Download Chapter Fourteen

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
labour
Non-tradable
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
Border
T4+D4
Port
T3+D3
Project size
T5+D5
T2+D2
Production centre
domestic proj. inputs
Value of traded goods
Price: convert world prices into local currency
at official exchange rate
Shadow price:
SPi = (Wpi x OER) + (Ti CFT + Di CFD)
CFi = SPi / DPi
Valuation of non-traded goods
Non-traded goods
Variable supply
Fixed supply
increase supply
Replacement,
subst.
(price )
price 
Non-traded inputs:
variable supply
 Shadow
price: long-run marginal costs of
additional supply (in world price equivalents)
SPj   aij .Pi .CFi   a jn .Pn .CFn   aLj .WL .CFL
i
n
traded
input
non-traded
input
l
labor
Example: non-traded electricity
production
Cost at domestic
price R3/kWH
CF
Cost at shadow
price Rs/kWH
Operating costs
Fuel
Local materials
30.00
60.00
0.961
0.670
28.83
40.20
Labour: skilled
Labour: unskilled
80.00
60.00
0.900
0.500
72.00
5.00
Capital: equipm.
Capital: buildings
60.00
60.00
0.950
0.737
57.00
44.22
300.00
CF electricity = 247.25 = 0.824
300
247.25
Non-traded inputs: fixed supply

Use average conversion factor for the
whole economy since more detailed info is
absent
ACF =
M+X
_
(M+TM-SM)+(X+TX+SX)
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   ai .mi .CF
i
SWR
SWR
CFL 

MWR 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:
MWR   ai mi ACF
i
 Option
2:
SWR foreign  rMWRF  (1  r )MWRF CCF
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
CF
World prices
Rs/acre
56.0
20.0
5.5
5.5
11.0
5.5
8.5
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 . CFq
or
r = a1i1+a2i2
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 Pwm and Pdom
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
SER
1

CFF 
ACF OER
SER ( M  TM  S M )  ( X  S X  TX )

(M  X )
OER
Shadow Exchange Rate
A
more perfect approach is:
DPj
DPi
SER
  ai
 aj
OER
WPi
WPj
i
j
Example: Shadow Exchange Rate
Commodities
$ value
Weights
Domestic
price Rs
20
16
14
0.33
0.12
0.55
1100
1440
2000
Rice
Wheat
Machines
SER/OER
OER = Rs10/US$
World Price ratio
price Rs
1000
1200
1500
weighted
average
1.10
1.20
1.33
1.24
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 Pwm (OER)
(N): non-traded goods valued at Pdm
NPV and DPS-analysis
 At
project level
NPV=F+N+LU+LS+T
 At
national economic level
ENPV=F.CFF+N.CFN+LU.CFLU+LS.CFLS
 More
detail: further decompose N
Traded goods: valuation at DPS
Derive CF (conversion factors)
DPSPi=(WPi.OER).CFF+(Ti.DPCFT+Di.DPCFD)
but CFF=SER/OER
thus DPSPi=(WPi.SER)+(Ti.DPCFT+Di.DPCFD)
Non-traded goods in DPS
 Principle:
value inputs in variable
supply at long-run MC
DPSPj   aij Pi .DPCFi   anj Pn DPCFn   aLj .WL .DPCFL
i
n
and
DPCF j 
DPSPj
DPj
L
Labour valuation at DPS
 Labour:
shadow wage is based on output
foregone
ai .M i .DPCFi
 Unskilled: DPSWR 

i

Skilled:
DPSWRF  rMWR F  (1  r ) MWRF .CCF .CFF
or
DPSWRF  (r.MWRF .CFF )  (1  r ).MWRF
Comparing DPS with WPS
Identical decisions are made in both systems
NPVDP>0 when NPVWP>0
and
NPVDP = NPVWP x CFF
with
CFF = SER / OER
Comparing DPS and WPS
analysis
DP System
analysis
NPV
WP
System
nnalysis
Discount
rate