Chapter 5The 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.

NumerairesEconomic analysis can be expressed in two ways –

using different units of account or the numeraire.

a) Valuing all project effects at world prices (world price numeraire)

b) 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 numerairesTaxes, 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. 80At 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…

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 pricesUse 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 /Revenues100

= 100*80=8000 in local currency units

=100*80*1.1 =8800adjusted for taxes

Inputs

Traded input 50*80 = 4000 50*80*1.1=4400

Non traded input600 in DP

600*0.9=540 600

Net RevenuesCF= DP/WP show by how much DP exceed world prices

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 FactorCaptures 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 FactorMethod 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 LaborIn 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 laborThus, 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 laborSkilled 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 supplyEconomic Shadow wage rateEWR= Σai mi .CFWhere ai is the proportion of new workers

coming from activity IMi output forgone at financial prices for workers

drawn from activity ICF is the conversion factor to convert it into WPs

CFL= EWR/FWRWhere FWR is the financial wage rate

ExampleA 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

ExampleEWR= [20*150]* 1.38 + [ 5*215]*0.8

Where 1.38 is the CF of export crop at BPP0.8 is the Avg Consumption CF

EWR= 5000FWR=10000CFL = 5000/10000=0.5

Workers in excess demandAdditional 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 WorkersEWRf = r.FWRF + [1-r]FWRF x CCF

EWR is the economic wage of foreign workersFWR is the financial wage of foreign workersr. is the proportion of wage remitted aboard[1-r] is proportion spent locallyCCF 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]

ExampleFWR to foreign worker =1000He sends 500 back and spend 500 locally

EWR = 1000*0.5+0.5*1000*0.8EWR=900

CF F= 900/1000 =0.9

Land in world price systemIn 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.

ExampleA 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

ExampleDomestic

financial prices CFWorld 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 5.5 0.95 5

Bullocks 11 0.8 8.8

Water 5.5 0.8 4.4

NET RETURNS 8.5 OC= 21.6

The Discount Rate – Alternative Approaches

CapitalCapital is treated as investment fundsMarket 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.

a) 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. CFQ is the return on marginal public sector projects at

domestic pricesCF is Cf required to express it at world prices

Capitalb) 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. CFQ is the return on marginal private sector projects at

domestic pricesCF 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