benefit Analysis: Issues and Methodologies (Baltimore: Johns Hopkins University Press for the World Bank, 1984). There are also course notes published by the Economic Development Institute (EDI) of the World Bank. The list of available materials is published in the EDI catalog of training materials, which is updated every one and a half years. 3Shadow prices are also known by other names. Since the terminology can be confusing, the alternative names are set out here: (1) efficiency prices, (2) social prices to reflect both pure efficiency and other social objectives of government, (3) accounting prices, (4) economic prices, (5) opportunity cost prices, and (6) value of marginal physical product, or MPP.

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analyst first identifies production systems representative of important economic activities, and then assesses the relevant economic alternatives that are forgone because resources are tied to production of specific commodities.

Valuation of Land, Labor, and Capital All analysts begin by asking a basic question: What does the economy forgo because input X is used in the production of Y? This is referred to as its contribution to the next best alternative forgone. There are two polar cases. First, no alternative is forgone. If input X is not used in production of Y, it stays idle; there is a surplus of X relative to available opportunities. Second, an alternative is forgone, and the contribution of X in the alternative output Z would have been as valuable as in the current production of Y. The task is to identify and price this next best alternative.

Identifying the next best alternative use of an input. In the case of land on which farmers can produce Y and Z (given cropping patterns and incentive structure), the opportunity cost of land used in production of Y is the forgone output Z. But the contribution of other major inputs in producing Z must be netted out so that only the contribution of land is included. In the case of labor, which can contribute to production of either Y or Z, the opportunity cost of labor in the production of Y is a fraction of Z-a fraction because there are other contributing inputs. For tractors and other equipment used to cultivate Y, the alternative to contributing to production of Y is to contribute to Z. Again, the opportunity cost of capital equipment in production of Y is a fraction of Z. For every domestic resource, the analyst searches for the next best alternative use. Each of these resources can be disaggregated into different types of land (by fertility), labor (by skills), and capital (by type). Shadow price of land. Once these alternatives have been identified, they must be priced. The opportunity cost of land in Y or its marginal product can be indicated by its rental value. If there is a competitive market in renting or leasing land, the analyst can consider the rental value as indicative of the contribution of land to the alternative output. If competitive rental values do not exist, the economic value of land can be estimated as a residual. The procedure is to assess the value added in the alternative crop per unit of land in border prices and deduct the shadow costs of other primary resources, labor, and capital. If the economic value of land is estimated as a residual, it is logical to estimate labor and capital first. Shadow price of labor. The opportunity cost of labor in production of Y is its contribution to Z, or its marginal product in the next best alternative. If

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Agricultural Price Policy

labor markets are competitive, an average of market wage rates over peak and slack seasons is indicative of the marginal product of labor. Assessing labor's contribution to the alternative output through wages is similar to using the rental value for land. Both use the demand price approach. But labor may be paid its marginal product in Z, and the output market for Z itself may be distorted (government policy either substantially raises or lowers the domestic price vis-a-vis the border value). The analyst then must adjust for the distortion in the output market. If data on wage rates or information on relative scarcities in labor markets over different seasons are not available, labor may have to be valued through the cost approach. The analyst can then value at border prices the cost of a subsistence bundle.

Shadow price of capital: the demand approach. There are two basic approaches to the pricing of the cost of capital assets: the demand approach and the supply approach. Essentially the analyst is trying to assess the marginal productivity of capital-the increase in output due to the increased use of a unit of capital. Ideally this increase can be assessed by comparing output levels in two production systems that are identical in every respect except for the use of this additional unit. This differential production is the marginal product of the additional unit. This difference in production is what the economy would forgo if this unit of capital were withdrawn from the alternative use. If input markets are competitive and in equilibrium, marginal products are equalized in all activities, and the marginal product of capital in the production of Y is also the output forgone in the next best alternative, which is also the opportunity cost of capital. But markets may not be competitive across the economy, or they may not be in equilibrium. In that case, the analyst tries to approximate the opportunity cost through either the price farmers are willing to pay for the services or use of this capital asset-the demand approach-or the cost of supplying the services-the supply approach. For example, the opportunity cost of tractor services can be approximated by the rental fee if a competitive market for tractor services exists. The rental fee indicates the marginal product of these services, because farmers are willing to pay what they assess the services will contribute to their production. The same argument applies to the fees charged for bullock services, rental of farm implements, and use of transportation. Shadow price of capital: the supply approach. If there are no competitive markets for such services as tractors, bullocks, or carts, the cost of supplying these services is assessed. The total cost is made up of the cost of owning the tractors and of maintaining them so that they can provide services. The economic cost of owning the tractors is the sum of the alternative rate of

Coefficients of Comparative Advantage

111

return forgone as a result of investing the financial capital in this particular capital asset and the depreciation-the decline in the original value of the asset as a result of wear and tear and obsolescence. In addition to the cost of capital, one must incur the recurrent cost of operating, repairing, and maintaining this capital equipment. The domestic resource cost of providing capital services is composed of the alternative financial return that could be earned, depreciation, and repair and maintenance. The last item-repair and maintenance-can be valued as part of the total labor costs. Within the supply approach there are two methods of computing an annual value of capital services (excluding repair and maintenance). The first method of valuing capital assesses each component separately and then sums them up. The first component is the alternative interest earnings forgone. This forgone return is also known as the opportunity cost of capital, or OCC. This is a real rate in the sense that the nominal rate must be adjusted by the prevailing inflation rate. The OCC is a measure of what the economy forgoes in real terms because the financial capital was locked into this particular investment. This rate can be computed by considering the rates at which the country can borrow for loans of different maturities on international capital markets. For many developing countries that are members of the World Bank, the opportunity cost of capital averages 10 percent. Alternatively, this rate can be computed by reviewing the rates of return that have been obtained in major investments, whether public or private, within the economy. The second component, depreciation, is often computed using either the straight-line method or the declining-balance method. The straight-line method spreads the initial cost of the capital purchase equally over each accounting period by assessing the residual or scrap value of the asset, deducting it from the original cost, and dividing the balance by the number of years of estimated useful life of the equipment. In the declining-balance method depreciation in the initial years is at a much higher rate than in the closing years. Depreciation is an economic cost incurred in using capital assets and is a fraction of the initial investment cost. The actual methods of assessing it, however, are arbitrary from an economic point of view. Depreciation rules are accounting procedures for tax purposes, and the method chosen is very important for cash-flow purposes. But neither depreciation method results in an accurate measure of the decline in the economic value of the asset. Since the assessment of depreciation is necessarily somewhat arbitrary, the practitioner may prefer to use an alternative method. The second method of valuing annual capital services is to calculate the capital recovery factor. The capital recovery factor is a number which when applied to the initial investment cost, yields the annual payments necessary to repay the initial investment loan over a given period of time at a given rate of interest. These annual payments are sometimes referred to as the capital recovery factor. These annual payments are interpreted as the annual cost of capital services,

112

I Agricultural Price Policy

which consists of both depreciation and interest payments. This method has an implicit depreciation rule. The period chosen for the stream of annual payments is the economic life of the asset. These annual payments are given by the formula K = CPk, where K is the annual service cost, Cis the capital recovery factor, and Pk is the cost of the capital asset. To the extent there are taxes or subsidies on this initial price, they should be removed. The capital recovery factor in tum depends on the interest rate chosen-namely, the opportunity cost of capital-and the period of time over which the capital equipment lasts. If one uses a financial rate of interest instead of the opportunity cost of capital, then the annual service cost is a financial (rather than an economic) measure of the annual cost of capital services. Compounding and discounting tables are needed to translate the choice of interest rate and time period into a capital recovery factor. 4 In principle, both methods used in the supply approach should yield the same results. In practice, this is unlikely because the estimates of depreciation are likely to be different. Ideally, the practitioner should use alternative methods to get a better feel for the range of estimates that best captures the economic cost of capital. The method used depends not only on data availability but also on the relative importance of the capital cost component and the policy concern. On these issues the practitioner is the best judge. The practitioner may wish to consider the following. If competitive markets for the supply of capital services exist, it is preferable and computationally simpler to use estimates of rental fee rather than estimate the cost of supply. If the supply is subsidized, there is usually evidence of parallel markets. Since these markets are usually illegal, price data from these markets often are not available in official documents. Practitioners should consider undertaking field visits to obtain such information. Prices in parallel markets often overstate the economic value of a commodity or service because they reflect the risks of illegal trading. These parallel market prices should be viewed as upper limits. Capital services often are substitutes for labor services in such activities as land preparation, harvesting, and transportation. Payment for labor to provide these services can also shed light on the value of the capital services. If there is no information on market demand (official and unofficial) for capital services, and capital cost is a major policy concern, then the practitioner must draw upon the expertise of rural engineers or agronomists to obtain a technical assessment of the cost of owning and operating the types of capital equipment involved. The importance of technical assessments in price policy analysis again emphasizes the need for a team approach to analysis. 4 See J. Price Gittinger, ed., Compounding and Discounting Tables for Project Evaluation, 2d ed., EDI Teaching Materials Series no. 7 (Washington, D.C.: Economic Development Institute of the World Bank, 1984).

Coefficients of Comparative Advantage

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113

Simplifying the valuation of inputs. The assessment of the opportunity costs of primary resources is typically time-consuming, and it is useful to explore some shortcuts. There are several possibilities for simplifying the computation of ORCs and NEBs. First, if it can be assumed that the requirements of land, labor, and capital are fairly similar for different crops and that the costs of traded inputs are only a small portion (30 percent or less) of total costs, the calculation of the ORC can be simplified by considering relative yields and relative border prices. The ORC for a particular crop can be obtained by comparing the gross value per acre of that crop to the gross value per acre of the next best alternative, both valued in world prices. For example, the ORC for cotton when rice is the next best alternative is P;r~;ld X yieldnceiacre world . ld Pcotton X y1e cotton/acre

=

DRC cotton

The higher the world price and yield of cotton relative to those for rice, the lower the ORC for cotton. Second, analysts can consider only one scarce domestic resource for which the efficiency of use is of greatest policy interest. Rather than shadow price land, labor, and capital, the analyst selects only capital or land and obtains an estimate of the relative efficiency of its use in production of a particular commodity. Third, analysts can focus only on factors where values tend to make a critical difference for relative efficiency: assumptions about yields and the exchange rate. The higher the yields assumed and the lower the value of domestic vis-a-vis foreign currency, the less the domestic resource costs and the more competitive domestic production becomes. As one would expect, more productive domestic technologies and less overvalued domestic currency result in more competitive domestic production. If yields are not known with certainty, it is useful to assume alternative levels and assess the sensitivity of ORCs to these varying levels. Fourth, analysts can consider only major inputs. Capital inputs in more commercialized farming tend to be more significant than in subsistence, small-scale farming. Thus the analyst should carefully assess rental values, or the opportunity cost of capital, and depreciation for the commercial farmer. Rough approximations can be used for small-scale farming systems. In subsistence farming labor tends to be the major nontraded input, and its economic or shadow price thus tends to be a critical factor. The analyst should then emphasize the cost of labor rather than simple farm implements that constitute capital. The general point is that the analyst first considers the major inputs in any production system and then focuses on their evaluation. Finally, analysts need to consider the competitiveness of factor markets. If

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factor markets are believed to be competitive, market values will also be shadow values, and the computation will be simplified. Data on the technical coefficients are still required, and they are usually contained in farm budget data. The general rule for simplification is that the selection should be based on an understanding of the factors that tend to make a critical difference in relative efficiency and the specific resources that are scarce (and consequently of relatively greater policy interest). Valuation of Services, Utilities, Credit, and Irrigation Water In agriculture the important nontraded intermediary inputs tend to be services such as transport and construction, utilities (such as electricity), irrigation water, and working capital or credit. If there are competitive markets for the services, observed market prices charged for these services are indicative of the opportunity costs incurred in supplying them. In cases where markets are competitive but the services are either taxed or subsidized, analysts need to adjust these market values by using data on tax and subsidy rates. In adjusting, analysts must ensure that the unit for the cost of the services matches the unit in which the tax or subsidy rate is imposed. As we saw in Chapter 2, analysts can adjust the market values to obtain the border equivalent values by applying a standard or commodity conversion factor (the ratio of market value to shadow value, expressed in border currency units). The market value is multiplied by the conversion factor to obtain the border equivalent value. Shadow price of utilities. The shadow price of utility services, such as electricity needed for tubewells, is the opportunity cost of producing the marginal unit if it is assumed that production in the relevant range is at a constant cost. If it is not at a constant cost, analysts need to know the demand price. Often the only data available are the purchase price and information on whether it is taxed or subsidized. The analyst then adjusts the purchase price with the tax or subsidy data, as in the case of nontraded intermediary services. Analogously, a conversion factor can be used to obtain the border equivalent value. Shadow price of capital in formal and informal credit markets. Governments in developing countries often subsidize credit to farmers and intermediaries to facilitate purchase of inputs or to lower the price of processing. Loanable funds are usually scarce, and the credit allocated could have earned some alternative return elsewhere. It is often necessary to perform a producer subsidy equivalent (PSE) calculation and compute the extent of subsidy involved to get a better assessment of the extent of protection afforded. If credit markets are highly developed and fairly competitive with no exter-

