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)



labour



land



capital (discount rate)



domestic price system analysis



shadow exchange rate



traded/non-traded goods



labour



(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 Benefits

tradable 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

Cons. Centre project outputs T 4 +D 4 Border Port T 3 +D 3 T 5 +D 5 Project size T 2 +D 2 Production centre domestic proj. inputs

Value of traded goods

Price: convert world prices into local currency at official exchange rate Shadow price: SP i = (Wp i x OER) + (T i CF T + D i CF D ) CF i = SP i / DP i

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)

SP j

 

i a ij

.

P i

.

CF i

 

n a jn

.

P n

.

CF n

 

l a Lj

.

W L

.

CF L

traded input non-traded input labor

Example: non-traded electricity production

Cost at domestic price R3/kWH CF Cost at shadow price Rs/kWH Operating costs Fuel Local materials Labour: skilled Labour: unskilled Capital: equipm. Capital: buildings 30.00 60.00 80.00 60.00 60.00 60.00 300.00 0.961 0.670 0.900 0.500 0.950 0.737 28.83 40.20 72.00 5.00 57.00 44.22 247.25 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+T M -S M )+(X+T X +S X ) Limitations: “average” instead of “marginal”, relies only on traded goods, omits effect of trade controlls (quota)

Labour valuation 

Possible distinctions



skilled vs. unskilled



workers 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)

SWR

 

i a i

.

m i

.

CF CF L



SWR MWR



SWR market wage

Labour: workers in excess demand 

Two options: 1: attract labour from other activities 2: increase labour supply by training or immigration



Option 1:



Option 2:

MWR SWR foreign

  

i a i m i rMWR F ACF F

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

Cotton output Family labour Fertilizer Pesticides Bullocks Water Net return Domestic market prices Rs/acre 56.0

20.0

5.5

5.5

11.0

5.5

8.5

CF World prices Rs/acre 1.25

1.25

0.95

0.95

0.80

0.80

70.0

25.0

5.2

5.0

8.8

4.4

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 . CF q or r = a 1 i 1 +a 2 i 2

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 P wm and P dom 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

CF F

 1

ACF



SER OER SER OER

 (

M



T M



S M

(

M X



X

) 

S X



T X

)

Shadow Exchange Rate 

A more perfect approach is:

SER OER

 

i a i DP i WP i

 

j a j DP j WP j

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

Classification



foreign exchange ( F )



domestic resources ( N )



unskilled labour ( LU )



skilled labour ( LS )



transfer payments ( T ) ( F ): traded goods valued at P wm (OER) ( N ): non-traded goods valued at P dm

NPV and DPS-analysis 

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



At national economic level ENPV=F.CF

F +N.CF

N +LU.CF

LU +LS.CF

LS



More detail: further decompose N

Traded goods: valuation at DPS

Derive CF (conversion factors) DPSP i =(WP i .OER).CF

F +(T i .DPCF

T +D i .DPCF

D ) but CF F =SER/OER thus DPSP i =(WP i .SER)+(T i .DPCF

T +D i .DPCF

D )

Non-traded goods in DPS 

Principle: value inputs in variable

DPSP j

supply at long-run MC



i



a ij P i

.

DPCF i

 

n a nj P n DPCF n

 

L a Lj

.

W L

.

DPCF L and DPCF j



DPSP j DP j

Labour valuation at DPS 

Labour: shadow wage is based on output foregone



Unskilled:

DPSWR

 

i a i

.

M i

.

DPCF i



Skilled:

DPSWR F

 

rMWR F

 ( 1 

r

)

MWR F

.

CCF

 .

CF F or DPSWR F

 (

r

.

MWR F

.

CF F

)  ( 1 

r

).

MWR F

Comparing DPS with WPS

Identical decisions are made in both systems NPV DP >0 when NPV WP >0 and NPV DP = NPV WP x CF F with CF F = SER / OER

NPV

Comparing DPS and WPS analysis

DP System analysis WP System nnalysis Discount rate