Download Product Markets in PAM: Price Determination and Gains from Trade

Slide 1
Product Markets in PAM: Price
Determination and Gains from
Trade
Scott Pearson
Stanford University
Lecture Program
Scott Pearson is Professor of Agricultural Economics at the Food Research Institute,
Stanford University. He has participated in projects in Indonesia, Portugal, Italy, and
Kenya, that combine field research, intensive teaching, and policy analysis. These
projects are concerned with studying the impacts of commodity and macroeconomic
policies on food and agricultural systems. This continuing effort has culminated in a
dozen co-authored books. These research endeavors are part of Pearson’s
longstanding interest in understanding better the relationships between a country’s
policies affecting its food economy and the underlying efficiency of its agricultural
systems.
Pearson received his B.S. in American Institutions (1961) from the University of
Wisconsin, his M.A. in International Relations (1965) from Johns Hopkins University,
and his Ph.D. in Economics (1969) from Harvard University. He joined the Stanford
faculty in 1968.
Product markets in the Policy Analysis Matrix are analyzed and illustrated in Eric A.
Monke and Scott R. Pearson, The Policy Analysis Matrix for Agricultural Development
(hereafter PAM), 1989, Chapter 3, pp. 37-56, and Chapter 11, pp. 188-196. An empirical
study of product markets in rice systems in Indonesia within the PAM framework is found in
Scott Pearson et al., Rice Policy in Indonesia (hereafter RPI), 1991, Chapter 2, pp. 10-17,
Chapter 8, pp. 138-145, and Chapter 9, pp. 162-169. The process of price determination is
elaborated in C. Peter Timmer, Walter P. Falcon, and Scott R. Pearson, Food Policy
Analysis (hereafter FPA), 1983, Chapter 4, pp. 152-164.
Slide 2
Supply in a Commodity
Market – Diagram
Price
(R/ton)
Supply
O
Quantity
(tons)
The diagram depicts supply in a national commodity market, for example, the market
for cabbages, by measuring relationships between price (Rupiah per ton) on the vertical
(y) axis and quantity (tons) on the horizontal (x) axis.
In this discussion of price determination, it is assumed that the government neither
taxes nor subsidizes cabbage production.
The analysis of food production systems is summarized in FPA, Chapter 3, pp. 77-149.
Slide 3
Supply in a Commodity Market –
Discussion
„
supply schedule – willingness, ability to produce
„
„
available technologies of production
costs of primary factors and purchased inputs
„
marginal cost of production – each point
„
increasing costs of production – upward slope
The supply schedule (“curve”) represents cabbage farmers’ and marketers’
willingness and ability to produce cabbages for sale on the market.
The supply schedule thus summarizes the ability of the country’s cabbage producers to
grow cabbages, given the available technologies of production and the costs of
primary factors of production (land, labor, and capital) and purchased inputs.
Each point on the supply schedule measures the cost of producing one additional ton of
cabbages, the “marginal cost of production.”
The supply schedule slopes upward because it is assumed that resources, especially
land, become more costly as national output expands (“increasing costs of
production”).
Slide 4
Demand in a Commodity
Market – Diagram
Price
(R/ton)
Demand
O
Quantity
(tons)
This diagram portrays a demand schedule (“curve”) in a national commodity market,
for example, that for cabbages.
In this discussion of price determination, it is assumed that the government neither
taxes nor subsidizes cabbage consumption.
The analysis of food consumption and nutrition is summarized in FPA, Chapter 2, pp.
19-76.
Slide 5
Demand in a Commodity Market
– Discussion
„
demand schedule – willingness, ability to
purchase
„
„
„
„
incomes, tastes, and size of population
relative prices of substitutes
marginal willingness to consume – each point
decreasing satisfaction of consumption –
downward slope
The demand schedule represents cabbage consumers’ willingness and ability to
purchase cabbages in the market.
The demand schedule thus summarizes the willingness of the country’s consumers to
purchase cabbage, given the incomes, tastes, and size of the country’s population
and relative prices of substitutes and complements for cabbage in the consumers’
budgets.
Each point on the demand schedule measures the willingness of consumers to buy one
additional ton of cabbages, the marginal willingness to consume and pay.
The demand schedule slopes downward because it is assumed that consumers’
willingness to purchase will increase at lower prices and decrease at higher prices.
Slide 6
Price Determination for a
Nontradable Commodity – Diagram
Price
(R/ton)
Supply
P1
Demand
O
Q1
Quantity
(tons)
The equilibrium price, OP1 and equilibrium quantity, OQ1 , are determined by the
simultaneous decisions of all of the country’s producers and consumers of
cabbages.