Coefficients of Comparative Advantage

115

nalities (rather than segmented and officially controlled as in most developing countries), market-observed interest rates will reflect the cost of using capital. We have already discussed the opportunity cost of capital in relation to pricing capital services. The concern here is how to compute this benchmark rate and take into account rates in informal credit markets in the domestic economy and rates from international capital markets, especially when the exchange rate has changed during the relevant period. Rates in informal credit markets tend to be high relative to official rates not only because of the subsidy element in the latter but also because of the greater risks and higher transaction costs inherent in the informal system. Since economies of scale and the pooling of risks are not well developed in these fragmented markets, rates are high and varied, and they reflect varied perceptions of scarcity, risk, and expected inflation. The question is whether these rates on the average reflect the opportunity cost of capital. They do if decision makers could have lent at these rates (instead of purchasing capital assets) or if they would have had to borrow at these rates were it not for their access to official, subsidized credit. Their multiplicity means that the opportunity cost of capital may be a wide range of rates rather than a narrow set. The practitioner would need very detailed information on the credit market options the decision maker faces to select a few representative rates. If the bulk of the credit is obtained from abroad rather than domestically, an additional complication is added if the exchange rate changes in the period during which the loan is outstanding. The difference between the domestic value of a foreign currency loan (for example, in dollars) at the time it is received and at the time it has to be paid back in full depends not only on the interest rate but also on the exchange rate. In effect, changes in the exchange rate alter the interest rate on the loan. If the value of the domestic currency falls (a devaluation or a depreciation), the repayment in domestic currency for a given dollar debt will be higher than if there were no devaluation. In the reverse case of a revaluation or an appreciation, the repayment in domestic currency will be less. With a devaluation the interest rate on the loan increases, and with a revaluation the rate decreases. The borrower assumes the foreign exchange risk in the transaction. The opportunity cost of foreign borrowing, in view of changing exchange rates, is given by:

r = ~+n Et

(1

+ r*) - 1

where r is the undistorted rate, r* is the rate applied to the loan, and E is the exchange rate at times t and t + n. 5 5See C. M. Santano, 'The Impact of Economic Policies on the Soybean Sector of Brazil: An Effective Protection Analysis" (Ph.D. diss. , University of Minnesota, Minneapolis, 1984), pp.

183-91.

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/ Agricultural Price Policy

If r* is in real terms, then r is also in real terms. The exchange rates used must reflect opportunity cost, or the shadow exchange rate. Therefore r is a measure of the opportunity cost of foreign borrowing. Using the above formula, suppose E1 = 10 rupees per U.S. dollar becomes E1 + n = 20 rupees per dollar during the period t + n, and r* = 10 percent, then r = 21 percent. If there were no devaluation, r* = r = 10 percent. A good estimate of r for many developing countries is the London Interbank Offer Rate (LIBOR), a competitive market-clearing rate for international capital flows. The LIBOR is denominated in six major currencies: the U.S. dollar, the British pound, the French franc, the German mark, the Swiss franc, and the Japanese yen. The LIBOR is applied to loans of different maturities, which range from an overnight rate to a year. The LIBOR is a nominal rate that must be adjusted for inflation. The International Financial Statistics published by the International Monetary Fund contains data on international interest rates.

Shadow price of irrigation water. The public provision of irrigation water in many developing countries is a major component of public investment. Irrigation generally increases the economic rent that farmers receive, and this incremental rent can serve as a measure of the marginal productivity of irrigation water. In principle, if one can compare the economic rent of a given piece of land before and after its access to irrigation water, the difference indicates the economic value of water. In this approach water is valued not as a separate resource but as an integral input into raising the quality of farmland. The economic valuation of farmland tends to be involved because land markets may not exist or may not be competitive, and its price may reflect the use of land as a store of value or a symbol of status rather than its productivity per se. In addition, the valuation of land as a residual also is complicated because of the difficulties of shadow pricing labor and capital. These problems of valuing land, and of water as an integral part of it, have led to simpler approaches. One approach assesses the level of funds needed for the adequate operation and maintenance of a given irrigation system and divides the total cost of servicing the total amount of land into the basic unit of interest. The rationale for this procedure is that operation and maintenance funds are diverted from use elsewhere in the economy and represent the value of output forgone. The drawback of this line of reasoning is that the economic relationships between operation and maintenance funds spent, output forgone, and additional output generated in the irrigated areas are very tenuous. Another approach is to use the level of water charges as an indication of the economic benefit of irrigation water. In many countries water charges are not sufficient to recover recurrent costs of operation and maintenance, either because the nominal rate is low (the rate is not indexed to reflect inflation) or

Coefficients of Comparative Advantage

117

because there are shortfalls in the collection rates. A host of factors accounts for the inadequacy of water charges, the major ones are usually institutional and cultural, including the traditional belief that water is "God-given." The distinction between water and irrigation water is not made. With these types of problems, water charges would tend to be gross underestimates of the economic value of irrigation water. Assessing the economic value of water can be a difficult task because its value is dependent on the particulars of the delivery system-quality, time, location, and dependability-and markets for water vary greatly depending on these features. The economic or opportunity cost of water is also dependent on its availability. If the total amount is limited, its shadow price is the forgone output from not using it for the next best alternative use. Second, if availability is not a constraint, water's shadow price is equal to the cost of operating and maintaining the delivery system. The best source of information would be a detailed cost-benefit appraisal of the investment in the irrigation system. It should then be possible to assess whether the features envisaged for the delivery system and the expected crop response of farmers are in fact largely borne out by subsequent experience. One can also compare yields with those of other regions or countries with similar agroclimatic zones, comparing those with irrigation to those without irrigation systems. In sum, while the principle of opportunity cost pricing is simple to understand, its application for specific inputs can be quite complex. The next best market opportunities are rarely obvious, whether within the domestic economy or beyond it. Nevertheless, the process of identifying and valuing relevant market opportunities is the core of economic analysis. When applied systematically this process is invaluable for understanding the opportunities and constraints driving the economic system. Research and development institutions tend to be better equipped than government agencies to undertake the complex analyses of nontradables. Practitioners in government agencies may find it useful to collaborate with them or draw upon their analytical results. The Domestic Resource Cost (DRC) The domestic resource cost compares the opportunity costs of domestic production to the value added that it generates. The numerator can be the sum of the costs of using land, labor, and capital-hence the total cost of domestic resources directly and indirectly applied and of nontraded inputs. The denominator is identical to that of the EPC. The components of the DRC, both numerator and denominator, vary depending on whether the Carden or Balassa method of disaggregating value added is used. The Corden method

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118

refers to direct and indirect value added, whereas the Balassa method refers to only direct value added (see Chapter 3, Table 3.6). When domestic resources are embodied in nontraded intermediary inputs, they are called "indirect." Thus the Corden measure for the numerator is the sum of the costs of primary resources, direct and indirect, and of the nontraded inputs (see Chapter 3, Table 3.5). The Balassa measure is only the sum of the costs of primary resources directly applied. The Corden measure of value added tends to be a larger total than the Balassa measure. Both measures exclude the cost of direct traded inputs from the denominator. The Corden measure excludes only the traded components of the nontraded intermediary inputs, whereas the Balassa method excludes the total nontraded intermediary inputs, suitably adjusted for tariffs or subsidies on the traded components. DRC is calculated as

DRCi

j=k+l

= ----,k,.----

(6)

Pf- L ai.lf j=l

where aii• 1 to k aii• k + 1 ton

= coefficients for traded inputs = coefficients for domestic resources

Vi

=

and nontraded intermediary inputs shadow price of domestic resource or nontraded input

P~

=

border price of traded output

P7 = border price of traded input

If the SER is used instead of the OER (because the OER is not the benchmark rate), then the product of / X SER is pbb for the traded input or traded output. Similar to calculations of other coefficients, the denominator can be expressed in foreign rather than border prices. Alternative exchange rates are used to convert foreign into border prices, and the numerical values obtained emphasize the key importance of exchange rate policy in contributing to comparative advantage. An alternative formulation is n

DRCi =

j=k+l

---k=---p fi -

where

" L...' j=l

aii pfi

Pf = foreign price of output PJ' = foreign price of input

(6a)

Coefficients of Comparative Advantage

119

The numerator and denominator in equation 6 are in border values; the denominator in equation 6a is in foreign currency. Equation 6 is the more common formulation. Either formulation should be interpreted thus: domestic resources and nontraded inputs valued at opportunity costs or shadow price Domestic resource cost = ------,,....=-7------:::-------:------"----,:-:--net foreign exchange earned or saved by producing the good domestically

Interpreting the DRC for Policy If equation 6 is used, the DRC can assume a range of numerical values. A ranking of DRCs by these values is indicative of varying levels of efficiency of domestic production or of its international competitiveness. The exchange rate used must be the opportunity cost benchmark. DRC < I Indicates that the economy saves foreign exchange from local production, because the opportunity cost of its domestic resources is less than the net foreign exchange it gains (in export) or saves (in substituting for imports). DRC < 1 also indicates efficiency and international competitiveness. The reverse holds for DRC > 1, because the economy is incurring costs in excess of what it gains or saves from the production in terms of net foreign exchange. Finally, DRC = 1 indicates that the economy on balance neither gains nor saves foreign exchange through domestic production. By definition, a good that is nontradable does not have a foreign or border price. Strictly speaking, a DRC is not estimated for a nontradable good, but the efficiency of domestically producing a nontradable can be estimated by using the price of the tradable substitute as the benchmark. As we saw in Chapter 2, the latter price has to be adjusted, using information on how consumers or producers substitute the nontradable good in response to a change in price in the traded good. A good may be nontradable in some domestic economies because of very high transport costs, although the same good may be traded internationally, as would be the case, for example, for maize in landlocked regions with poor transportation facilities. In this case a national border price is estimated by using the world price of maize at a major trading center and adjusting it for transportation costs to the national border or port. If the DRC is calculated using equation 6a, the result is expressed in units of domestic currency per unit of foreign exchange. This is a commodityspecific, implicit rate of exchange between domestic and foreign currency, and it is then compared with either the official rate of exchange or the estimated opportunity cost benchmark. (The official rate is not the appropriate benchmark if there are good reasons to believe that it is over- or under-

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valued.) If that implicit rate is less than the opportunity cost benchmark, the commodity is internationally competitive for the following reasons. The numerator indicates the resource costs that the economy has to incur in the production of a given commodity. If the resource costs are less than those the economy would otherwise have to incur, as indicated by the benchmark, the economy earns (in the case of an export) or saves (in the case of an import substitute) foreign exchange through the specific production. Alternatively, if the resource costs are greater, the economy loses foreign exchange, and domestic production is inefficient. The DRC is a summary measure of the relative efficiency of domestic production. Its computation tends to be complex and time-consuming because the analyst must resolve a series of difficult questions. What are the major domestic resources that should be included? What are their opportunity costs? What is the relevant economywide exchange rate with which foreign prices are converted into domestic prices or with which the DRC is to be compared? The analyst addressing these issues must have a firm understanding of the production structure and the major technologies used, of the alternative markets for the inputs to be included in the analysis, and of the foreign exchange market and foreign trade options available to the economy. In other words, this understanding must range from the macro level, including foreign trade, to the micro level, including farm-level production structures, all of which are usually required for careful analysis of policy issues.

Calculating the DRC To proceed from the estimation of the EPC, shown in Tables 3.8 and 3.9 in Chapter 3, to the calculation of the DRC, analysts need two types of additional information: quantities of domestic resources and nontraded inputs in representative farming systems; and an understanding of the major alternative uses of these inputs under given market structures. Farm budgets can provide the first set of data. It would be best to consult an agriculturalist to assess whether adjustments are needed in view of either the incompleteness of the data or the period within which they were collected. Information on market structures and alternatives is typically the domain of the economist proper. Like the estimation of the EPC, the DRC calculation requires teamwork between the economist and technical specialists. Since Table 4.1 builds on the example for meat presented in Tables 3.8 and 3.9, the same policy context is assumed. But the DRC measure is in terms not of policy prices but of opportunity cost or benchmark prices. The only point in a DRC calculation where policy directly affects the numerical results is in step 2, where value added at international prices is computed. In Table 4.1, step 2 presents two alternative formulations of the DRC, both of which require an estimate of the

Coefficients of Comparative Advantage Table 4.1.

