1. Domestic Price System of Economic Analysis
Chapter 6
Domestic Price System of Economic Analysis

2. Unit of Analysis
A WP analysis converts all DP for nontradables into WP equivalents, assuming that the economy wide ratio of SCF holds for each nontraded item
This is directly comparable with the procedure in a DP system of valuing these goods at their Domestic financial prices, by converting all WP/BPP for tradables into local currency at Shadow Exchange Rate

3. Estimating Shadow Exchange Rate[SER]
Its an economic price of foreign exchange
SER is different from official exchange rate [OER] due to taxes and subsidies on the demand and supply of tradable goods.
Shadow Exchange Rate Factor
SERF is calculated as the ratio of shadow exchange rate to official exchange rate
SERF= SER/OER
This ratio gives the CF for foreign exchange

4. Shadow Exchange Rate Factor
SERF expresses the difference between the economic cost of traded goods at the official exchange rate and at the domestic market prices actually paid for them
SERF can be affected by changes in the structure of taxes and subsidies and trade controls

5. Standard conversion Factor
SERF= SER/OER= [ M+Tm-Sm]+[x-Tx+Sx]
M+ X
This approach is used in case of calculating prices at DP
Recall SCF= [M+ X]
[ M+Tm-Sm]+[x-Tx+Sx]
Thus SERF is inverse of Standard conversion factor which shows the ratio of WP to DP

6. Example SERF= SER/OER Then SERF x OER = SER
1/SCF = SERF replace in the second equation
1/SCF x OER = SER
This was done because SCF is mostly known and its equal to 0.8
OER =Rs 80 to dollar
SCF = 0.8
Then SER ???????

7. Comparison of two systems
WP system
DP system
Converts domestic prices into world price equivalents
Converts world prices into domestic price equivalents
OER = Rs 80/
SER = 1/0.8 x 80
SER = Rs 100/

8. Equivalence of world and domestic prices
Input or output
World price system
Domestic price system
Traded good
WP * OER
WP * SER
Non traded good
DP * SCF
DP* 1or [ SERF * SCF]

9. Valuation World Price system Domestic price system Output Traded Good
WP* OER
100*80 = 8000
WP * SER
100*100=10000
Inputs
Traded Goods
50* 80 = 4000
50 * 100=5000
Non traded goods
600*0.8 =480
600*1 =600
Or [600* 0.8*1.25]
Or 600* SCF*SERF
Net Revenues
3520
4400
Or simply net revenues at WP * SERF = 3520*1.25= 4400

10. Acceptance or rejection?
When identical assumptions are made in both systems the project decision will be the same since
NPV dp> 0 and NPV wp> 0
And
NPVdp= NPV wp * CFf
Where NPVdp is NPV at domestic prices
NPVwp is NPV at world prices
CFf is conversion factor for foreign exchange given by SER/OER

11. Traded good in dp system
DPEP= [Wpi x OER] x CFf + Ti DPCFt + Di DPCFd]
Where DPEP is the economic price of i. to a project in domestic price system
Wpi is its border price
OER is the official exchange rate
CF f is the SER/OER
T and D are the transportation , distribution cost per unit of I from port to project at financial prices
DPCFt and DPCFd are CFs for transport and distribution in a domestic price system
Since CF f = SER / OER then you can rewrite the first eq as
DPEP= [Wpi x SER] + Ti DPCFt + Di DPCFd]
DPCF= DPEP/DP , where DPCF is conversion factor in DP system and DP are the financial prices

12. Non traded goods in dp system
Variable supply criteria applied here
Costs in DP rather then WP
DPEP = Σaij. Pi. DPCFi + Σanj. Pn. DPCFn +Σ alj. WL. DPCFL
It’s the same formula on CF are in DP terms
The new Conversion factor is
DPCF= DPEP/DP

13. Example table 6.3 see footnotes
Input
Domestic Financial prices CF
Case 1 economic prices domestic price numeraire
Operating cost
Fuel 30
1.068
32.04
Local Materials 60
1.00
0.744
44.64
Labor
Skilled 80 1
Unskilled 10
0.5
5.5
0.55
5.55
Capital Cost
Equipment
1.05
6.3
1.055
63.3
Buildings
0.819
49.1
Total
300
1.003
300.89
0.915
274.64
CF case 1 = /300= 1.003
CF case = 274.6/300= 0.915

14. Unskilled Labor in DP system
Treatment is same in both WP and DP systems but the unit of account is in domestic price unit
DPEWR = a. m. DPCF
FWR= 10,000
Labor worked 150days at Rs 20 with CF = 1.38
The remaining days 215 worked at Rs 5 per day with SCF 0.8
Case 1 Both EP are converted
Case 2 Export EP is converted only

15. Case 1 Both EP are converted Case 2 Export EP is converted only
Example
Case 1 Both EP are converted
Case 2 Export EP is converted only
DPEWR = {[150*30]*[1.38]*1.111 }+{ [215*5]*0.8*1.11} = Rs 5555 DPCFL= 5555/10000 =0.555
DPEWR = {[150*30]*[1.38]*1.111 }+{ [215*5]*1} = Rs 5675 DPCFL= 5675/10000 =0.568

16. Skilled Labor WP system use SCF for conversion
DP use 1 for conversion factor

17. Foreign Workers
If all local consumption component can be identified as a foreign exchange cost
DPEWRf =
[r.FWRF + [1-r]FWRF x CCF] x SERF
Foreign labor consumption has 0 foreign exchange component
DPEWRf =
[r.FWRF x CF]+ [1- r]FWRF

18. Land and discount rate
FP are converted to DP for land using SERF and no change for interest rare