The World Price System of Economic Analysis Chapter 5 The World Price System of Economic Analysis

Need for Two numeraires… Most project effects will be valued at their border price equivalent value. This will apply for traded goods and services. However, other items, nontraded outputs, will be valued initially in domestic market price values. These two forms of valuation need to be brought to a common base so that they can be aggregated and compared.

Numeraires Economic analysis can be expressed in two ways – using different units of account or the numeraire. Valuing all project effects at world prices (world price numeraire) Valuing all project effects in domestic price units (domestic price numeraire). In general where domestic prices differ from border prices or world prices because of trade protection The average difference between the two price levels defines the relation between the world price and domestic price numeraires.

Difference between the two numeraires Taxes, subsidies, quotas and licencing controls all create a divergence between domestic prices and world prices net of adjustments for transportation and distribution. This average divergence, termed as SCF, provides a simple link between domestic and world price units. Domestic Price = World Price + Import/Export taxes

Using the two numeraires :Example 1… Suppose a project produces two forms of output: an export product worth $100 at FOB border price and an import substitute product also worth $100 at CIF border price. Exchange rate: $1= Rs. 80 At the economic prices given by their price at the border, both the export and the import substitute are worth the same to the economy in terms of the domestic currency (Rs. 8000 each) However, suppose that the price of the import substitute good is raised by an import duty on competing imports of 10% and that on average the domestic prices for all traded goods are 10% higher than the border price. The export product is not subject to a tax or a subsidy and sells in the domestic market for Rs. 8000. In financial prices, the import substitute product has a higher prices, although the value to the national economy at world prices is equal to that of the export product…

World Prices Domestic prices How can the domestic financial prices of the two products be adjusted to reflect the fact that they are worth the same from the national point of view? World Prices Domestic prices Use the world price numeraire to adjust the domestic price of the import substitute good downwards to its world price by the ratio of 8000/8000 = 0.90909 Thus the adjustment can be either to adjust one price downwards or to adjust the other price upwards. In either case the adjusted value of the import substitute and export good will be equivalent. Use the domestic price numeraire to adjust the world price of the import substitute good upwards by a factor of 8800/8000=1.10 ( here 1.10) represents the extent to which domestic prices exceed the border prices.

Which numeraire to choose? As long as a particular numeraire is chosen and used consistently to value all outputs and inputs,it does not matter which one we use. The values in one can be readily translated into the other. If production is worthwhile as measured through one numeraire, it will also be worthwhile if measured through the other.

Valuation Export/ import subs. WORLD PRICES DOMESTIC PRICES Output /Revenues 100 = 100*80=8000 in local currency units =100*80*1.1 =8800 adjusted for taxes Inputs Traded input 50*80 = 4000 50*80*1.1=4400 Non traded input 600 in DP 600*0.9=540 600 Net Revenues CF= DP/WP show by how much DP exceed world prices

EP=(WPx OER) +( TiCFt + DiCFd) For non tradables use two methods WE will only use the first method of valuation i.e. world price for this chapter thus all prices will have to be converted to world price equivalents , for tradables its just the BPP adjusted for TDH EP=(WPx OER) +( TiCFt + DiCFd) For non tradables use two methods

Valuation of Nontradables Break it down Use SCF If the inputs are in variable supply Talking in terms of long run Break up the input costs into tradables and nontradables and apply the formula EPj= Σaij.Pi. CFi + ΣajnPn.CFn + ΣALj.WL.CFL Use average weighted conversion factor Two methods to find SCF Note : For non tradables its mostly taken as 0.8

Standard Conversion Factor Captures the divergence between world and domestic prices for similar goods. A weighted average ratio of world to domestic prices for the main sectors of the economy is the SCF.

Standard conversion Factor Method One Method Two (M+X) SCF= (M+T-S)+(X-T+S) Advantage: It uses data that is readily available. Drawbacks: It includes only the traded goods in comparison whereas SCF is also applied to convert nontraded items into world prices. It omits the effect of trade controls like import quotas and licenses, which, where they are operative add an additional scarcity margin to the domestic price of traded items. Use the weighted average of the CFs for the main productive sectors of the economy, both traded and non-traded. This approach has the advantage of overcoming the drawbacks of using method 1. Both traded and non traded sectors may be covered If the sectoral CFs are derived from a direct comparison of domestic prices to world prices, they are likely to incorporate the price effects of trade restrictions.