121

Estimating the domestic resource cost (DRC) per ton for meat

Steps

Comments

Step 1. Calculating the domestic costs per ton: I. Components of domestic costs (nontraded inputs and domestic resources):

We assume that the traded component portion of nontraded inputs has a! ready been deducted. Based on an average live weight of 1070 pounds; average dressed weight 638 pounds. See Table 3.8. The components of item I b are domestic resources of land, labor, capital services (transport, animal draft) embodied in the nontraded input, berseem. The discrepancy in the wage rate suggests labor surplus and noncompetitive market structure. Marginal opportunity cost attempts to measure the shadow price. In this example the market wage is above the shadow wage.

a. Number of fattened animals/ton of meat: 3.13

b. Berseem (cost of components/animal):

(I) Labor: (hours/bushel)(bushels/animal)

(wage rate/hour) Market prices: (0.25)(48)(LE 0.6)

= LE 7.20

Marginal opportunity cost: (0.25)(48)(LE 0.30) = LE 3.60 (2) Transport: (average kilometers transported) (cost/bushel)(bushels/animal) Market prices: (4)(LE 0.052)(48) = LE 10.00 Marginal opportunity cost: (4)(LE 0.052)(48) = LE 10.00 . ( bushels/ animal ) (3) Ammal draft: (hours/feddan) yield/feddan (cost/hour) Market prices: (6)(70/100)(LE 0.48) = LE 2.0 Marginal opportunity cost: (6)(70/1 OO)(LE 0.48) = LE 2.0 bushels/ animal ) (4) Land: ( yield/feddan (land rental cost/feddan) Market prices: (70/ IOO)(LE 25. 7) = LE 18 Marginal opportunity cost: (70/1 OO)(LE 77.1) = LE 54 c. Wheat straw: (tons/animal)(price/ton) Market prices: (0.72)(LE 12) = LE 8.64 Marginal opportunity cost: (0.72)(LE 12) = LE 8.64 d. Maize: (bushels/animal)(price/bushel) Market prices: (57.14)(LE 1.4) = LE 80 Marginal opportunity cost: (57 .14)(LE 1.4) = LE 80 e. Labor for animal care: (hours/animal)( wage/hour) Market prices: (133.33)(LE 0.60) = LE 80 Marginal opportunity cost: (133.33)(LE 0.45) = LE 60 f. Land: (feddan/animal)(land rental cost) Market prices: (0.5)(LE 20) = LE 10 Marginal opportunity cost: (0.5)(LE 60) = LE 30

This discrepancy suggests rent control on land.

Nontraded input. Maize is usually a traded component, but sometimes high domestic transportation costs can make it a nontraded commodity. Same comments as for step I, item I b(l). Items e and f are domestic resources directly applied to producing a ton of meat, in contrast to the domestic resources indirectly applied, because they (continued)

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Table 4.1.

(Continued)

Steps

Comments

g. Total (DC') Market prices: LE 215.84/animal Marginal opportunity cost: LE 248.24/animal 2. Total domestic costs/ton of meat: Market prices: DC = (LE 215.84)(3.13) = LE 675.58 Marginal opportunity cost: DC' = LE 776.99

(LE 248.24)(3.13)

Step 2. Calculating the international value added (IV A) and DRC: IV A

Pf - a;i Pf =U.S. $1515- (U.S. $130.86)(3.13) =U.S. $1105.41

=

DRC = DC' /IV A LE 776.99/U.S. $1105.41 = LE 0.703/U.S. dollar

Alternatively, DRC = LE 776.99/LE 884.9 = 0.9 If OER = LE 0.70/U.S. dollar is used, then DRC = LE 776.99/LE 774.3 = 1.0

are embodied in the nontraded input, berseem. Multiplying by 3.13 transforms the unit from per animal to per ton of meat. DC' is also the sum of domestic resources valued at their opportunity costs. See Table 3.8, step 6, item 2. IV A is also net foreign earnings gained or saved as a result of the domestic production.

Since EER = LE 0.80/U.S. dollar, meat production has a comparative advantage. The DRC can thus be interpreted as a commodity-specific exchange rate. DRC < I indicates positive domestic comparative advantage at EER = LE 0.80/U.S. dollar. Note how domestic comparative advantage falls as domestic currency is valued more highly, at LE 0.70/U.S. dollar instead of LE 0.80/U.S. dollar.

benchmark for foreign exchange. The first calculates the results using equation 6a; the second uses equation 6, the latter being the more common presentation. Table 4.1 uses the sophisticated Corden measure to estimate the numerator: direct value added in terms of land and labor directly employed (step 1, items I e, f); indirect value added in terms of land, labor, and capital services indirectly employed in the production of the nontraded berseem (step 1, item lb); and nontraded inputs in terms of wheat straw and maize (step 1, items e and d). The Balassa measure would include only land and labor directly employed (items e and fin step 1). The Corden measure requires more de-

Coefficients of Comparative Advantage

I

123

tailed production coefficients than the Balassa method and is therefore potentially more time-consuming. Whether the practitioner should adopt the Corden method or the Balassa method depends partly on which resources are considered scarce and therefore of policy interest, partly on the cost contribution of land and labor directly employed relative to the other items in the non traded input category, and partly on data and time available. In this example land is the scarce resource, as indicated by the marginal opportunity cost greater than the controlled market price. If the policy interest is mainly the best use of scarce land, the Balassa measure, which deals with direct value added, is adequate. If the policy interest is on other resources as well-transport, draft animals, wheat straw, and maize-the Corden measure is preferable. An additional advantage of the Corden measure in this example is that the cost components listed in step 1, items b, c, and d account for a major portion of total cost: 58 percent in market prices and 64 percent in opportunity cost values. Omitting these nontraded inputs would significantly reduce the numerator of the DRC. However, this omission need not be translated into a downward bias in the DRC ratio itself, because the Balassa measure of the residual is also less than the Corden measure. If the DRC estimates are to be compared across commodities and over time, it is important that they use a common approach to disaggregation. Switching between the Corden and Balassa measures would make them noncomparable. In the example shown in Table 4.1, the estimated DRC is LE 0. 703 per U.S. dollar, or a pure number, 0.9. But this number, which indicates the country's comparative advantage in producing a commodity, is sensitive to the exchange rate used in the calculation. In step 2 the commodity-specific exchange rate (LE 0. 70) is compared to the economywide exchange rate (LE 0.80). When the overvalued rate of LE 0.70 was used as a benchmark, the international competitiveness of the commodity fell, but a ratio of less than one still indicates international competitiveness. But the country has a greater comparative advantage in the domestic production of meat if the benchmark rate is LE 0.80 per U.S. dollar instead of the official rate of LE 0.70 per dollar. In the EPC calculations in Table 3. 8, producers of meat, an import substitute, are protected, even if an adjustment for overvaluation is factored in. Both the EPC and the DRC indicate that the government is not protecting an inefficient economic activity. It is cheaper to produce meat domestically than to import it, but should the government encourage a major expansion of this activity purely on efficiency grounds? Two additional steps are needed before making such a major policy and public investment recommendation. The first step is to compute a set of ORCs rather than relying on just one. The set should be either over time or incorporate alternative assumptions about key

124

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Agricultural Price Policy

parameters of the DRC. These parameters are often yields and exchange rates. This set of DRCs would indicate whether there is a good case for further exploring the efficiency aspects of expanding this commodity. The second step is to undertake a full cost-benefit analysis. The role of DRCs in policy analysis is therefore to identify the efficient as opposed to the inefficient so· that policymakers will have a better rationale for discouraging or promoting production of various commodities. We saw in Table 3.9 that production of beef cattle was highly protected. Table 4.2 builds on this information to show that in terms of the use of nontraded inputs the production of beef cattle is not efficient. The opportunity costs of nontraded or domestic resources of LE 107.64 per animal far exceed what the economy would save by not importing cattle at LE 36.9 per animal. Thus, under the current production and price structure, the economy would save resources by importing meat rather than producing cattle domestically. These domestic resources should be released to produce other commodities of higher value. It is often useful to go beyond the final comparisons of value added to identify where the inefficiencies in the structure lie. In this case the domestic resource cost of producing milk and meat isLE 107.64, which is actually less than the cost of producing one animal, which is LE 248.24 (Table 4.1, step 1, item g). The productivity of these cows is relatively low, however, and this is the main factor accounting for the noncompetitiveness of domestic production. If, for example, productivity could be tripled so that value added at international prices was roughly LE 111 instead of LE 36.9 (obtained by converting $46. 14 into Egyptian pound at the estimated EER of LE 0. 8 per U.S. dollar), domestic production would be internationally competitive. Referring back to Table 3.9, this means that the total value of the annualized flow of meat and milk must rise from LE 71.3 (see step 1, item 2d), obtained by converting $89. 15 at the estimated EER of LE 0. 80 per U.S. dollar, to LE 164.85; this is almost a threefold increase. Referring to Table 4.2, step 2, IV A will be LE 111 if the value of traded output isLE 164.85, given cost of traded inputs at $43.00/0.8 = LE 53.8. In other words, the same resource costs of LE 107.64 ($153.77) will save the economy LE 111 ($158.57) instead of only LE 36.9 ($52.71) if the official rate of LE 0.7 per dollar is used. If the rate were LE 0.8 per dollar instead, the resource costs and net savings would be valued at $134.55, $138.57, and $46.12, respectively. If the government insists on granting protection because of income distribution or other political reasons, an important question is how to raise productivity and significantly increase milk and meat output from cows. The general point is that the information of DRCs can be used not only to restructure incentive policy but to identify areas in which productivity needs to be improved.

Table 4.2.

Estimating the domestic resource cost (DRC) for beef cattle

Steps

Comments

Step I. Calculating domestic value added (per animal): I. Components of domestic (nontraded inputs) value added and domestic resources: a. Berseem (see Table 4.1): (I) Labor: Market prices: LE 7.20 Marginal opportunity cost: LE 3.60 (2) Transport Market prices: LE 10.0 Marginal opportunity cost: LE 10.0 (3) Animal draft: Market prices: LE 2.0 Marginal opportunity cost: LE 2.0 (4) Land: Market prices: LE 18.0 Marginal opportunity cost: LE 54.0 b. Wheat straw: Market prices: LE 8. 64 Marginal opportunity cost: LE 8.64 c. Maize (forage): (metric tons/animal)(cost/metric ton) Market prices: (0.25)(LE 60) = LE 15 Marginal opportunity cost: (0.25)(LE 60) = LE 15 d. Labor for animal care: (hours/animal)( wage/hour) Market prices: (32)(LE 0.6) = LE 19.2 Marginal opportunity cost: (32)(LE 0.45) = LE 14.4 2. Total domestic costs: Market prices: LE 80.04 = DC Marginal opportunity cost: LE 107.64 = DC' Step 2. Calculating international value added (IVA) and DRC: " ailb IVA = Pib - " LJ beet cattle J

=U.S. $89.14- U.S. $43.00 =u.s. $46.14 DRC =DC' = LE 107.64/U.S. $46.14 = LE 2.333/U.S. dollar

The traded component of the nontraded inputs has already been deducted.

See Table 3.9 on the EPC for beef cattle. OER = LE 0.7/U.S. dollar, EER = LE 0.8/U.S. dollar, U.S. $89.14 = LE 62.4 at the official exchange rate, U.S. $43.00 = LE 30.1 at OER. Since EER = LE 0.8/U.S. dollar the production of beef cattle does not have a comparative advantage. The commodity-specific exchange rate, LE 2.3/U.S. dollar, is greater than the estimated EER at LE 0.8/U.S. dollar.

Alternatively, DRC = LE 107.64/LE 36.9 = 2.9

U.S. $46.14 = LE 36.9.

If OER = LE 0.70/U.S. dollar is used instead, then DRC = LE 107.64/LE 32.3 = 3.3

At the overvalued OER of LE 0.70/U.S. dollar, DRC increases, thus indicating a further deterioration of comparative advantage.

X

0.8

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I Agricultural Price Policy

ORCs indicate the efficiency of domestic production as an export or as an import substitute. The meat and milk (beef cattle) example questions the soundness of the government's protection of this domestic import substitute. The practitioner should use this information to explore the rationale for government policy. For example, is the government paying this price to ensure food security? Who are the major beneficiaries of this policy? If producers are primarily larger farmers, and most consumers are well-off, the economy is incurring efficiency losses, but not for the sake of vulnerable groups. An alternative rationale for incurring these costs is to foster the development of an infant industry or subsector. Then the focus would be on the major factors currently inhibiting productivity and the complementary nonprice measures that can be applied to address these constraints. The general point is that ORCs should not be mechanically interpreted to advocate expansion or contraction of an activity. One should consider whether the cost or the benefit identified is supportive of broader objectives and thus whether it should be maintained or modified. If a cost is identified, the practitioner should consider whether the cost is a trade-off for some other benefit and then suggest either a less costly means to attain the same objective or some alternative uses of the resources should this activity be contracted. If a benefit is identified, the practitioner should consider whether the cost structure will significantly deteriorate if the activity should expand (increasing costs), and whether demand is likely to expand or be sufficient to absorb the added supply. The economic interpretation of ORCs is straightforward: they indicate efficiency. The policy interpretation, however, is not straightforward. The task is to integrate the information within a broader framework of objectives and market opportunities. The reason for this integration is simply that efficiency is not everything. It is important, but it must be balanced with other considerations. Also, it does vary as production and market structures change.

The Net Economic Benefit (NEB) The net economic benefit refers to the difference between the gross value of output and the total costs of all inputs (traded and nontraded intermediary and primary inputs). The difference is valued in economic prices; namely, border and shadow prices-hence the term net economic benefit, which essentially refers to the economic surplus generated in production. A positive NEB reflects efficient resource use; a negative NEB reflects inefficient resource use. The NEB will always produce the same result as the ORC with respect to comparative advantage classification because the NEB can be derived directly from ORC equation 6. Algebraically,

Coefficients of Comparative Advantage

Net economic benefit [A]

border price of output [B]

sum of traded inputs at border prices [C]

sum of domestic resources and nontraded inputs valued at domestic shadow prices [D]

127

(7)

The same information is used in the DRC, but arranged differently. In DRC equation 6 the arrangement is [D]

DRC = [B] _ [C]

The denominator is value added at border prices, or what is referred to as international value added (IV A) in Tables 4.3 and 4.4. Positive NEBs are equivalent to DRC < 1, negative NEBs to DRC > 1, and NEB = 0 to DRC = 1. The distinction between traded and primary inputs is not as critical in the estimation of the NEB as it is for the DRC. For the DRC, if traded inputs are wrongly attributed to the numerator as domestic resource costs, the estimate of the DRC will be inflated. The productive activity may be erroneously judged to be noncompetitive internationally. This error in classification will not affect the NEB's absolute value, provided the conversion of foreign to border prices for traded inputs is applied correctly. A ranking of activities by their NEBs, however, is not independent of the units in which the outputs are measured, for example, tons, yards, and so on. Therefore, a ranking in terms of NEBs is not a good indicator of relative efficiency unless the outputs are measured in a common unit. Estimating the net economic benefit (NEB) for meat

Table 4.3.

