Implications of Economic Policy for Food Security : A Training Manual

Annex 2D : Measures of Protection

1. Introduction

One important objective of economic adjustment is the elimination of economic inefficiencies resulting from price distortions, which give inappropriate price signals to producers and consumers. Sources of price distortions are price, market, trade, fiscal and exchange rate interventions. The common expression for such distortions are 'rates of protection'. The rate of protection measures the average percentage deviation of actual prices from those that prevail without interventions.

If a price distortion is the direct result of sector- or product-specific interventions (e.g. price or market regulations, import/export taxes/subsidies), it is called 'direct protection'; 'indirect protection' arises if the price distortions are the result of macro-economic policies (e.g. exchange rate over-valuation) or of interventions in other sectors (e.g. repercussions of industrial protection on agriculture). Both effects add to 'total protection'. In the case of an overvalued exchange rate, the indirect protection rate has a negative value (signifying negative protection/taxation) which may be compounded or compensated by the effects of direct protection (taxes imply negative, subsidies positive protection rates).

Different concepts are applied to measure protection.

The simplest measurements of protection are "price gaps" measures. Amongst those, the most popular measure is the so-called "nominal protection coefficient" (NPC), defined as the percentage ratio between the domestic distorted price and the counterfactual (undistorted) price. For a "small country" the undistorted price is generally taken to be the border price adjusted for transportation and marketing costs. Both domestic and border prices are measured in a common currency by using an appropriate exchange rate. Instead of NPC the practitioners often use the equivalent definition of "nominal protection rates" (NPR) defined as NPC - 1.

The (direct) NPR is calculated using the following formula:

(X3936E160)

where

    NPR = nominal rate of protection for the good examined

    Plc = border price in units of local currency

    Pfc = border price in units of foreign currency

    r = rate of exchange in units of foreign currency per unit of local currency

In addition to NPC/NPRs, shadow exchange rates have to be computed. These exchange rates take into account (i) the distortions in all sectors of the economy that produce tradables and (ii) the distortions in the non-tradable sectors. This is necessary because the ultimate effect of protection is always two-fold: (i) it changes the combination of tradables produced moving it away from the optimal one and, (ii) it changes the combination of tradables and non-tradables.

Notwithstanding a number of complexities and conceptual ambiguities involved in computing the NPR it is the most frequently used measure of protection because of its relatively limited data requirements and its ability to capture most of the market distortion effect. As an 'ex-post' measure of price gap, the NPR has two distinct advantages: (i) it can be constructed from a direct comparison of domestic and border prices (with due correction for transportation and marketing costs), (ii) since it is constructed after the economic system has reacted to the policies at the origin of the price differential, it is also a measure of the incidence of market-price altering interventions. From the point of view of the policy maker, the NPR has the further advantage of being easy to understand and monitor.

There are other forms of measuring protection, apart from the NPR, such as the "effective rate of protection", "subsidy equivalents", or "real income gap" measures. These measures are more precise insofar as they take additional factors into account (e.g. input prices, shifts in production and demand due to the price changes), but they are also more complex and have greater data requirements. Therefore, the NPR concept is the most widely used.

Source: Scandizzo, P.L., Measures of protection: methodology, economic interpretation and policy relevance, FAO Economic and Social Development Paper 84, Rome 1989.