4.5.1 The basis for comparison
4.5.2 Estimating rates of protection
4.5.3 Official and shadow rates of exchange
4.5.4 Relevant exercises
For a detailed empirical policy analysis, it is important to assess quantitatively the effect of various policy instruments used. First, the degree to which different policy instruments have been applied should be determined. For example, suppose a major policy objective is to increase farmers' incomes and that the chosen instruments for doing so are measures to raise milk prices. We now need to find out the extent to which these measures have succeeded in raising prices above what they would otherwise have been. However, to do this we need something more than a simple statistic quantifying the instruments applied, such as ad valorem rates for tariffs, subsidies and taxes, or volumes for commodities restricted by quotas. Different policy instruments should be measured in comparable terms. To do this, a common denominator or basis for comparison should be identified. This common denominator would need to contain information which could be used to determine the impact of different policies on income transfers and quantities produced, consumed and traded within the economy.
This basis for comparison should reflect the degree of price distortion caused by each instrument. It should measure the extent to which prices under present policy circumstances differ from those which would prevail in a "no policy" environment.
For traceable commodities, the basis for comparison is the border price equivalents. Thus, the yardstick used to measure the degree of distortion caused by different policy instruments is the extent to which domestic prices diverge from those prevailing in international trade.
The use of border price equivalents as a reference point for policy analysis is justified by the fact that they are the prices that would prevail on domestic markets in an open economy with a competitive free market. In an open market, traceable commodities can always be imported or exported. Domestically-produced traceable commodities should therefore be valued on the basis of what they would attract in international trade.
(Hint to instructors: You may wish to discuss border and shadow prices further at this point. Refer participants to Little and Mirrlees, 1974; Gittinger, 1982; and Timmer et al, 1983).
The advantage of using this indicator as a quantitative measure of the effects of policy is that the effects of different policy instruments, such as an import quota, an import tariff, a domestic subsidy or the operations of a domestic marketing monopoly, can be analysed and expressed in comparable terms.
The case of tradeables
The difference between the domestic price and the border price equivalent (expressed as a proportion) gives the nominal rate of protection (NPR) for a commodity. That is:
where:
NPR = nominal protection rate
DP= the domestic price for the commodity
BP = the border price equivalent for the commodity
Another formula for expressing the same concept is the nominal protection coefficient (NPC), derived as:
NPC = DP/BP
Thus,
NPC = (NPR/100) + 1
Since NPR can be either positive or negative, NPC can be above or below 1.
When calculating NPR or NPC, policy analysts should avoid using data collected only over the short term, since these may reflect short-term fluctuations caused by exceptional circumstances which may soon be reversed.
In estimating the border price equivalent, marketing margins (including transport and handling) must be taken into account in order to ensure that international and domestic prices are compared at the same point in the marketing chain.
When a policy has different implications for producer and consumer prices, two different rates of protection may need to be estimated. Similarly, if the government has interfered with the regional price structure, different rates of protection may apply to different regions of the country. The uniform pricing for milk applied across regions in Alphabeta is a case in point. Alphabeta's dairy policy also shows how different rates of protection might be applied for different seasons of the year.
The case of non-tradeables
Estimating rates of protection will only be possible when the commodity concerned is actually traded. In the livestock subsector, most commodities are traded except liquid milk, where high transport costs are prohibitive. Ideally, the domestic equilibrium price would be used as a reference point in those circumstances (i.e. the price at which domestic supply and demand are equal to one another in the absence of government intervention). The rate of protection would be estimated by comparing actual consumer and producer prices with this equilibrium price. However, due to the difficulty in estimating domestic equilibrium price, ad hoc approaches are sometimes needed to estimate the reference price.
Dried skim milk, which is traded, can be used as a proxy for liquid milk, provided the quantities are adjusted for reconstitution as liquid milk (Exercise 4.2). Using dried skim milk as a proxy is not entirely satisfactory, since fresh liquid milk may give greater satisfaction to consumers than reconstituted skim milk and so command a higher price on the domestic market. In this case, a premium should be added when calculating the NPR to allow for price differences.