Steps

Comments

Step 1. Calculating the domestic costs in shadow prices (DC'):

See Table 4.1.

DC'

=

LE 776.99

Step 2. Calculating the international value added (IV A) in domestic prices using the equilibrium exchange rate (EER): IVA in foreign prices: U.S. $1105.41 IVA in domestic prices using EER: (U.S. $1105.41) (LE 0.8/U.S. dollar) = LE 884.32 Step 3. Calculating the NEB: NEB= IVA- DC' = LE 884.32 - LE 776.99 = LE 107.33

A positive NEB indicates comparative advantage. It is equivalent to a DRC < I.

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I Agricultural Price Policy

Table 4.4.

Estimating the net economic benefit (NEB) for beef cattle

Steps

Comments

Step 1. Calculating the domestic costs in shadow prices (DC'):

See Table 4.2, step l, item 2.

DC' = LE 107.64 Step 2. Calculating the international value added (IVA) in domestic prices using the equilibrium exchange rate (EER): IVA in foreign prices: U.S. $46.I4 IVA in domestic prices using the EER: (U.S. $46.14) (LE 0.8/U.S. dollar) = LE 36.91 Step 3. Calculating the NEB:

NEB= IVA- DC' = LE 36.91 - LE 107.64 = -LE 70.73

See Table 4.2, step 2.

A negative NEB indicates comparative disadvantage. It is equivalent to DRC > l.

Calculation of the NEB is shown in Tables 4.3 and 4.4. These tables are derived from the previous tables, which demonstrated ORC calculations. They contain no new information, and they are presented simply to show the equivalence of ORC and NEB measures. Thus ORC < 1 is equivalent to NEB = LE 107.33, and ORC > I is equivalent to NEB = -LE 70.73. In Table 4.3, the value added at border prices (LE 884.82) exceeds the estimate of domestic costs in shadow prices. In Table 4.4, value added at border prices (LE 36.91) is less than the corresponding estimate of domestic costs in shadow prices. The policy interpretation of NEBs is similar to ORCs. The main advantage to calculating NEBs, compared to ORCs, is that the NEB estimate is not as sensitive as the ORC estimate to the classification between traded and primary inputs. Efficiency and the Development Process ORCs and NEBs (the latter to a lesser extent) are frequently used measures of comparative advantage. If a country has a comparative advantage in a commodity, it should either produce it or expand its production; if it does not have a comparative advantage, it should not produce it or expand its production. This argument is made strictly in efficiency terms, and other considerations such as welfare, risk, or security are not included. Commodity ORCs and NEBs are specific to the technique of production, region, scale of output, level of demand in domestic and foreign markets, and exchange rate. If estimated ORCs or NEBs are favorable, a country should consider producing or expanding the commodity, provided all the factors

Coefficients of Comparative Advantage

129

listed above are not likely to change, thus raising costs, decreasing benefits, or both. Both sets of changes may occur. For example, expanding the scale of domestic exports may raise opportunity costs per unit of output as less productive soils need to be cultivated and labor markets tighten. At the same time the country may run into demand constraints. For a "large" country, a commodity's price may have to fall to absorb extra production. If production of a commodity for which a country is "small" can expand under constant costs, and if demand for the commodity at a given price is unlimited, expanding this output is an efficient way to earn additional foreign exchange. The changes in costs and returns as scale expands can be reflected in ORCs or NEBs. It is useful to distinguish between current ORCs or NEBs and future ORCs or NEBs, which incorporate expected changes. The current coefficients are considered average rather than marginal in two senses. First, they reflect techniques adopted by the majority, or the average producers. These average producers may be collecting rents in efficiency prices, whereas marginal producers-those using less productive techniques and resources-may be just breaking even. Second, precisely because they are average coefficients they do not indicate how costs and returns may change as output is expanded at the margin. This second sense simply reinforces the point already made, namely, that current coefficients do not have sufficient information to guide decisions for production and investment. The emphasis is on sufficientadditional information on demand and cost is needed to supplement ORCs and NEBs. If estimated coefficients are unfavorable, domestic production is inefficient, and the country should seek cheaper ways of earning or saving foreign exchange. If the country is already producing the commodity, it should-on pure efficiency grounds-consider ways of reducing the output. Continued production is justified only if the infant-industry argument applies: Unit costs are expected to fall because of learning by doing as the infant grows. Net returns are expected to rise because markets are tightening, thus increasing market-clearing prices. The basic point here is that current coefficients reflect current efficiencies, but they do not contain sufficient information to guide future decisions. Future coefficients provide more relevant information. But this information is also not sufficient because investment decisions require full-blown costbenefit analyses. Since ORC analysis is essentially a simplified cost-benefit approach, it can be used to identify potentially promising investment opportunities. It captures only a time slice of an ongoing development process. While a full cost-benefit analysis discounts streams of costs and benefits, ORC analysis takes a snapshot of costs and benefits. ORCs and NEBs incor-

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porate the principle of comparative advantage in policy design and assessment, which is their key contribution to policy analysis. Efficient development can be thought of as a process that exploits current comparative advantage and invests the surplus to strengthen future comparative advantage.

CHAPTER

5

Market Analysis: Getting Started

Chapters 3 and 4 focus on price ratios, which are indicative of the incentives generated by agricultural price policy and the efficiency of the resource allocations these incentives entail. The inference is a linkage from price ratios through incentives to resource allocation structure. The link between prices and quantities is only implicit, however. While coefficients of protection and coefficients of comparative advantage provide a useful first glimpse of a country's structure of incentives, few inferences can be made about the response of consumers and producers to a change in the commodity's price. It is precisely because of this implicit link between prices and resource use that prices are key policy instruments and thus are a focus of economic analysis. The analysis of prices and related responses go hand in hand. Price analysis is the process of systematically identifying key prices and related responses for a given commodity-across commodities, over space, and over time-to help policymakers improve the functioning of markets and achieve socioeconomic goals. Within the partial-equilibrium framework, analysis of price ratios is one approach; analysis of markets is the other. In graphical terms, coefficients of protection and comparative advantage focus only on the price axis and reveal nothing about changes along the quantity axis. Market analysis, the topic of Chapters 5 and 6, relates price to the quantity axis. Analysts can thus measure the response to a change in price and calculate the financial implications for producers, consumers, the government, the volume of trade, and the foreign exchange balance. Formal quantitative assessment for a single market requires empirical estimates of price elasticities at market levels. A change in price for a commodity, however, is likely to affect other related markets, and if analysts are to measure such responses, they need to have cross-price elasticities among the commodity's substitutes and complements and use more sophisticated analytical 131

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techniques that capture multi-market, sectoral, intersectoral, and generalequilibrium effects. The theoretical framework presented here, which focuses on single-market analysis, serves to guide the analyst's expectations with regard to the financial implications of a price change as well as the efficiency and welfare effects. The second part of this chapter discusses the elasticities of demand and supply on which market analysis depends and presents guidelines for using available estimates. More detailed discussions of the supply and demand apparatus can be found in basic economics textbooks, some of which are listed in the Bibliography.

Theoretical Framework for Market Analysis At the simplest level, any market can be analyzed in terms of the interaction between demand and supply. Demand is what consumers are willing to purchase at different prices. Supply is what producers are willing to produce and market at different prices. The prices consumers and producers use for their transactions are referred to as financial prices. These are distinguished from prices that reflect scarcity and are called opportunity costs or economic prices. Price elasticity is the responsiveness of consumers or producers to a given change in price, or more precisely, a percentage change in quantity consumed or produced in response to a percentage change in price, at a given price. With data on prices, quantities, and elasticities in the relevant range, analysts can calculate the financial implications of a change in price for producers, consumers, and the government budget. In policy analysis it is useful to distinguish between "positive" and "normative" analysis, or "what is" as opposed to "what should be." The market model is useful for making a positive assessment of the multiple consequences of a price change. Such analysis does not require the assumption of perfect competition, but it does require reliable data on prices, quantities, and responsiveness of market agents. If certain assumptions derived from the model of perfect competition hold, normative assessments in terms of efficiency and welfare are possible. It must be recognized, however, that even positive statements have normative overtones; they point to consequences of policy that are interpreted as costs or benefits. The distinction is useful in clarifying the nature of policy discussions and disagreements.

The Perfect Competition Model Demand and supply curves have special social and economic significance when conditions of perfect competition hold. They do not reflect simply what

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consumers are willing to pay for different amounts or what producers are willing to supply at different prices. Equilibrium is not simply the point of no excess demand or supply. Given an initial distribution of assets and incomes, market equilibrium reflects the bliss points for consumers and producers: for consumers because the market output is produced at minimum cost and the output mix reflects their preferences, given initial endowment and income distribution; for producers because they cannot rearrange their resources within and among commodities to increase their profits. Equilibrium prices equate private costs to private benefits, private costs to social costs, and private benefits to social benefits. These are the "right" prices! The derivation of the demand and supply curves requires that many factors be held constant. The market demand curve is a horizontal summation of individual demand curves. Individual demand curves are based on the assumption that income, prices of other commodities, and preferences will stay constant, and changes in any of these parameters shift the demand curve. A movement along the curve is triggered only by a change in the price of the given commodity. Strictly speaking, as the price changes along the curve, so does real purchasing power within a given fixed-money income. Money income stays constant along a curve, but real income (in the sense of purchasing power and attainable levels of welfare) changes. It is assumed that changes in real income generated by price movements within a market do not affect consumption and purchasing power in other markets. This assumption is true for "small" commodities-those that absorb a small fraction of the total consumer budget. Consequences within that specific market can then be analyzed without having to incorporate changes in other markets, which in turn may feed back on the market, where the initial change occurred. The social, or welfare, interpretation of the demand curve requires that many factors be held constant. In the market paradigm, consumers are considered "small"; they are price takers and can adjust their expenditures only to derive maximum satisfaction. The consumer is "small" in a second sense: his or her level of satisfaction does not impinge on the satisfactions others derive. Satisfaction or utility is assumed to be independent among consumers. Consumers operate in an impersonal and transparent world of certainty regarding their own preferences and the market options they face. The independence of utilities makes it possible to add up individual curves so that the market curve is the sum of its parts. Prices reflect the subjective worth, or satisfaction consumers derive at different levels of consumption. The market demand curve is a measure of marginal social benefit. Given these utility assumptions, one can interpret the area under the demand curve as total consumer satisfaction in market values. If consumers pay less than the price they are willing to pay, they enjoy surplus. The lower the market price, the greater the consumer surplus. At one extreme, if a com-

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modity is provided free, then the entire area under the demand curve measures consumer surplus. At the other extreme, if the market is not perfect and producers are able to charge different groups of consumers according to what they are willing to pay, then there is no consumer surplus. A uniform market price divides the area under the demand curve into two parts: the part above is the consumer surplus; the part below is total consumer expenditure. Under perfect competition the supply curve reflects much more than what producers are willing to produce and market at different prices. The curve reflects opportunity cost-the cost the private producer has to incur is what the economy has to give up to devote resources to this particular line of production. The situation of producers is analogous to that of consumers. Producers are profit maximizers and price takers, and they make their choices with perfect knowledge of their technological and market options. They allocate their resources among alternative uses until no further rearrangement can increase their profits. If the price they receive in the market is higher than the amount they require in order to supply that level of output, they earn a surplus. Producer surplus is not a measure of utility but of income. It refers to the difference between the total revenue producers must receive to supply a given amount and the revenue they actually receive. Consumer surplus can be viewed as a measure of unspent income; producer surplus as a measure of extra revenue. Under perfect competition the supply curve is not only a private cost curve but a social, or opportunity, cost curve reflecting marginal social cost. The area below the supply curve represents the total private and social costs of production; the area above it, bounded by the market price, represents producer surplus. To derive the supply curve for any market structure, one must assume that certain factors of production are fixed and that others are variable. The shorter the time horizon-the time available for adjusting input mix-the higher the ratio of fixed to variable, and the more inelastic the curve. Supply curves drawn for noncompetitive market structures are not interpreted as social opportunity cost curves. The area above the supply curve still, however, represents producer surplus. Under perfect competition, market processes serve to further both private and social interests and to harmonize them. Given these conditions, the optimality of competitive solutions is a matter of logic. Any deviation from competitive equilibrium involves a transfer of welfare between producers and consumers and thus a loss in efficiency. Price distortions generate efficiency losses because producers either under- or overproduce and consumers under- or overconsume compared to the norm of market equilibrium. In addition to welfare transfers, distortions entail a net loss in efficiency to the economy as a whole. The framework for considering net efficiency gains and losses is no longer the single market but the economy as a whole. Resources

Market Analysis: Getting Started I 135 are withdrawn from the economy in the case of expansion of this market, and they return to the economy in the case of contraction in this market. One is comparing the relative efficiency of using resources either within this market or in some competing alternative. There is a net efficiency loss when the loss of one group is not captured by the gain of some other group in this market or in the rest of the economy as a whole. In the reverse case of net efficiency gain, the gain of some group within this market or of the rest of the economy is not matched by an equivalent loss within the market. Net efficiency losses or gains are referred to either as net economic losses or as gains in production or consumption. They are sometimes called deadweight losses or gains. A more precise definition is given in Chapter 6.