Valuation of Labor In a competitive labor market, there is full mobility of labor between different regions and jobs, thus MP= wage and it can be taken as the value of labor In developing countries this is not the case due to immobility , government set minimum wages , fragmented markets , lack of opportunities /information , monopolies thus there is a need to determine the OC of labor

Valuation of labor Thus, we need to find the economic wage rate, which is the economic value of the output workers would have produced in their alternative occupation. Since we are valuing all other inputs and outputs at world price , we need to value labor at WP as well in order to be consistent.

Types of labor Skilled which are in excess demand SCF for Skilled labor is mostly 0.9 Unskilled labor which is in excess supply SCF for unskilled labor is mostly 0.5

Valuation of workers in excess supply Economic Shadow wage rate EWR= Σai mi .CF Where ai is the proportion of new workers coming from activity I Mi output forgone at financial prices for workers drawn from activity I CF is the conversion factor to convert it into WPs CFL= EWR/FWR Where FWR is the financial wage rate

Example A new project employs workers at annual wage of Rs 10,000 for permanent employment and draws worker from rural areas The workers during peak season which last for 150 days get to work on farm producing export crops with estimated productivity at Rs 20 per day at DP Off peak time they work on small farms producing domestic crops which gives average income of 5 per day at DP

Example EWR= [20*150]* 1.38 + [ 5*215]*0.8 Where 1.38 is the CF of export crop at BPP 0.8 is the Avg Consumption CF EWR= 5000 FWR=10000 CFL = 5000/10000=0.5

Workers in excess demand Additional demand for a new project attracts workers away from activities where they were previously employed Additional demand generated further supply through labor training and immigration Market wage on new project is a reasonable proxy for their productivity elsewhere at domestic prices , so multiple by CF and you get EWR

Foreign Workers EWRf = r.FWRF + [1-r]FWRF x CCF EWR is the economic wage of foreign workers FWR is the financial wage of foreign workers r. is the proportion of wage remitted aboard [1-r] is proportion spent locally CCF is consumption conversion factor[ goods bough by avg consumer, their prices in World market will be 80 percent of their cost to consumer in domestic prices]

Example FWR to foreign worker =1000 He sends 500 back and spend 500 locally EWR = 1000*0.5+0.5*1000*0.8 EWR=900 CF F= 900/1000 =0.9

Land in world price system In a competitive land market, land market prices would equal the expected future gain from the purchase or rental of an additional unit of land. However, land markets in the real world are far from competitive e.g: Urban areas: speculative buying The economic price of land is given by its opportunity cost- that is the net income at world prices that could be obtained from the land in its alternative non-speculative use.

Example A sugar mill is to be established that requires the expansion of sugarcane farming. The aim is that small farmers previously growing cotton will shift to cane, a higher value crop. The cost of land that is considered is not that for the factory site, but much larger area that was previously used for cotton cultivation The OC of land is the return per acre at world prices if farmer had continued to grow cotton

Domestic financial prices Example Domestic financial prices CF World prices Output cotton 56 BPP are 25% above the prices paid to farmers= 1.25 70 Inputs Family labor 20 1.25 25 Fertilizers 5.5 0.95 5.2 Pesticide 5 Bullocks 11 0.8 8.8 Water 4.4 NET RETURNS 8.5 OC= 21.6

The Discount Rate – Alternative Approaches

Capital Capital is treated as investment funds Market for capital is that for funds and the price is interest rate Market for capital involves the demand and supply of loanable funds. In a competitive capital market in equilibrium r = marginal return on capital = income savers require to compensate them for forgoing additional consumption At this equilibrium S=I and no further saving is justified – all projects that are viable are attracting finance.

Complications in using the discount rate for economic analysis… However, the opportunity cost of using the funds on a new project is going to be different depending on the source of funds and how their use on the project affects other activities. Where the public investment budget is fixed over a period of time. Government projects competing for limited funds The opportunity cost of funds will be the return on the marginal project – that is the least attractive project for which funds are available. R1= q. CF Q is the return on marginal public sector projects at domestic prices CF is Cf required to express it at world prices

Capital b) Where the total investment budget of the economy is fixed over a period of time but the government investment budget can be expanded by taxation or borrowing from the private sector. Here an additional government project will displace private investment, thus the opportunity cost of funds is the return that could have been obtained in the private sector. R1= q. CF Q is the return on marginal private sector projects at domestic prices CF is Cf required to express it at world prices

c) Where the investment budget is flexible (increasing investment by drawing additional domestic or foreign savings). Here the opportunity cost is the cost of supply of those funds – real interest rate (nominal interest rate adjusted for inflation). Where both foreign and domestic savings are involved, the discount rate will be a weighted average of the two rates. R2= a1i1+a2i2 I is the real interest rate A1 and a2 are shares in foreign and domestic savings in the financing of projects