Border price equivalents are based on international prices expressed in foreign currencies (often the US$). To express foreign currencies in the domestic currency, we use a rate of exchange. In developing countries, official rates of exchange often overvalue the local currency. For this reason, it may be preferable to use a shadow rate of exchange in order to reflect the real value of local currency.
Shadow rates of exchange are not necessarily the same as black market rates, since the former should represent the equilibrium rate of exchange in the absence of government intervention, while the latter represent the scarcity value of foreign exchange. If the difference between black market and official rates of exchange is small, then the black market rate can be taken as a good indicator of the shadow rate. If almost all transactions take place at the official rate but the difference between the two rates is very large, this may reflect an artificial scarcity of foreign exchange. Thus, a half-way point between the two rates should be chosen in the absence of any other indicators of what the shadow rate should be. In some countries, a standard shadow rate of exchange is applied for all national planning and policy making purposes, in which case this should be used.
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Box 4.3: The case of Alphabeta. The central case study provides examples of NPCs. The NPC for beef averages 0.95 over all grades, at the official exchange rate. Domestic producers in Alphabeta thus receive an average price 5% below the level they could expect in a free market. This could be described as an example of negative protection (or producer taxation). The NPC varies between beef grades, owing to the policy of distorted price differentials between grades. Since MMC took no measures to widen or diminish the difference between producer and consumer prices, we can assume that the NPC is the same for consumers as it is for producers. For milk, a time series of NPCs is given. In year 11, for example, the NPC at the official exchange rate was 0.66. In that year, producers received a price 34% below the border price equivalent. A similar rate of protection for the consumer can be assumed. |
Exercise 4.2: Estimating NPRs at official and shadow exchange rates.
Example: Assume our country has recently become a net importer of maize. The current producer price at the farm gate is L$ 30/t, while the current consumer (retail) price is L$ 50/t (sifted). The price for an equivalent quality c.i.f. at the border is US$ 150/t, and the official exchange rate is US$ 1 = L$ 0.30. It costs approximately L$ 5.00/t to store maize and transport it between the border and the wholesale market, and an additional L$ 3.00 to sift the grain, package it and transport it to retail outlets. Transport from the farm gate to the wholesaler averages L$ 4.00/t. Market processing, handling and transport facilities are competitive, with no monopoly element, but the official exchange rate is 30% overvalued. Given this information, producer border price equivalents and NPRs can be estimated as follows:
|
Maize import price c.i.f. (US$/t) |
150.00 |
|
x official exchange rate (US$ 1.00 = L$ 0.30) |
|
|
= import price equivalent (L$/t) |
45.00 |
|
+ transport/storage costs to wholesaler (L$/t) |
5.00 |
|
= local wholesale border price equivalent (L$/t) |
50.00 |
|
- transport costs, farm gate to wholesaler (L$/t) |
4.00 |
|
= border-equivalent farm-gate price at official exchange rate (L$/t) |
46.00 |
|
+ adjustment for currency overvaluation3 |
13.50 |
|
= border-equivalent farm-gate price at shadow exchange rate |
59.50 |
3 The adjustment for currency overvaluation is calculated as: border price in US$ x (shadow exchange rate - official exchange rate), where exchange rate is stated as amount of local currency per US$.
Thus, the NPC for producers at the official exchange rate is 0.65, while at the shadow rate it is 0.50. At the official rate, the NPR at the farm gate is -35%. That is, farmers are implicitly being taxed at a rate of 35% for growing and selling maize. The NPR for producers at the shadow rate of exchange is even more negative at -50%.