Using the Perfect Competition Model The efficiency and welfare interpretations of the supply and demand curves within the market model require many restrictive assumptions characterizing perfect competition. But perfect competition rarely, if ever, exists, and if these assumptions do not hold, the curves can no longer be interpreted as representing marginal social costs and benefits. Instead, they reflect primarily private costs and benefits. Since analysts deal with the real world where markets are imperfect, how can they use the supply and demand apparatus for efficiency and welfare considerations? It has been argued so far that the competitive paradigm serves to organize reality and guide analysts in thinking through the implications of price changes. The theory of the second best, however, warns us that piecemeal changes to move the real world to the theoretically ideal world can worsen rather than improve market operations. It follows that there are no established guidelines on how to move from theory to practice. In an effort to grapple with the limitations of this perfectly competitive framework, economists have moved on three fronts: to develop more powerful analytical tools that attempt to model better the functioning of real markets, to develop better intuitive insights into the functioning of actual markets by examining experience in different contexts, and to realize that the most practical and socially responsible approach is to change some key prices to reflect opportunity costs better. The theory of the second best does not say that it is preferable to be passive in a situation characterized by severe economic distortions. Moreover, passivity may be much worse than piecemeal reforms in a context within which distortions tend to be cumulative. The existence of some distortions motivates the imposition of others, and governments typically respond to the problems caused by distortions by imposing others to offset them. A typical case is the use of input subsidies for modem inputs-namely, fertilizer,

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tractors, and irrigation water-to counteract the negative impact of low official commodity prices and monopolistic official marketing. In such a real-world environment the critical question is not total reform or no reform; it is what kinds of reform. Arguments in favor of piecemeal reforms stress that it is idealistic to assume that wholesale changes can be made and that a start has to be made somewhere. Experience indicates that economic management that adopts piecemeal rather than wholesale reforms can improve economic conditions. The relevant question is whether total passivity in the face of severe economic distortions is necessarily preferable to piecemeal reforms. This book is addressed to those who believe it is socially responsible to adopt a gradual approach to economic reform. Analysts and policymakers who share this view, however, must always be conscious of the limited applicability of the theoretical paradigm. The competitive paradigm is a valuable starting point for systematic analyis of complex markets. It is a simple and consistent framework that can highlight areas of possible gains and losses in efficiency and welfare implied by a given change in the price structure. The restrictive nature of the analysis. Even if analysts are willing to accept this gradualist approach and use the analytics of the market model, they may still object to the restrictive focus of the framework. Economic analysis focuses on efficiency, and its concept of Pareto optimality states that welfare is at an optimum when nobody can be made better off without somebody else being made worse off. But governments and individuals are rarely concerned only with efficiency, static or dynamic. Reducing the risks of operating in the market or improving the income position of subgroups in the market are important additional objectives for which the paradigm provides no guidance. A major dilemma in the food subsector has been how to balance welfare and efficiency considerations. Measures to improve welfare in the short run also undermine incentives needed for efficient growth in the longer run. Policymakers can ill afford to ignore the welfare losses entailed in promoting efficiency and the efficiency losses entailed in promoting welfare. Practitioners can use the market paradigm to assess what price society is paying for either objective. These estimates are necessarily rough, but they do help to indicate the broad magnitude of the problem. 1 The focus on static efficiency also bypasses important economic issues raised by changing technologies, resource endowment, and market opportunities, both domestic and foreign. Changes in any of these factors can be I The trade-off between concerns of efficiency and welfare is treated at length in Food Policy Analysis, by C. Peter Timmer, Walter P. Falcon, and Scott R. Pearson (Baltimore:.Johns Hopkins University Press for the World Bank, 1983), pp. ix, 283-93.

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analyzed within the framework of comparative statics, that is, comparing two or more equilibrium positions. The disequilibrium path itself, along which most markets remain, is not analyzed, however. Practitioners should, to the extent possible, draw on technical expertise to identify structural forces that can transform the productivity and profitability of economic activities. As a starting point, they should consider the following factors: technology options, mechanisms for technology transfer, and receptivity of farmers; longterm trends in the growth of population and labor force participation in agriculture relative to available cultivable land; and the expected evolution in the structure and size of domestic and foreign demand for major commodities.

The scope for price interventions. In practical terms, analysts need to determine if, in a given situation, government intervention actually helps or hurts. The competitive paradigm suggests that government intervention that reduces distortions will generate improvement in efficiency over time. The paradigm can serve as a benchmark and a guide to identifying the inefficiencies and imperfections of actual markets, even though analysts may not be able to interpret market supply and demand curves strictly as social cost and benefit curves. Market imperfections, however, mean that changes in production and consumption away from market equilibrium may actually improve efficiency and welfare rather than reduce them. In the standard cases of market failure-externalities, public goods, and monopolies-market prices do not reflect opportunity costs. In certain circumstances government price interventions can improve rather than undermine market operations. In the case of agricultural markets, however, direct price interventions may undermine market operations because the decentralized nature of agricultural production and consumption and the homogeneity of many commodities are important features of atomistic competition. Experience in many developing agricultures shows that direct price interventions have undermined both short-term and long-term efficiency of agricultural production and markets. These interventions have hurt both farmers and the economy. In a specific context no a priori conclusions should be drawn, but analysts should determine if government intervention that shifts the official price of a commodity away from market equilibrium is likely to reduce opportunity costs and increase welfare through higher consumption in the longer run. The analysis might point to other tools of government policy that would accomplish these ends, such as public investment to reduce marketing costs, improve information flow and infrastructure, and foster agricultural research and disseminate its results to producers. A necessary assumption when computing measures of surplus is that the price change is marginal; that is, it does not cause a major change in real

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income. For example, a change in the price of pins can be safely considered as marginal for most households, whereas a change in the price of a basic staple for low-income households is likely to make a significant difference in their levels of real income. The computation also assumes that the price change does not significantly affect intragroup distribution of income; a price increase in favor of maize producers, for example, may make them significantly better off while making consumers worse off. The general guide is to assess the relative importance of a commodity and the price change envisaged in the budgets of both producers and consumers before making welfare inferences from these measures of surplus. If the commodity is important and the price change dramatic, then the entire market structure may change. The market may even disappear! A commodity is "important" if it absorbs 20 to 50 percent of the average consumer budget, it is a major source of farm income, it is important as an export or import, and it is important in the government budget. 2 One can, and sometimes should, go beyond the single market to consider closely related markets. 3 One can go beneath the single market in terms of disaggregating among different economic groups. The main constraint here is not conceptual but practical: either no reliable data or inadequate time. The limitations discussed above are important and should affect the way results are interpreted. In assessing the likely efficiency gains from reducing distortions, one should consider possible trade-offs in terms of increased risk or a further improvement in the income position of the relatively wealthy at the expense of poorer groups, which may be left out of the process. One should conduct the analysis for different time periods-short, medium, and long term-and think through how the various adjustment processes may strain the political or socioeconomic fabric. One can then distinguish between effects that are likely to materialize over different time periods. Analysts need to be aware of the limitations of partial-equilibrium analysis and try to compensate for them by drawing on other information, thus informally enriching the information yielded by partial techniques. Advanced modeling 2C. Peter Timmer, Getting Prices Right: The Scope and Limits of Agricultural Price Policy (Ithaca, N.Y.: Cornell University Press, 1986), chap. 2, p. 35. 3Partial analysis is sometimes also referred to as single-market analysis to contrast it with multi-market analysis, which is also considered partial. For multi-market analysis see Avishay Braverman, Choong Yong Ahn, and Jeffrey S. Hammer, "Alternative Agricultural Pricing Policies in the Republic of Korea: Their Implications for Government Deficits, Income Distribution and Balance of Payments," Staff Working Paper no. 621 (Washington, D.C.: World Bank, 1983). For agricultural sector models see Gerald O'Mara and Vinh Le-Si, "The Supply and Welfare Effects of Rice Pricing Policy in Thailand," Staff Working Paper no. 714 (Washington, D.C.: World Bank, 1985). See also Gary P. Kutcher, Alexander Meeraus, and Gerald T. O'Mara, "Agricultural Modeling for Policy Analysis" (Washington, D.C: World Bank, 1985; typescript).

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can incorporate risk and dynamic processes, although often only in mechanical ways. The analyst may therefore decide that it is important to mobilize both formal and informal skills in these areas. The limitations of the formal framework also have implications for the mix of economic, sociopolitical, and technical skills the team should have. These various perspectives need to be integrated into the initial analysis. Economists should aim at integrating micro with sectoral and macro considerations, including domestic and foreign marketing. Analytical techniques need to be applied in ways that yield information relevant to policy-making. Analysis is viewed as a systematic way of exploring effects within a consistent framework. Analysis without the framework is measurement without meaning.

Measuring Economic Response: Conceptual Aspects Before the analyst can trace the effects of price policies through the domestic economy, two distinctions must be made: between "closed" and "open" economies, and between "large" and "small" countries. Most price policies are implemented at a country's border-through tariffs or export taxes, for example-and thus the country's economy is "open" to international trade, at least for trade on government account. It is difficult to implement a price policy on a commodity that is not traded in world markets. In a country with a "closed" economy, one that does not trade a particular commodity, the government would have to implement a price policy through a food logistics agency that would be responsible for purchasing from farmers and would play a direct role in determining the price to consumers. Although microeconomic theory generally deals with closed economies, a price policy is usually an instrument available to countries with open economies, and the analyst needs to consider the impact of foreign supply and demand conditions, in addition to domestic factors in price formation, to determine the ultimate effect of a price policy.

Large versus Small Economies The differing effects of a price policy in closed and open economies and of price formation in a large country can be seen in Figures 5.1 and 5.2. The initial conditions for a closed economy are shown in Figure 5. 1, which illustrates the effects on producers, consumers, and the government budget of introducing a price policy that would raise the price of a commodity to producers. As noted above, a producer subsidy in a closed economy requires that the government set up an agency to implement the support price. Country A faces a downward-sloping demand curve (D) for the commodity under

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s

Price

Quantity

Figure 5 .1. Closed economy: country A

study, and the equilibrium price is pe. If the government introduces a support price to farmers, the quantity of the commodity produced increases to Q., and producers' revenues rise tops x Q., or the rectangle OPsCQs. With the higher price, consumption falls to Qct, and consumers spend a total of ps x Qct, or the rectangle OPsBQd. The producer surplus rises, and the consumer surplus falls. The government's expenditures on behalf of producers are indicated by the shaded rectangle QdBCQ 5 , and the government also bears the cost of carrying stocks because it must handle much of the marketed surplus of the commodity. Producers thus gain at the expense of consumers and of taxpayers in general. Figure 5.2 shows the effects on consumers, producers, and the government budget when country A opens its border to trade and then introduces a pricesupport scheme. The figure also shows the factors that affect domestic price formation for a "large" country in the commodity. Assume initially that there is no government intervention, and the market clears at price pe_ If anything is to be exported, this domestic price must be lower than the world price. The excess of domestic supply over demand above the equilibrium point is indicated in Figure 5.2B by the excess supply curve from country A. The excess of domestic demand over supply in country C, at prices lower than the

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B. World market

A Country A exporter "large" country Price

Price

ES 2 Excess supply from A

pS pW~----------~~-----+T-----

I

Pe

---------~1

fromC

r 0

0 Price

s

D

0 C. Country C importer

Figure 5.2. Open economy: country A and country C

domestic equivalent of Pb, generates the excess demand from country B's curve shown in Figure 5.2. The world price pw is determined by the interaction of excess supply from country A and excess demand from country C. The domestic price in country A rises from pe to the world price pw (in the absence of government intervention). Total world trade of OQT must be equal to country A's exports of QdQs and country B's imports of Qi'Q;.