The assumption of no government price policies is maintained throughout this
discussion of price determination. Product price policies are introduced in the following
two lectures.
Slide 7
Nontradable Commodity –
Discussion
„
market-clearing condition – at equilibrium price,
quantity supplied = quantity demanded
„
market balance – no excess supply or demand
„
nontradable commodity
„
„
no international markets, so no imports or exports
price set where domestic supply equals domestic
demand
At the equilibrium price, OP1, the cabbage market is in balance, because the quantity
supplied, OQ1, equals the quantity demanded, also OQ1 . This market-clearing
condition is required for price determination.
If the price temporarily were higher than OP1, supply would exceed demand, there
would be excess supply on the market, and there would be downward pressure on
prices until the market reached balance at price OP1.
Similarly, if the price temporarily were lower than OP1, supply would be less than
demand, there would be excess demand on the market, and there would be upward
pressure on prices until the market reached balance at price OP1.
If the country cannot import part of its consumption or export part of its supply of a
commodity, the commodity is termed a nontradable commodity. Because no
international market exists for it to purchase imports or sell exports, the price of a
nontradable commodity is set where domestic demand and supply are equal.
Slide 8
Price Determination for a
Potentially Tradable Commodity –
Diagram
Price
(R/ton)
Supply
c.i.f.
P1
f.o.b.
O
Demand
Q1
Quantity
(tons)
A tradable commodity is one for which part of domestic demand is imported
(known as an importable) or part of domestic supply is exported (known as an
exportable).
The commodity in the diagram is potentially tradable because an international market
exists. But high domestic transportation and handling costs cause the import and
export prices for the commodity to be irrelevant. The country neither imports nor
exports any of this commodity.
Slide 9
Potentially Tradable Commodity –
Discussion
„
potentially tradable commodity –
„
international market exists, but no trade occurs
„
„
„
„
cif import price exceeds domestic price
fob export price is less than domestic price
domestic price set where domestic supply equals
domestic demand (as for a nontradable)
potentially tradable could become tradable
„
„
if cif import price falls beneath domestic price
or if fob export price rises above domestic price
The commodity is internationally tradable but only potentially so. No international
trade is transacted. The cif import price (the “costs, insurance, freight” price of an
importable commodity delivered to a port in the importing country and including all costs
of international freight and insurance) is higher than the domestic market price, OP1.
And the fob export price (the “free on board” price of an exportable commodity
delivered to a ship in a port in the exporting country but excluding all costs of
international freight and insurance) is lower than OP1.
Price determination occurs at OP1, where domestic supply, OQ1, and domestic
demand, also OQ1, are equal, just as if the commodity were nontradable (that is,
where no international market exists). Neither the cif import price nor the fob export
price have any impact on this process. Price determination for a potentially tradable
commodity thus takes place exactly like that for a nontradable commodity.
The potentially tradable commodity would become importable if the cif import
price were to fall to a level beneath OP1, the intersection of the domestic supply and
demand schedules. Similarly, the potentially tradable commodity would become
exportable if the fob export price were to rise to a level above OP1.
Slide 10
Price Determination for an
Importable Commodity – Diagram
Price
(R/ton)
Supply
P2 =
(c.i.f.)
(f.o.b.)
O
imports
Demand
Q2
Q3
Quantity
(tons)
Tradable commodities are either importable or exportable. The commodity pictured in
the above diagram is importable. The import parity price (cif import price), OP2, is
less than the domestic market-clearing price so the country becomes a net importer
of the commodity. The export parity price (fob export price) is also less than the marketclearing price and less than the import parity price, but is irrelevant because the country
is a net importer and does not export this commodity.
Slide 11
Importable Commodity –
Discussion
„
„
importable commodity: import parity (cif) price
price < domestic, market-clearing price
if no policy, domestic price = cif import price
„
„
„
set by domestic supply, domestic demand,
availability of imports at cif price
market balance: domestic demand = domestic
supply + imports
import price represents efficiency price – sets
opportunity costs of next ton supplied
The equilibrium price, OP2 , is simultaneously determined by the decisions of all of
the country’s producers and consumers of wheat and by the availability of wheat
imports at price OP2 .
At the equilibrium price, OP2 , the wheat market is in balance, because the
quantity supplied domestically, OQ2, plus the quantity imported (supplied
internationally), Q2Q3 , equal the quantity demanded domestically, OQ3 .