Border price equivalents and NPRs for the consumer are calculated as follows:
|
Maize import price c.i.f. (US$/t) |
150.00 |
|
x official exchange rate (US$ 1.00 = L$ 0.30) |
|
|
= import price equivalent (L$/t) |
45.00 |
|
+ transport/storage costs to wholesaler (L$/t) |
5.00 |
|
= local wholesale border price equivalent (L$/t) |
50.00 |
|
+ processing/transport costs to retailer (L$/t) |
3.00 |
|
= border-equivalent consumer price at official exchange rate (L$/t) |
53.00 |
|
+ adjustment for currency overvaluation |
13.50 |
|
= border-equivalent consumer price at shadow exchange rate |
66.50 |
Thus, the NPC for consumers at the official exchange rate is 0.94; at the shadow rate it is 0.75. At the official rate, consumers are paying 6% less than the border price equivalent; at the shadow rate they are paying 25% less.
Exercise: (estimated time required: 3 hours).
Question 1. Refer to Question 2 of Exercise 3.8, Table 3.11 and the graphs derived for beef production and consumption. The country is a net exporter of beef, as shown by the net traceable surplus calculations. Calculate the border-equivalent consumer and producer prices and NPRs for beef, given the following information:· The 1986 farm gate price CDW for FAQ beef is L$ 340/t.· The 1986 retail price for cut beef CDW is L$ 350/t.
· The f.o.b. border price for CDW cut beef is US$ 1500/t and handling costs to the border from the wholesaler are L$ 6.30/t.
· It costs L$ 6.00/t to transport and market beef from the wholesaler to the retailer in cut form. Transport from the farm gate to the wholesaler costs L$ 9.00/t and processing to cut beef costs L$ 32.00/t. The value of by-products retrieved during processing (hides, blood, bone etc) is L$ 56.00/t.
· Exchange rates are the same as in the example given above, and marketing and transport activities are competitive, with no monopoly elements.
Enter your calculations into Tables 4.1 and 4.2 and comment on the results.
Question 2. Refer to Question 2 of Exercise 3.8, Table 3.11 and the graphs derived in the exercise for whole milk. The country is a net importer of whole milk, as indicated by the net traceable surplus figures. Calculate the border-equivalent consumer and producer prices and NPRs for milk, given the following information:
· The 1986 international price c.i.f. at port of entry for powdered whole milk is US$ 800/t (13.5 kg of whole milk powder with added water is reconstituted to form 100 litres of liquid whole milk).· The 1986 farm-gate price of whole milk is L$ 50.00/t and the consumer price (processed, in carton or bottled form) is L$ 60.00/t.
· It costs L$ 4.00/t of liquid milk equivalent to transport powder from the border to the wholesale point, and another L$ 8.00/t of liquid milk equivalent to reconstitute powder to liquid form.
· It costs L$ 7.00/t to transport whole milk from the farm gate to the wholesale point.
· Processing of whole milk to bottled or carton form plus wholesale to retail marketing costs are L$ 2.00/t.
Given the same exchange rates, and assuming that marketing functions are competitive, complete Tables 4.1 and 4.2 for whole milk and comment on the results.
Table 4.1. Border equivalent producer prices and NPRs for beef and whole milk.
