Transcript 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.
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 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…
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
 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.
Domestic prices
 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
Traded input
50*80 = 4000
50*80*1.1=4400
Non traded input
600 in DP
600*0.9=540
600
Inputs
Net Revenues
CF= 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
 Use average weighted
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
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
(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.
Method Two
Use the weighted average of the CFs for
the main productive sectors of the
economy, both traded and nontraded.
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
Example
Domestic financial
prices
World prices
CF
Output
cotton
56
BPP are 25% above
the prices paid to
farmers= 1.25
70
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
Inputs
OC= 21.6
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.
a)


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