If the import parity price were to rise above OP2 , the domestic price would rise and the
domestic market would clear at the higher import price with more local production, fewer
imports, and less consumption.
Alternatively, if the import parity price were to fall below OP2 , the domestic price would
fall apace and the domestic market would clear at the lower import price with less local
production, more imports, and greater consumption.
The cif import price for wheat determines the domestic price of wheat (at OP2 in the
diagram) in the absence of government policy. The import price thus sets the
opportunity costs for an importable commodity such as wheat. In this sense, the
import price is considered to be an efficiency price for an importable commodity in
PAM analysis.
Slide 12
Gains from Trade for
An Importable – Diagram
Price
(R/ton)
Supply
P1
P2 =
(c.i.f.)
O
b
a
c
d
Q2
imports
Demand
e Q
3
Quantity
(tons)
The opportunity to import wheat allows the country to reap gains from international
trade, amounting to triangle abc. These gains arise because the availability of
imports (at price OP2) reduces the domestic price from OP1 to OP2 and creates
opportunities for more efficient production and consumption of wheat.
Slide 13
Gains from Trade for
An Importable – Discussion
„
cif import price sets lower domestic price
„
creates opportunities for two efficiency gains
„
„
„
consumption efficiency – buyers purchase more at lower
price
production efficiency – wheat imports cost less than
replaced domestic production
foregone gains from trade = production and
consumption efficiency losses
If the country were to refuse to import wheat, the domestic wheat price would be set at
the domestic market-clearing price, OP1 (as in the case earlier of cabbages, a
nontradable commodity). The decision, instead, to import wheat without restriction
reduces the domestic price from OP1 (the no-trade level) to OP2 (the free-trade
level). The country then enjoys two kinds of efficiency gains from importing wheat.
Wheat consumers benefit because they can purchase more wheat at a lower
price. Their efficiency gain amounts to triangle bcd – the difference between their
valuation of the additional wheat consumed, bcQ3e, and the import cost of that wheat,
dcQ3e.
Wheat producers lose because the lower domestic price results in less output
and reduced profits. But the country achieves a gain in production efficiency if the
resources formerly used to grow wheat, beQ2a, can be used to produce other
commodities. The country’s gain in production efficiency is the difference between the
domestic and import costs of wheat – beQ2a less adeQ2, or abd.
The total gains from trade thus amount to triangle abc – the sum of the consumption
efficiency gain, measured by triangle bcd, plus the production efficiency gain, measured
by triangle abd. If the country’s policy makers were to ban wheat imports, the
foregone gains from trade would become efficiency losses – a consumption
efficiency loss of triangle bcd and a production efficiency loss of triangle abd.
Slide 14
Price Determination for an
Exportable Commodity – Diagram
Price
(R/ton)
Supply
(c.i.f.)
(f.o.b.) = P3
O
exports
Demand
Q4
Q5
Quantity
(tons)
The commodity is pictured is exportable. The export parity price is greater than the
domestic market-clearing price so the country becomes a net exporter of the
commodity. The import parity price (cif import price) is also greater than the marketclearing price and greater than the export parity price, but is irrelevant because the
country is a net exporter and does not import this commodity.
Slide 15
Price Determination for an
Exportable Commodity – Discussion
„
„
exportable commodity: export parity (fob) price
price > domestic, market-clearing price
if no policy, domestic price = fob export price
„
„
„
set by domestic supply, domestic demand,
opportunity to export at fob price
market balance: domestic demand + exports =
domestic supply
export price represents efficiency price – sets
opportunity costs of next ton supplied
The equilibrium price, OP3 , is simultaneously determined by the decisions of all of
the country’s producers and consumers of palm oil and by the demand of other
countries for palm oil exports at price OP3.
At the equilibrium price, OP3 , the market is in balance, because the quantity
demanded domestically, OQ4, plus the quantity exported (demanded
internationally), Q4Q5 , equal the quantity supplied domestically, OQ5.
If the export parity price were to rise above OP3, the domestic price would rise along with it.
And if the export parity price were to fall beneath OP3, the domestic price would fall along with it.
The fob export price for palm oil determines the domestic price of palm oil (at OP3 in the
diagram) in the absence of government policy. The export price thus sets the opportunity
costs for an exportable commodity such as palm oil. In this sense, the export price is
considered to be an efficiency price for an exportable commodity in PAM analysis.
Slide 16
Gains from Trade for
An Exportable – Diagram
Price
(R/ton)
Supply
P3 =
(f.o.b.)