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If the government intervenes in the form of a support price ps above the initial world price pw producers gain and consumers lose. Domestic production expands to Qs·, no matter what the world price is. Consequently, the excess supply curve from country A is vertical for all prices below ps. The domestic price support has increased excess supply to OQ-r, at every price below ps. This increased supply is represented by the dashed line ES2 in Figure 5.2B. With increased supply and a given excess demand curve from importing country C, the world price falls from pw to pw•. The beneficiaries of this government support are domestic producers and foreign consumers. The losers are domestic consumers and foreign producers. The economy is open in the sense that excess domestic supply can spill over into international trade, but there is still no free trade because government policy determines the domestic price for producers and consumers. There is expanded external trade as a result of domestic price policy: A's production has expanded and consumption has contracted, with opposite results inC, where production has contracted and consumption has expanded. World trade has risen from OQT to OQT· in Figure 5.2B. The difference (OQT· - OQT) is equal to the reduction in consumption in A (OQd - OQd·) plus the increase in production (OQs·- OQJ. The implications for the government's budget depend on whether trade is free or controlled. In the closed system the government must transfer QdBCQs of tax revenue to producers and stock QdQs of production. In the open and free system there is no intervention and no budgetary costs. In the open and controlled system the government must transfer QdB'C'Qs· of budget revenue to domestic producers, but it sells all the excess supply to earn a total of OPw'D'QT· in foreign exchange (see Figure 5.2A and B). The general point here is that the impact of price policy depends fundamentally on how domestic policy controls the economy's participation in international trade and how important the country is in world markets for the commodity under consideration. Practitioners need information on these aspects of institutional settings for policy implementation in order to assess policy effects. Analysts of price policy in a "large" country need additional information for calculating these effects, and Appendix A discusses the kinds of data required and lists their sources. The distinction between large and small as regards market share is important in determining the effects of price policies. In the case of a tariff on imports, for example, domestic producers and the government in a small country gain revenue at the expense of domestic consumers, but in a large country the losers are not only domestic consumers but also foreign producers. The large country thus exerts power over the gross earnings of foreign producers. The distinction between large and small is also important when a country

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imposes an export tax. For a small country, the government and consumers gain at the expense of producers. Many developing countries fall into this category. Consumers receive no gain if the tax is imposed on commodities with little or no domestic demand, such as cocoa or rubber, and thus only the government realizes the gains-from the export tax revenues. If the domestic currency is overvalued as well, the producers will be subject to a double layer of taxation, while the government gains through the explicit form of taxation as well as through its role as the primary holder of foreign-denominated debt. When a large country imposes an export tax, the gainers remain the government and domestic consumers, but the losers are not only domestic producers but also foreign consumers. An export tax can thus be a powerful tool for transferring surplus from foreign consumers to domestic consumers and the government budget. The more dependent foreign consumers are-the more inelastic their demand elasticity-the higher the surplus in terms of foreign earnings that the domestic government can extract. With time, consumers are likely to switch to cheaper substitutes, which means that the price elasticity of demand for this taxed commodity increases. In the longer run an export tax is likely to become a less lucrative and hence a less powerful tool for transferring surplus. Whether a country is large or small in world markets has obvious implications for identifying the correct border price benchmark. If a country's own actions in world markets drive the border price up or down, the analyst's task is vastly complicated, especially because short-run and long-run elasticities of demand in foreign markets are likely to be sharply different. Most countries cannot affect the world price in the long run-the substitutions in production and consumption are simply too powerful-but many importers and exporters find that their actions influence the prices they pay and receive in the short run. Although this short run is important to policymakers, it should not cause analysts to lose sight of the longer-run picture. The analysis developed in Chapter 6 assumes the country is small in world markets for the commodity, which is equivalent to assuming that the analysis is done for a small country in the short run or for a larger country in the longer run. For countries as large as India, China, the United States, and the Soviet Union, or for the European Economic Community, the analyst must always be aware of the impact of domestic policies on world markets. The important task for the practitioner is to assess the likely response of world supply or demand for a given commodity and for the relevant period of analysis. This can be quite difficult to determine because reliable empirical estimates of elasticity may not be available. The practitioner must then explore features of the market that suggest market power, such as the country's share in exports or imports (as distinct from its share in total world production or consumption), geographical segmentation in the market struc-

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ture, existence of bilateral government-to-government contracts, and peculiarities of tastes and other cultural preferences. 4

From Economic Theory to Empirical Measures of Market Response The practitioner should be aware of the many steps that must be undertaken before the theory of market response can be translated into empirical measures of market response. The resuiting estimates are very sensitive to the way the theory was specified mathematically, to the estimation procedure, and to the data set used. Two econometricians analyzing the same set of decisions and data are likely to produce different estimates. Whatever the estimates chosen, they are likely to contain a range of uncertainty and should never be used in isolation to justify any particular price change. This section reviews the types of specification issues of which the practitioner should be aware. This understanding is essential for borrowing appropriate elasticities from other settings and adapting them to the specific analysis at hand. There are four major steps from economic theory to empirical measurement. First, economic theory provides a coherent framework that identifies the major objectives, incentives, and constraints on producer and consumer decisions. It identifies the basic elements that bear upon the decision-making process. For example, a producer wants to maximize expected profits subject to the constraints embodied in the resources available, the technological options, and the institutional framework. Similarly, a consumer wants to maximize utility subject to the structure of personal preferences, income level, and prices. Second, this general framework for decision making must be translated into a set of equations that specify how the decision variable of interest depends on a set of factors that defines resources, constraints, and relative prices. For example, the amount of fertilizer purchased depends on farm size, soil fertility, cropping pattern, family labor available, rainfall, expected price of fertilizer relative to expected prices of outputs, and minimum level of family consumption. Third, the nature of the technical relationships must be specified mathematically. For production, the relationship is between inputs and outputs; for consumption, the structure of preferences among consumption bundles. Fourth, these relationships must be translated into measurable variables for which data can be collected. In the fourth step the analyst must resolve a wide range of specification issues that theory leaves unresolved. The resulting estimates are thus condi4for example, the important features of the international rice market that make Thailand a large exporter are discussed in George S. Tolley, Vinod Thomas, and Chung Ming Wong, Agricultural Price Policies and the Developing Countries (Baltimore: Johns Hopkins University Press for the World Bank, 1982), pp. 83-88.

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tional on the validity of economic theory as well as the analyst's decisions concerning these specification issues. The major implication is that the relative contributions of theory and the analyst's judgments in the resulting estimates cannot be identified. In other words, empirical estimates are a product of economic theory, econometric techniques, and personal judgment. The Range of Specification Issues

Specification is required for the following major aspects: the time period during which decisions to adjust resource allocation can be made; the precise definition of commodities (consumption, goods, inputs, and outputs) involved; the variability of the levels of these commodities during the decision period; the exact functional forms of the relations indicated by the theory of choice; the basic decision units and their constraints; and the specification of a sample of observations of economic decisions that could be used to obtain empirical estimates. At this point the analyst can undertake measurement proper. The goals are to minimize errors in measurement of variables involved, choose the estimation method that is best suited for determining the empirical form of the relations, and determine the computation method that is required to calculate measures of the responsiveness of choices. Relevant time period. The period of time in terms of days, months, and years during which decisions are made is not specified by the theory of choice. In agriculture the short run is typically defined as one production period-the time from initial input commitment to harvest. The long-run decision is defined as involving a sufficient number of production periods to allow for the adjustment of resource levels that cannot be adjusted during one production period. In the case of consumption decisions, the period of time during which decisions are made depends upon the type of consumption decisions being studied and the frequency with which the consumer is faced with a new economic environment that leads to a new allocation of available income. Defining a product. In both the production and consumption cases, the decisions may involve dozens or even hundreds of commodities, which then must be aggregated. Aggregation reduces both the number of decisions and the number of prices that influence those decisions. If some commodities were the same as others within the context of the decision maker's objective, then aggregation of these commodities would be appropriate. Under what conditions is it appropriate to aggregate different commodities? Can apples and oranges be treated as identical and aggregated into a

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category labeled fruit? Theory provides some guidance in answering this question. Two commodities can be aggregated if either the two commodities are perfect substitutes, or the optimal choices of all other commodities are insensitive to (or separable from) the relative levels at which those two commodities are produced or consumed. However, the analyst cannot know whether these conditions are met. Separability is a necessary and sufficient condition for aggregation. It enables one to assume that the choice of products in the group that is to be aggregated can be made independently from the choice of other products not in that group. The choice problem can thus be viewed as occurring in two stages. In the first, choices of the levels of product aggregates can be made, and the question of setting levels of each specific product can be ignored. In the second stage, levels of specific types are chosen conditional on the level of the aggregate chosen in the first stage. Traditionally, commodities have been aggregated according to the judgment of the analyst as to whether these conditions are met. In the production case, for example, different types of fertilizer have been assumed to satisfy the second condition above. Similarly, different types of hired labor, power services, land, or seeds have each been aggregated. On the output side, products have been aggregated in a variety of ways. In the case of consumption, it has been argued that available income is allocated to broad categories such as housing, transportation, health care, and food. The allocation of the budget for each of these categories has been argued to be independent across categories. In the end, however, the specification of which commodities can be aggregated is usually based only on the analyst's opinion. Variable versus fixed factors. Another area in which the theory of choice has little to say is the decision maker's specification of which commodities are variable in the decision period. Decision theories suggest that if a commodity is variable, its relative price should affect choices. If it is fixed or beyond the control of the decision maker, its quantity determines choices. But prior to estimation the analyst can rely only on observation of economic decisions to formulate a hypothesis concerning which commodities are variable.

Exact functional form. The exact nature of the functional forms upon which the empirical model is to be based is also left open to the estimator. Theory provides very little guidance in specifying the functional forms involved. The only alternative available to the analyst is to specify functional forms that are not inconsistent with properties implied by the theory of choice.

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Relevant basic decision units and their constraints. Frequently the behavior of a group of firms is of interest to the policy analyst. A supply function can be derived only through aggregating the supply choices of all the firms in the economy. Given the tremendous heterogeneity of the quality and quantity of resources available to firms in an economy, aggregation of firms generates a set of very complex issues. How should the choices made by different firms be aggregated? Suppose the choice of interest is the supply of rice. Should the rice outputs by all firms simply be added up? If quality varies across firms, the value of the output would vary. A related problem arises in the measurement of the factors determining aggregate choice. When these units are distributed over space, however, they may face different prices. In the face of such heterogeneity among firms, how can concepts of aggregate determinants of choice be defined and measured? As in the case of aggregated commodities, a variety of methods for the construction of indexes of the factors determining choice have been developed by economists. The practitioner may want to consult Robert S. Pindyck and Daniel L. Rubinfeld, Econometric Models and Economic Forecast (New York: McGraw-Hill, 1981), or Jan Kmenta, Elements of Econometrics (New York: Macmillan, 1971). In addition to this source of heterogeneity, the functional form of the relations among endogenous (dependent) and exogenous (independent) variables may vary across economic units. The properties of the exact set of production possibilities available to the firm would depend upon levels of fixed resources and other constraints. This would imply that each firm can be viewed as being at a different position on the surface of the production function. It is even more difficult to argue that functional forms are similar across consumers. In this case, two approaches have been taken. Either utility functions have been assumed to be identical for all consumers with identical characteristics (e.g., social, cultural, or political), or it has been assumed that preferences are such that the utility function is of a form that allows aggregation. In either the production or consumption case, theory pertaining to an individual economic unit is of limited usefulness for the study of aggregate behavior. Specifying a relevant sample. Once the empirical model of economic choices is fully specified by resolving the issues discussed above, the next step is to compose a sample of observations of the behavior of either a set of economic units or of a single economic unit over time. In the first case the sample is called a cross-section; in the latter case the sample is called a time series. In each case data recording both the value of exogenous, or determin-

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ing, variables as well as of endogenous, or dependent, variables must be collected. Specification of the sample represents another critical step in the construction of an empirical model. Theory predicts how choices will change as certain elements (e.g., prices) of the economic environment change and states that other aspects of that environment have no effect on choices. But this prediction is like a laboratory experiment in which the objectives and constraints involved in the decision maker's choice are static except for the particular determinant that changes. Economic behavior does not lend itself to such laboratory control. Instead, the character of the objectives and constraints faced by decision makers may vary over time and among different decision makers. Although theory suggests the relations that must be static in a particular representation, e.g., the utility function and income constraints in the case of the choice problem, whether those relations are in fact static is not addressed by the theory. Instead, analysts must rely on the decision maker's knowledge of the economic environment under study. In a cross-section the relations involved must be static across economic units. For a time series the relations must be static over time. Given that relations involved are static across observations, the differences in choices among observations can be attributed to different prices and levels of other determining factors faced by the decision makers.

From Functional Forms to Empirical Measurement The analyst estimating the model tries to minimize two types of error. One is the set of deviations of the predicted values from the actual values for the dependent, or endogenous, variables. It is assumed that the model is designed to predict only the mean (or average) values of the endogenous variables given (or conditional upon) the levels of the exogenous variables. These errors or deviations must not be systematic, which would suggest that the causal relationship was wrongly structured and specified. The deviations must be random. The actual values of the endogenous variables are assumed to deviate from this conditional mean (or average) by a statistical error. In addition to statistical error there is a possibility for error in measurement of the variables involved. There are two problems here: the first is to translate a theoretical concept (e.g., income) into an empirically meaningful form, and the second is to choose the method for recording the level of variables. As noted above, a theory of a system's structure does not specify how to measure the values taken on by exogenous and endogenous variables. For example, over what period of time does the economic unit make decisions about how to allocate income to consumption alternatives? What prices are to

Market Analysis: Getting Started

I

149

be used to match the period of analysis? Furthermore, if prices are recorded by asking consumers the price paid for a commodity some time after the purchase was made, they may report inaccurate prices. Similarly, income from some sources may not be recorded accurately. Whether errors in measurement are introduced because of inappropriate definitions or errors in recording, their effect on the accuracy of resulting estimates of the empirical model is likely to be substantial, although difficult to assess. Certainly it must be presumed that every effort has been made to eliminate these errors in measurement. It is realistic, however, to conclude that they are present in any set of data used in estimating an economic model.