|
Situation |
Net exporter |
Net importer | |
|
Operator (+, -, x) |
|
| |
|
Export situation (beef) |
|
| |
|
Export price f.o.b. (US$/t CDW) |
|
n.a | |
|
Official exchange rate (US$ 1 = L$ 0.30) |
|
n.a | |
|
Export price f.o.b. (L$ equivalent/t CDW) |
|
n.a | |
|
Handling costs, border to wholesale (L$/t) |
|
n.a | |
|
Processing and transport, farm gate to wholesale (L$/t) |
|
n.a | |
|
By-products from processing (L$/t) |
|
n.a | |
|
Border equivalent farm-gate price/t CDW equivalent (official exchange rate) |
|
n.a | |
|
Effect of currency overvaluation |
|
n.a | |
|
Border equivalent farm-gate price/t CDW equivalent (shadow exchange rate) |
|
n.a | |
|
|
i) Nominal protection coefficient (official exchange rate) |
|
n.a |
|
|
ii) Nominal protection coefficient (shadow exchange rate) |
|
n.a |
|
Import situation (whole milk) |
|
| |
|
Import price c.i.f (US$/t whole milk equivalent) |
n.a. |
| |
|
Official exchange rate (US$ 1 = L$ 0.30) |
n.a. |
| |
|
Import price (L$/t whole milk equivalent) |
n.a. |
| |
|
Transport costs, border to wholesale (L$/t) |
n.a |
| |
|
Costs of reconstitution (L$/t) |
n.a. |
| |
|
Transport costs farm gate to wholesale (L$/t) |
n.a. |
| |
|
Border equivalent farm-gate price/t (official exchange rate) |
n.a |
| |
|
Effect of currency overvaluation |
n.a |
| |
|
Border equivalent farm-gate price/t (shadow exchange rate) |
n.a |
| |
|
|
i) Nominal protection coefficient (official exchange rate) |
n.a. |
|
|
|
ii) Nominal protection coefficient (shadow exchange rate) |
n.a. |
|
n.a. = not applicable
Table 4.2. Border-equivalent consumer prices and NPRs for beef and whole milk
|
Operator - Situation |
Net exporter |
Net importer |
|
Exporter |
(Beef) |
(Milk) |
|
Export situation (beef) |
|
|
|
Export price f.o.b (US$/t CDW, cut form |
|
n.a. |
|
Official exchange rate (US$ 1 = L$ 0.30) |
|
n.a. |
|
Export price f.o.b (L$ equivalents CDW) |
|
n.a. |
|
Handling costs, border to wholesale (L$/t) |
|
n.a. |
|
Transport and marketing cost, wholesale to retail, (L$/t) |
|
n.a. |
|
Border equivalent consumer price/t CDW equivalent (official exchange rate) |
|
n.a. |
|
Effect of currency overvaluation |
|
n.a. |
|
Border equivalent consumer price/t CDW (shadow exchange rate) |
|
n.a. |
|
i) Nominal protection coefficient (official exchange rate) |
|
n.a. |
|
ii) Nominal protection coefficient (shadow exchange rate) |
|
n.a. |
|
Import situation (whole milk) |
|
|
|
Import price c.i.f. (US$/t whole milk equivalent |
n.a. |
|
|
Official exchange rate (US$ 1 = L$ 0.30) |
n.a. |
|
|
Import price c.i.f (LS$/t whole milk equivalent) |
n.a. |
|
|
Transport and storage costs to wholesale (LS$/t) |
n.a. |
|
|
Cost of reconstitution (L$/t) |
n.a. |
|
|
Transport and processing costs to retail (L$/t) |
n.a. |
|
|
Border equivalent consumer retail price/t (official exchange rate) |
n.a. |
|
|
Effect of currency overvaluation |
n.a. |
|
|
Border equivalent consumer retail price/t (shadow exchange rate) |
n.a. |
|
|
i) Nominal protection coefficient (official exchange rate) |
n.a. |
|
|
ii) Nominal protection coefficient (shadow exchange rate) |
n.a. |
|
n.a. = not applicable.
|
Important points (4.5) · For detailed policy analysis, it is essential to assess quantitatively the effect of various policy instruments. To compare various policy instruments, a common denominator is required. · For any tradeable commodity, the border price equivalent is used as a common denominator. · The difference between border price equivalent and the domestic price is taken as the yardstick to measure the effects of different policy instruments in terms of price distortions. · The divergence of domestic prices from the border price equivalent is generally expressed in terms of nominal rate of protection (NPR) for a commodity or normal protection coefficient (NPC). Their values are calculated as: NPR = {(DP - BP)/BP} X 100 NPC = DP/BP = (NPR/100) + 1 where DP = the domestic price for the commodity BP = the border price equivalent for the commodity · Since policies may have different implications for producer and consumer prices; two different rates of protection may need to be estimated. · For non-tradeable commodities, the domestic equilibrium price is used as a reference, point. Sometimes ad hoc approaches are more appropriate. · Shadow rates of exchange express the real value of a local currency. |
