Economic Analysis under World and Domestic Price System

(C&W Chapter 5, 6)

R. Jongeneel

Lecture Plan World price system analysis

inputs/outputs (tradable/non-tradable)labourlandcapital (discount rate)

domestic price system analysisshadow exchange ratetraded/non-traded goodslabour(land, discount rate)

World Prize System-Analysis Main objectives:

efficient utilization & existing resources

growth of resources

improving distribution (equity)

Trade-offs

short-run optimization

long-run optimization

World Price System-Analysis Main focus: efficiency analysis focus on

efficient resource utilization

Opportunity costs: defined in terms of

benefits foregone from the use of existing

resources in one project rather than in their

most likely alternative use

World Price System-Analysis

World price numeraire choice

Focus is on projects that produce traded

goods and whose main benefits are in

foreign exchange (trade efficiency)

Assessing Costs and Benefitstradable Non-tradable

outputs

Project

inputs

tradable Non-tradable

labour land capital

Traded and non-traded goods

Tradables project affects country’s balance

of payments

classification depends on government’s

trade policy

non-tradables goods may be non-traded for

various reasons

Valuation of traded goods

Border parity pricing: use border prices and

add domestic margins (transport,

distribution) to obtain border prices at

project level

export output: fob price - value T + D

import input: cif price + value T + D

Value of traded goods

T 1+D 1

Project size Production centre

domestic proj. inputs

Border

Port

T2+D2

T4+D4

T5+D5T3+D3

Cons. Centre

project outputs

Value of traded goods

Price: convert world prices into local currency

at official exchange rate

Shadow price:

SPi = (Wpi x OER) + (Ti CFT + Di CFD)

CFi = SPi / DPi

Valuation of non-traded goods

Non-traded goods

Variable supply

increase supply

(price )

Fixed supply

Replacement, subst.

price

Non-traded inputs: variable supply

Shadow price: long-run marginal costs of additional supply (in world price equivalents)

traded non-traded labor

input input

i n l

LLLjnnjniiijj CFWaCFPaCFPaSP ......

Example: non-traded electricity production

Cost at domestic price R3/kWH

CF

Cost at shadow price Rs/kWH

Operating costs Fuel Local materials

30.00 60.00

0.961 0.670

28.83 40.20

Labour: skilled Labour: unskilled

80.00 60.00

0.900 0.500

72.00

5.00 Capital: equipm. Capital: buildings

60.00 60.00

0.950 0.737

57.00 44.22

300.00

247.25

CF electricity = 247.25 = 0.824 300

Non-traded inputs: fixed supply Use average conversion factor for the

whole economy since more detailed info is absent

ACF = M + X _

(M+TM-SM)+(X+TX+SX)

Limitations: “average” instead of “marginal”, relies only on traded goods, omits effect of trade controlls (quota)

Labour valuation

Possible distinctionsskilled vs. unskilledworkers in excess supply vs. workers

in excess demand

Problem: ill-functioning labour market, immobility of labour

Labour: workers in excess supply

Opportunity costs: value of the output produced in the alternative occupation (which may offer only part-time work or underemployment)

wagemarket

SWR

MWR

SWRCF

CFmaSWR

L

iii

..

Labour: workers in excess demand

Two options: 1: attract labour from other activities2: increase labour supply by training or immigration

Option 1:

Option 2:

i

ii ACFmaMWR

(1 )foreign F FSWR rMWR r MWR CCF

Land

Comp. Land market price: equal to the expected future gain from the land purchased / rented

problem: land market subject to regulation / speculation

Example: land valuation cotton/sugarcane

Domestic marketprices Rs/acre

CF World pricesRs/acre

Cotton outputFamily labourFertilizerPesticidesBullocksWaterNet return

56.020.05.55.5

11.05.58.5

1.251.250.950.950.800.80

70.025.05.25.08.84.4

21.6

Capital: discount rate

Where do funds come from...?

Determines relevant opportunity costs

Opportunity costs (examples) return on the marginal project return obtained in the private sector weighted average of discount rates (real)

in domestic and foreign markets

Capital: discount rate

r = q . CFq

or

r = a1i1+a2i2

Domestic price system-analysis

Choice of price unit in itself does not determine the opportunity cost of an item

Using DPS does not mean that domestic prices determine opportunity costs of (non-traded) goods

The difference between WPS and DPS arises because in general Pwm and Pdom differ by more that the margin for T+D-costs

Shadow exchange rate

If domestic prices are the numeraire allowance must be made for any general divergence between domestic and world prices in the economy

Solution: use shadow exchange rate

Shadow Exchange Rate

1

( ) ( )

( )

F

M M X X

SERCF

ACF OER

M T S X S TSER

OER M X

Shadow Exchange Rate

A more perfect approach is:

j j

jj

i i

ii WP

DPa

WP

DPa

OER

SER

Example: Shadow Exchange Rate

Commodities $ value Weights Domestic price Rs

World price Rs

Price ratio

Rice Wheat Machines SER/OER

20 16 14

0.33 0.12 0.55

1100 1440 2000

1000 1200 1500

weighted average

1.10 1.20 1.33 1.24

OER = Rs10/US$

Approximations in DPS-Analysis

Classificationforeign exchange (F)domestic resources (N)unskilled labour (LU)skilled labour (LS)transfer payments (T)

(F): traded goods valued at Pwm (OER)

(N): non-traded goods valued at Pdm

NPV and DPS-analysis

At project level NPV=F+N+LU+LS+T

At national economic level ENPV=F.CFF+N.CFN+LU.CFLU+LS.CFLS

More detail: further decompose N

Traded goods: valuation at DPS

Derive CF (conversion factors)

DPSPi=(WPi.OER).CFF+(Ti.DPCFT+Di.DPCFD)

but CFF=SER/OER

thus DPSPi=(WPi.SER)+(Ti.DPCFT+Di.DPCFD)

Non-traded goods in DPS

Principle: value inputs in variable supply at long-run MC

j

jj

i n LLLLjnnnjiiijj

DP

DPSPDPCF

and

DPCFWaDPCFPaDPCFPaDPSP

...

Labour valuation at DPS

Labour: shadow wage is based on output foregone

Unskilled:

Skilled:

i

iii DPCFMaDPSWR ..

FFFF

FFFF

MWRrCFMWRrDPSWR

or

CFCCFMWRrrMWRDPSWR

).1()..(

..)1(

Comparing DPS with WPS

Identical decisions are made in both systems

NPVDP>0 when NPVWP>0

and

NPVDP = NPVWP x CFF

with CFF = SER / OER

Comparing DPS and WPS analysis

Discount

rate

NPV DP System

analysis

WP System

nnalysis