Estimating parameters. Estimating the parameters of a fully specified empirical model requires the analyst to choose a method that will yield estimates with desirable properties. The analyst desires the best possible estimates, e.g., estimates that rely upon all available relevant information and estimates that allow the estimated mathematical forms to provide the best possible prediction of the endogenous variables. The analyst wants to produce unbiased and efficient estimates. A full appreciation of the concept of bias and efficiency requires an understanding of statistical theory and methods. (See the Bibiliography for selected references to statistics textbooks.) At an intuitive level, the practitioner must be aware that the analyst is trying to infer the true value of an empirical relationship from sample values. In other words, the analyst makes judgments about population values on the basis of sample values. For each sample, one parameter estimate would be obtained. From repeated samples a range of parameter estimates is obtained, each with a frequency or probability. With the help of statistical theory, the analyst can characterize this probability distribution. The sample estimate B is said to be unbiased if on average it is equal to the population value B. The sample estimate B is efficient if its variance, a measure of the range of its possible values, is as small as any other possible estimate. Whether an estimate satisfies these properties depends upon how the estimation method employs available information. Furthermore, these concepts can also be employed to make inferences concerning the true value of B. If the estimated variance is small, then different sets of observations could be expected to produce similar estimates of B. Equivalently, a high degree of confidence could be held that the particular estimate B was not only on average equal to B but also was probably close in value to B. The estimated variance is the foundation for testing hypotheses concerning the true value of B. Hypotheses are formulated about what the true, or population, value of B is. For example, the analyst given an estimated B might be interested in determining whether the true value of B is zero. This would be equivalent to asking whether the variable X

150

I Agricultural Price Policy

with which B is associated should be included in the model of the determination of Y. Using statistical methods for hypothesis testing, the analyst can determine whether zero is highly unlikely. If so, then the hypothesis b = 0 can be rejected. In this case X is said to be a statistically significant (or important) determinant of Y. Alternatively, if zero is highly likely, then the hypothesis b = 0 cannot be rejected. In this case X is said to be a statistically insignificant (or unimportant) determinant of Y. It is critical to recognize, however, that properties of estimates of B and their usefulness in making such inferences depend on the validity of the empirical model relating X and Y. In tum, the validity of the model is dependent on the validity of the economic theory on which it is based as well as the way in which the specification of the empirical model is completed. By implication, the confidence that can be placed in a model is limited by the confidence that can be placed in the accuracy of the theory on which the model is based, as well as the appropriateness of the various decisions made by the analyst in completing the model's specification. Statistical significance should not be interpreted as theoretical significance. The importance of this last point cannot be overemphasized, although it is often overlooked. When the relations involved in an empirical model are estimated using the statistical methods described above, the result is an estimated model which by definition is consistent with or fits the data in the sample to the greatest extent possible. Various measures of the extent of the degree of this fit of individual parameters or of the entire empirical model can be calculated. These measures indicate only the fit of the particular model estimated, however, and do not validate the decisions made in specifying the exact form of the model, the choice of the sample, the accuracy with which variables were measured, or the appropriateness of the estimation method used. Instead, the estimated model is conditional upon these decisions. The quality of estimates obtained is dependent upon both the theory adopted and how the analyst resolved the model's specification. Although there are better and worse estimates, they are all sensitive to specification. The implications of this result for the use and interpretation of estimates for policy analysis are profound.

Estimating response. Once an estimated model is obtained, estimates of responsiveness must be calculated. One method of quantitative analysis estimates econometrically the parameters of an empirical model of the reducedform choice functions. Another uses mathematical programming. The approach discussed here focuses on econometric estimates. These estimates indicate directly the choices' responsiveness to change in determinants and can be easily transformed to estimates of elasticities. Since no further compu-

Market Analysis: Getting Started

I

151

tation is required, the accuracy of these estimates is directly related to the accuracy of the estimated model of the choice functions. The practitioner has to be aware of the major elements of the analytical framework that enter into the estimations of responsiveness and elasticities. The multiple steps between economic theory and estimation rely on a combination of analytical skills in several areas: mathematical formulation of theory into functional forms; empirical definitions of theoretical concepts; and sampling and choice of the most suitable estimation techniques. Inevitably, in this long and complex process objective and subjective considerations interact in specifying how theory takes empirical form. Empirical estimates are very sensitive to specification decisions. One also must remember that estimates with desirable statistical properties in no way imply that the underlying theory and specification decisions are sound.

Measuring Economic Response: Practical Aspects Economic theory of producer and consumer behavior suggests the directions of response to price changes, but it cannot indicate actual magnitude. For policy analysis it is often crucial to know the likely range of responses in order to assess the likely magnitude of impact. Economic analysis has to be empirical if it is to give practical guidance. The practitioner has basically two options to guide this assessment: rely on insights derived from experience, or conduct surveys. Econometric techniques and linear programming methods can be used to derive these insights, but practitioners typically use estimates of price elasticity calculated by others rather than computing the estimates themselves. This section focuses on what to look for and how to interpret available estimates and other economic information in policy analysis rather than how to compute the elasticities themselves. The calculation of elasticities requires the skills of a specialist. Time and administrative resources are needed to conduct surveys and gather and process data. Strengthening the data base is institution building, and the practitioner should consider taking the initiative in starting the process. In this important task the practitioner is guided by theory. Theory identifies potentially relevant kinds of information. For now, we will assume that the analyst has some data. The question is how to use them. First, the practitioner assessing the relevance of estimates of response should always distinguish between short-run as opposed to longer-run responses. Given the dependency of consumers or producers on specific commodities or ways of doing things, the short-run elasticity is typically much lower than the longer-run elasticity. In fact, the concepts of "short" and

152

I Agricultural Price Policy

"long" are not arbitrarily defined in terms of a time span, but rather on the range of factors that have to be taken as given relative to those that can be varied. The distinction between short run and long run also reminds us that it is not merely price changes that affect behavior but also the expectations of how permanent these changes are going to be. Price changes that are expected to be quickly reversed may not lead to any response. Second, the practitioner should also distinguish the levels of aggregation to which the response refers. For example, an important distinction is between the supply response of a specific commodity and the supply response of an aggregate of commodities. A recurrent concern is whether an increase in prices will indeed spur an increase in total agricultural output rather than only increases in specific commodities at the expense of a decline in others. Experience and empirical evidence indicate that elasticity of supply and demand is likely to be higher for a specific commodity than for a broader aggregate-for example, rice as opposed to the aggregate food-because possibilities of substitution are higher at the commodity-specific level. Third, practitioners are interested in assessing market response in terms of how much change in production and consumption will result. This concern is an integral part of a broader concern, namely, the scale of total production and consumption that current development can generate. Therefore the practitioner is interested not only in elasticity but in the scale on which changes occur. The scale of the change in the short run in turn may be translated into changes in investment, which then fundamentally alter the entire market through productivity changes. In terms of the supply and demand apparatus, the analyst is interested not only in movements along the curve (elasticity) but in shifts in the curve brought about by changes in the underlying structure of production. These shifts are sometimes referred to as dynamic responses to price policy, which are components of longer-term responses. Lack of time and funds typically forces the practitioner to borrow and adapt elasticities from other situations that are comparable to the analytical task under way. Determining which estimates can be borrowed appropriately requires that practitioners understand economic behavior of individuals in their own countries and that they judge what other settings are likely to be similar. The previous discussion emphasizes the caution necessary when using elasticity estimates from other settings, because they are quite sensitive to the ways in which various models are specified. Since no single estimate is likely to be perfectly adaptable, practitioners should try out various estimates in the analysis and determine a plausible range of responses. This iterative process can gradually sharpen one's understanding of the impact of policy. The first step is to locate the estimates. The practitioner is usually interested in the following kinds of elasticity estimates for short and longer runs: domestic supply and demand, foreign supply and demand if the country is

Market Analysis: Getting Started I 153 large in international trade, domestic supply and demand disaggregated for the major income groups of interest to policymakers, income elasticity of demand by major commodities or aggregates thereof, and cross elasticities between complements and substitutes in both production and consumption. (A well-known source is Hossein Askari and John T. Cummings, Agricultural Supply Response: A Survey of Econometric Evidence [New York: Praeger, 1976].) Appendix D provides a more extensive listing of elasticity estimates as reported in Pasquale Scandizzo and Colin Bruce, Methodologies for Measuring Agricultural Intervention Effects, which includes estimates from Askari and Cummings. Askari and Cummings present an extensive tabulation of short- and longrun inertial adjustment supply elasticities with respect to price. The distinction between short and long refers to the extent to which the adjustment process toward the desired or planned level is partial or complete. The short run refers to adjustment within one year; the long run to adjustment beyond the first year. Some of these results are reprinted in Appendix D. Tables 5.1 and 5.2, extracted from the review, indicate that short-run responses for agricultural commodities range from 0.1 to 0.8, and long-run responses range from 0.3 to 1.5. The next step involves the use of elasticity estimates to calculate responses. This is a mechanical procedure, as the following examples illustrate. Suppose that the range of the supply elasticity is 0.4 to 0.8. By convention, an elasticity of less than 1 percent is considered inelastic. Suppose the price change is 30 percent. The change of output thus ranges from 0.4 x 0.3 = 0.12 (12 percent) to 0.8 x 0.3 = 0.24 (24 percent). If the initial amount is 20 million metric tons, the change in output ranges from 2.4 to 4.8 million tons. Although the response is inelastic, the absolute amounts involved may be significant. The supply elasticity may not be in terms of output produced or marketed but in terms of acreage for a specific commodity or possibly an aggregate of food or cash crops. A low response in terms of acreage, however, may be major in terms of absolute levels of acreage involved or the output they generate. For example, if the acreage elasticity is 0.1 and total acreage is 10 million acres, then a price change of 10 percent translates into a change of 100,000 acres (0.1 x 0.1 x 10,000,000) switched to or from a given crop in the short run. The practitioner can repeat the same numerical exercise for the demand side-for example, fertilizer demand or consumer demand for a specific commodity. Examples in Appendix C show how to compute these effects. The third step is to determine a range of plausible estimates, because no single estimate is likely to be the correct one. This step requires a detailed understanding of the structure of the economy and thus is not mechanical. Since plausibility is a matter of judgment, the practitioner should, to the

.......

~

Vl

India, Syria, Iraq, Jordan, Egypt

Other foodgrains

Egypt, Iraq

Pakistan

India, Jordan, Egypt, Syria, Bangladesh Greece India, Nigeria, Philippines Brazil, India, Bangladesh, Ecuador, Dominican Republic, Venezuela, Nigeria, Kenya India, Uganda, Tanzania, Bangladesh

India, Pakistan, Lebanon, Egypt, Sudan, Philippines, Hungary, Jordan

Argentina b. India India, Pakistan, Bangladesh, Thailand, W. Malaysia, Philippines, Egypth.d, Sri Lanka India, Pakistan, Hungary, Jordan, Lebanon, Egyptb.c

0-0.33

India, Uganda, Tanzania, Nigeria, Sudan

Greece India Brazil, Nigeria, Malawi, Ghana, Venezuela

India•, Thailand•, Syria•, Kenyah, Brazilh

India, Lebanon, Kenya•

India Brazil, India, Jamaica, Ghana, Ivory Coast, Cameroon, Colombia, Nigeria Egypt, Pakistan, Uganda

India, Tanzania

Greece India Brazil, Nigeria, Cameroon

Iraq b, Sudan •

Syria•, New Zealand•, Chile•

India, Egypt•

India, Pakistan, Kenya, Egypra·ct, Syria, Lebanon, Argentina, Chile India, Hungary, Sudan, Lebanon, Jordan, Syria, Brazil India, Lebanon India

W. Malaysia•, Iraq•, Thailand (Thonburi only)

>I

Taiwanb

0.67-1

India, Peru, Indonesia (Java), Iraq

0.33-0.67

Country or region

Source: Pasquale Scandizzo and Colin Bruce, "Methodologies for Measuring Agricultural Price Intervention Effects," Staff Working Paper no. 394 (Washington, D.C.: World Bank, June 1980), p. 30. •Long-run elasticity. bShort-run elasticity. cPre-World War II. dPost-World War II.

Cotton, jute, sisal, and wool

Milk and meats Sugar and oils Coffee, tea, cocoa and tobacco

Syria, Jordan, Lebanon, Pakistan

India, Iraq

Wheat

Vegetables and spices

India, Egyptb.c

Agricultural products Rice

d

~ I

= 9716 9515

= 1.021

See Table 3.2B, step 2 for handling and transportation costs. Compare the adjusted border price of Rs 9515 here with RS 9008 in Table 3.2B, step 2. The large country assumption raises the estimated border price, which is used as a reference price. The average retail price of Rs 9716 is derived in step I. Note that if Ph = Rs 9008 were used instead of estimated P 1 = Rs 9515, the result-

The "Large" Country Case Table 8.28.

213

(Continued)

Steps

Comments Sugar

p

Rs 9716=Pd Rs 9515=P 1 0 1mports

Q

ing NPC would overstate the degree of protection offered. In the case of an import, the large country assumption means that the appropriate reference price is unobservable and is higher than the observed border price. The difference between the two is due to the fact that foreign suppliers pay part of the tariff imposed; in other words, part of the burden is shifted onto foreign suppliers.