P1
O
g
f
h
exports
i
Demand
j
Q4
Q5
Quantity
(tons)
The opportunity to export palm oil allows the country to reap gains from international
trade, amounting to triangle fhi. These gains arise because the opportunity to export
(at price OP3) increases the domestic price from OP1 to OP3 and creates opportunities
for more efficient production and consumption of palm oil.
Slide 17
Gains from Trade for
An Exportable – Discussion
„
fob export price sets higher domestic price
„
creates opportunities for two efficiency gains
„
„
„
production efficiency – producers sell more at higher
price
consumption efficiency – exports are worth more than
foregone domestic consumption
foregone gains from trade = production and
consumption efficiency losses
If the country were to refuse to export palm oil, the domestic palm oil price would be set
at the domestic market-clearing price, OP1. The decision, instead, to export palm oil
without restriction increases the domestic price from OP1 (the no-trade level) to
OP3 (the free-trade level).
Palm oil producers benefit because they can sell more palm oil at a higher price.
Their gain amounts to triangle ghi – the difference between the value of the palm oil
sold, ghQ5j, and the cost of domestic resources used to produce the palm oil, ihQ5j.
Palm oil consumers lose because the higher domestic price results in less
consumption at higher cost. But the country achieves a gain in consumption
efficiency because the value of the exported palm oil, fgjQ4, exceeds the valuation
of that palm oil by domestic consumers, fijQ4. The gain in consumption efficiency is
thus fgi.
The total gains from trade thus amount to triangle fhi – the sum of the producers’ gain,
measured by triangle ghi, plus the consumption efficiency gain, measured by triangle
fgi. If the country’s policy makers were to ban palm oil exports, the foregone
gains from trade would become efficiency losses – a production efficiency loss of
triangle ghi and a consumption efficiency loss of triangle fgi.
Slide 18
Price Determination, Gains from
Trade, and Government Objectives
„
price determination for tradable commodities
„
„
„
importable – cif import price sets domestic price –
marginal demand met by imports
exportable – fob export price sets domestic price –
marginal supply sold on world market
gains from trade and government objectives
„
„
use of world markets – efficient allocation of
resources and products
possible trade-offs between efficiency gains and
non-efficiency objectives (equity, security)
Why does the import parity price determine the domestic price for wheat, an
importable, whereas the export parity price sets the domestic price for palm oil, an
exportable?
Only the cif import price is relevant for an importable commodity, and only the fob export
price matters for an exportable commodity. The import price of wheat sets the
domestic price of importable wheat because the marginal demand for wheat (the
next ton of wheat demanded domestically) would be met from abroad by imported
wheat, not from domestic production. The export price for palm oil sets the
domestic price for palm oil because the marginal supply of palm oil (the next ton
of palm oil produced domestically) would be sold on the world market, not on the
domestic market.
Is the use of world markets, permitting realization of the gains from international trade,
always more efficient than restricting trade?
The gains from international trade are measures of efficiency permitted by the
opportunity to use world markets. The use of world markets, and hence the reaping
of the gains from trade, consistently provides gains from a more efficient
domestic allocation of resources and products. However, other objectives of
national policy, such as equity or security, might be impeded by the open use of
international trade, especially if world markets are unreliable and world
commodity prices are unstable. Then the gains from greater efficiency have to be
traded-off against the perceived benefits of furthering these non-efficiency
objectives (lecture 1, slide 6).
Slide 19
Price Determination in MarketOriented vs. Centrally-Planned
Economies
„
market-oriented economy
„
„
„
prices determined by producers’ and consumers’ decisions
prices allocate resources and goods
centrally-planned economy
„
„
prices set by government and regulated through quantity
adjustments and enforcement
planners allocate resources and goods
Lecture Program
In a market-oriented economy, prices and quantities are determined by the
simultaneous interactions of producers’ decisions to grow and sell and of
consumers’ decisions to buy.
The government can introduce policies that affect these decisions to produce and
consume. But the prices (and the quantities produced and consumed) are still
determined by the joint behavior of producers and consumers acting independently to
pursue their self-interests.
In a centrally-planned economy, government planners establish prices and
attempt to maintain the regulated prices through a combination of quantity
adjustments (made by the central planners) and strict enforcement (carried out by
the police or military).
The key difference is in how resources and products are allocated in production and
consumption. In a market economy, prices allocate resources and products, whereas in
a planned economy, central planners control prices and allocate resources and
products by their decisions on how much should be produced and consumed.