Economic Analysis under World and Domestic Price System

1. Economic Analysis under World and Domestic Price System (C&W Chapter 5, 6) R. Jongeneel

2. 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)

3. World Prize System-Analysis • Main objectives: • efficient utilization & existing resources • growth of resources • improving distribution (equity) • Trade-offs • short-run optimization • long-run optimization

4. 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

5. 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)

6. tradable Non-tradable outputs Project capital inputs labour land tradable Non-tradable Assessing Costs and Benefits

7. 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

8. 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

9. Cons. Centre project outputs Border T4+D4 Port T1+D1 T3+D3 T5+D5 Project size Production centre domestic proj. inputs T2+D2 Value of traded goods

10. Value of traded goods Price: convert world prices into local currency at official exchange rate Shadow price: SPi = (WpixOER)+(TiCFT+DiCFD) CFi = SPi/DPi

11. Non-traded goods Variable supply increase supply (price ) Fixed supply Replacement, subst. price  Valuation of non-traded goods

12. Non-traded inputs: variable supply • Shadow price: long-run marginal costs of additional supply (in world price equivalents) traded non-traded labor input input

13. Example: non-traded electricity production

14. 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)

15. Labour valuation • Possible distinctions • skilled vs. unskilled • workers in excess supply vs. workers in excess demand Problem: ill-functioning labour market, immobility of labour

16. 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)

17. Labour: workers in excess demand • Two options: 1: attract labour from other activities2: increase labour supply by training or immigration • Option 1: • Option 2:

18. Land • Comp. Land market price: equal to the expected future gain from the land purchased / rented • problem: land market subject to regulation / speculation

19. Example: land valuation cotton/sugarcane

20. 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

21. Capital: discount rate r = q . CFq or r = a1i1+a2i2

22. 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

23. 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

24. Shadow Exchange Rate

25. Shadow Exchange Rate • A more perfect approach is:

26. Example: Shadow Exchange Rate

27. 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

28. NPV and DPS-analysis • At project level NPV=F+N+LU+LS+T • At national economic levelENPV=F.CFF+N.CFN+LU.CFLU+LS.CFLS • More detail: further decompose N

29. 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)

30. Non-traded goods in DPS • Principle: value inputs in variable supply at long-run MC

31. Labour valuation at DPS • Labour: shadow wage is based on output foregone • Unskilled: • Skilled:

32. 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

33. Comparing DPS and WPS analysis DP System analysis NPV WP System nnalysis Discount rate