If the tariff had been a specific tariff, the unadjusted NPC would fall somewhat. Before the increase in demand, pct = pb + T (where T = the specific tariff amount), and the NPC would be T 1 + pb After the increase in demand, the new, lower NPC would be Pb' + T = 1 pb'

T

+ pb'

where pb' is the new, higher border price.

Marginal export revenue. If the domestic economy increases its supply of exports, what is the change in revenue that occurs through exporting an additional unit of the good? In the small country case, MXR = pb because the country receives the same price no matter how much is sold, just as MIC = pb on the import side. However, the marginal export revenue (MXR) will not be equal to the border price (Pb) in the large country case; likewise, on the import side, MIC was not equal to Pb. Assume initial export revenue P 1Q 1 gives way to new export revenue P 2 Q2 • The change in export revenue is P 2 Q2 - P 1Q 1 • Algebraically,

214

I

Appendix B

TRx = PzQz- P1Q1 = (PI + LlP)(Ql + LlQ) - PIQI = PIQI + Q,LlP + P,LlQ + LlQLlP - PIQI = Q,LlP + PILlQ + LlQLlP The marginal export revenue is

For readers familiar with elementary calculus, TRX = PQ

dTRx = QdP dQ dQ

+p

=P(QdP+l) PdQ = P (1- +1) ndx If we define ndx as PLlQ/QAP and assume P/P 1 to be small, the general expression is MXR=Pb(_l +1) ndx The formula also applies in the case where the supply of the commodity Sx had already been shifted vertically upward by an export tax. This MXR can be useful for determining the opportunity cost at the margin of obtaining more foreign resources through an expansion of exports. Analogous to the import side, the NPC does not change if MXR is used. With tax t, we know pd equals Phf(l + t), and thus the NPC is pdfpb = [Phf(l + t)]fPh, or 1/(1 + t). If the supply increases (the supply curve shifts down) and the border price Ph falls, but so does the domestic price pct, and by a proportionate amount. The NPC still equals 11(1 + t), as the two prices continue to differ by the wedge of the export tax rate [P'/(1 + t)]fPh' = 1/(1 + t), where Ph' is the new border price. Only if the tax were a specific tax T would the NPC change (it would

The "Large" Country Case

215

Table B.JA. Nominal protection coefficient (NPC) and marginal export revenue (MXR) for raw cotton, export tax impact on producers of cotton-large country case Comments

Steps

Nominal protection coefficient Step I. Estimating the average domestic price of raw cotton at the farm-gate (producer) level: I. Official price: CF 138,000/metric ton quantity: 300,000 metric tons 2. Market price: CF 150,000/metric ton quantity: 470,000 metric tons 3. Average domestic price of raw cotton at the farm-gate level: (

P1armgate

~~~:~~ ) (150,000)

+ ( =

330,000 )(138 000) 770,000 '

CF 150,701

Step 2. Estimating the free-trade price of cotton lint and seed: I. Unadjusted border price of cotton lint: CF 378,525 2. Elasticity of world demand for cotton lint: -2.5 3. Elasticity of domestic supply of exports of cotton lint: 2.0 4. Export tax on cotton lint: CF 40,000/metric ton 5. Unadjusted border price of cotton seed: CF 43,610 6. Elasticity of world demand for cotton seed: -1.5 7. Elasticity of domestic supply of exports of cotton seed: 2.0 8. Export tax on cotton seed: CF 3000/metric ton 9. Unadjusted border price of cotton lint, assuming no intervention: P\im = =

P~(nct,

- e")

I[

nct, - e" (

378,525(-2.5- 2.0)

= 378,525(-4.5) =

I[

I[

~)

From Table 3.3A, step 2.

Derivation of P 1 , case of the ex port tax. Recall that P~ = ~ + export tax.

]

-2.5- 2.o(

-2.5- 2.o(

From Table 3.3A, step 2.

378 , 5~~8 = 2io.ooo)

~;~:~;~)

]

]

CF 359,663

10. Unadjusted border price of cotton seed, assuming no intervention: P';eed

I[ 1[

= 43,610(1.5- 2.0) =

43.610(-3.5)

-1.5- 2.0(

-1.5- 2.0 (

43,6i~,6103000) J

:~:~:~) J

= CF41,840

(continued)

Appendix B

216

(Continued)

Table B.3A.

Comments

Steps Step 3. Estimating the NPC for cotton at the producer (farm-gate) level: I. Adjusted border price of cotton: p;otton = 0.36(359,663 - 2000) + 0.64(41,840- 2000)- (14,000- 7575) I = CF 147,831 2. Adjusted border price of cotton in the presence of taxes and overvalued exchange rate:

p~otton

= {0.36) [ (

3~9S~~3

+ (0 . 64) [

) - (2000 - 200) ]

•840 ) - (2000 - 200)] ( 41 0.845

- (14,000 - 2000) - (7515

500)

Data on processing ratios from Table 3.3A, step 2. Prices estimated using nonintervention, and ginning and transport costs, Table 3.3A, step 2, items 2b, 2c, 3b, 3c. The adjustments for transportation and processing taxes are made by subtracting 200, 200, 2000, and 500; for overvaluation, by dividing by 0.845. Taxes on ginning from Table 3.3A, step 4, item 2b.

= CF 164,103

3. NPC: NPC

150,701 p~otton = 147,831 = 1.02

P?anngate

Net NPC: N t NPC =

e

P~anngate p~ouon

= 150,701 = 0 918 . 164,103

Marginal export revenue I. MXR for cotton lint:

MXRiim

=

The unadjusted price for cotton lint is given in step 2. Note the negative sign of

P~( I + _.!.._) ndx

=

378,525( I+

=

CF 227,II5

Ignores distortions due to transport taxes and overvalued exchange rate. The gap may be due to tariff or quantitative controls. The net NPC adjusts for distortion due to taxes and overvalued exchange rate (both explicit and implicit taxation). Farmers should receive CF 164, I 03 in the absence of distortion; in fact, they receive CF 150,701. Note that the net NPC is lower than the gross NPC, unadjusted for overvaluation. Therefore the unadjusted NPC overstates the degree of protection given to exports; in other words, it understates the negative protection afforded.

-~ 5 )

ndx·

The "Large" Country Case Table B.3A.

217

(Continued)

Steps

Comments

2. MXR for cotton seed: MXRswJ

=

43,610 (I +

=

CF 14,522

-:.S)

The unadjusted border price for cotton seed, Rs 43,6 I0 was given in step 2. Again note the negative sign attached to the demand elasticity.

3. MXR for raw cotton adjusted to the farm-gate level: MXRcawcotton = 0.36(227, 115 - 2000) + 0.64(14,522 - 2000) - (14,000 - 2000) - 7515 = CF 69,540 Further adjustments for overvaluation and taxes:

MXRrawcotton

= (0 .36) [

( 227' 115 ) - (2000 - 200) ] 0.845

+ (0 .64) [ ( 14 •522 ) - (2000- 200)] 0.845 - (14,000- 2000) - (7515 - 500) = CF 86,943

Adjustments for: processing ratios: 0.36, 0.64; transport from port to mill: 2000; ginning costs: 14,000; tax on ginning: 2000; transport from farm gate to mill: 7515. EER adjustment added along with an adjustment for taxes for transportation and ginning. Note that if the implicit and explicit taxes were removed, the farmer would get the higher price of CF 86.943 instead of CF 69,540.

increase somewhat). Before the supply increase, the NPC would be p 0 and the dollar is also depreciating (second term positive), then the depreciation in B will be larger than in E because of the reinforcing effect from a depreciating dollar. The bilateral c : 1 rate can be depreciating while the multilateral basket rate appreciates because of the strong counteracting effect of an appreciating dollar. Thus, if :8 < 0, and Eel > 0, the second term must be a strong negative. The important point is that changing value of the dollar is a key component in the numerical relationship between the bilateral and multilateral rates. To compute :8, one needs data on separate indexes of official rates and trade shares as weights denoted by ai. The trade share of a given country is obtained by calculating an arithmetic average of the country's share in exports and imports. Suppose the United Kingdom's share in the domestic country's exports is 0.20 and in imports it is 0.35. The overall trade share is (0.2 + 0.35)/2 = 0.28, which one can round to 0.30 for convenience. To compute b1 (see equation F.2), one needs price indexes for the domestic economy and the respective trading partners in addition to the computed B1 index. Summary The main points of this brief review on the major uses of price indexes in partial-equilibrium agricultural price analysis are the following: (1) price indexes summarize useful information on price trends and therefore are helpful in assessing terms of trade, both internal and external-broad intersectoral resource pulls and movements in real purchasing power of domestic as compared with foreign currency; (2) the Laspeyres index, which is the most frequently used, tends to overstate the extent of price increases, especially when price increases have been substantial over a long period because the indexes do not capture the shift away from these more expensive items; (3) the technique of splicing and constructing a chain index can reduce the biases imparted by fixed base-year weights; (4) in interpreting price movements from indexes, one must be aware that they do not reflect improvements in quality and productivity brought about by new technology; and (5) the actual collection and processing of raw survey data may introduce biases that would tend to disappear if the institutional capability for undertaking such work were strengthened.

Interpreting Price Indexes

287

To the extent that data are available to estimate the indexes as theoretically conceived, they can yield valuable information on the movements in relative purchasing power between agriculture and industry. Data problems tend to limit the value of these indexes, and these problems tend to be more severe when one or several of the following factors exist: complexity of the agricultural production structure, significant shifts and changes within the production structure, complexity within the industrial production structure and significant quality changes within it, and significant and changing differences between production and marketed surplus. In sum, the more pronounced the structural changes in output, in terms of both quality and mix, the less the terms of trade can capture the changing relative purchasing power of agriculture as compared with industry, or vice versa. Finally, for a predominantly subsistence agriculture, the terms of trade is potentially of little value because the ratios in exchange between agricultural and nonagricultural commodities are not the important indicators of relative resource pulls and agriculture's purchasing power. In the extreme, if agriculture sold nothing to industry, and thus there was no trade, the terms of trade would be meaningless. If agriculture sold only one good to industry, and industry bought only one good from agriculture, and if there were no quality changes in either good, then terms of trade would be a valuable summary measure of movements in purchasing power between the sectors. But in these two extreme cases there is no need for a price index. The need arises precisely because there are many commodities and price movements are more complex. Indexes provide indirect information on likely direction and magnitude of changes in relative incentives and resource pulls, and it is to these purposes that they should be applied, along with other partial indicators.

APPENDIX G

The Purchasing Power Parity Approach to Estimating the Equilibrium Exchange Rate The practitioner may have to compute equilibrium exchange rates for different years. A common approach is to apply the concept of purchasing power parity (PPP), which relates the purchasing power of one currency in terms of another by adjusting for differential inflation rates. Basically, four sets of factors affect the purchasing power between two currencies: inflation, productivity changes, speculation given the function of money as a store of value, and international capital movements. The PPP approach focuses on inflation only and assumes that the other three factors are not operating to any significant degree. This restrictive assumption is more likely to be realistic for shorter time periods. In particular, during a period of broad-based fundamental structural changes in the economy, one can expect changes not only in the price level but also in relative prices among domestic commodities. Under these circumstances, the PPP approach is too restrictive. To apply the purchasing power parity approach one needs a base year or benchmark estimate, which reflects equilibrium. Any recent year in which the balance of payments was in equilibrium can serve as a base year. Frequently practitioners select a year that is also considered "normal." Alternatively, analysts can use the estimate for the shadow exchange rate (SER) as the base for computation. If current statistics are used to compute the SER for year t, then the SER in real terms for year t is given by SERR t

where

= SER~P: pD t

SER~ = shadow exchange rate in real terms for period t SER~ = shadow exchange rate in nominal terms for period t

P: =

P:) =

index of international inflation for period t index of domestic inflation for period t 288

The Purchasing Power Parity Approach

289

The practitioner must decide which specific price indexes would be suitable for P~ and PP. The main ones are wholesale, producer, consumer, GNP price deflator, and the unit value of manufactured exports-namely, wholesale price index (WPI), producer price index (PPI), consumer price index (CPI), and unit value index of manufactured exports (MUV). The MUV is a unit value index of manufactured exports from a sample of developed to developing countries. The practitioner may wish to evaluate the real rate, not with respect to a general global inflation index but with respect to an index that reflects the average inflation rates of its major trading partners. In this case information is also needed on the nominal exchange rates between domestic and foreign currencies of these particular trading countries in a year when the balance of payments was in equilibrium. When using this basket-of-currencies approach, however, the practitioner cannot use the shadow exchange rate, which does not distinguish among trading partners. The real value of the nominal official rate in terms of this basket is given by BPT-D

b =

P?

_t_t_

t

where

t

b1 = real rate for period t B1 = index of the nominal basket for period t P~-o = index of price levels of selected economies that are the country's major trading partners for period t ~ = index of domestic inflation for period t

The index of the nominal basket is in turn defined as m

Bt =

2:

aiEcit

i=l

where

ai

Ecit

= weight of trading partner i in the total trade of domestic economy, and = nominal index of the bilateral nominal official exchange rate between domestic currency and trading partner i for period t

So the real value of the official rate in terms of this basket of currencies is given by m

2:

i=l