4.6.1 Estimating price elasticity
4.6.2 Effects on quantity
4.6.3 Effects on producer income and consumer surplus
4.6.4 Effects on budget and net welfare
4.6.5 Limitations of the analysis
4.6.6 Relevant exercises
To complete our analysis of current market price and trade policies, we need to measure their effects on consumer and producer welfare as well as on the amounts of a commodity produced, consumed and traded. To do this, information on price elasticity must be incorporated.
The concept of price elasticity expresses the responsiveness of demand and supply to price changes. In this section, we discuss the problem of how to estimate elasticity, outlining a few of the factors known to influence it.
Elasticity must be estimated empirically, and there is often controversy about the estimates used. In addition, econometric analysis tends to be cumbersome and time consuming. As a result, policy analysts often have to rely on their best guesses, based on whatever estimates are available for other similar commodities or countries. In Africa, elasticity estimates are rarely available, and there is a dearth of reliable data from which to calculate them.
Price elasticities of demand and supply vary significantly between commodities. As a rule, they tend to increase as the degree of substitutability between commodities increases. For example, elasticities of demand and supply for individual grades of beef will tend to be higher than for beef as a whole. This is because consumers are more likely to switch between different grades of beef than to switch from beef to some other meat. Likewise, producers will find it easier to adjust the kind of beef they produce than to move out of beef altogether. The availability of the inputs or technology required to increase production is an important determinant of the price elasticity of supply. For example, livestock production based on the use of purchased feed is likely to be more flexible than production based on rangeland feed resources.
In terms of supply, an important consideration is the time horizon used to estimate probable response. The short-term elasticity of supply tends to be considerably less than the long-term. This is particularly true for livestock production, where short-term market supply responses may even be negative (Table 3.9).
The quantity effects of policies can be calculated by multiplying the NPR for a commodity by its elasticity:
% change in quantity = elasticity x NPR (%)
where NPR is also the percentage change in price caused by the current policy measure. This formula holds for both supply and demand.
Having estimated the effects of a policy instrument on domestic supply and demand, it is relatively simple to calculate its probable international net trade effect. This is simply the difference in the surplus available for export (or deficit requiring to be imported) resulting from the change in domestic production and consumption. The effect on the balance of payments can easily be calculated by multiplying the net trade effect by the border price. Exercise 4.3 gives examples of how these effects are calculated.
The aggregate effect of a price change on the income of producers can also be estimated. It will be brought about by a combination of changes in price and changes in the amount produced. This can best be understood by looking at the area between the two price lines (P1 and P2) and the supply curve shown in Figure 4.4.
Conceptually, the overall income change can be broken down to small incremental changes. Each small change in income consists of a separate price multiplied by its respective volume of production.
If the calculation of these income effects were limited to the effects on producers' income, then rises in commodity prices would usually seem desirable because they would lead to rises in producers' income. Similarly, price falls would usually seem undesirable because they lead to falls in producers' income.
In reality, the effects of commodity price changes on consumers need to be taken into account to offset them against the effects on producers. Effective policies often depend on striking a fair balance between the interests of the consumer and those of the producer.
The concept of consumer surplus enables us to quantify the effects of price changes on consumer welfare. Consumer surplus is defined in terms of the amount consumers would have been prepared to pay for a commodity in excess of what they actually paid. Suppose you would have been prepared to pay $ 0.75 for an egg but only had to pay $ 0.50 for it. Your consumer surplus is $ 0.25. Figure 4.5 helps us understand the concept of consumer surplus. The change in consumer surplus is represented by the area between the two price lines and the demand curve. Again, this can be calculated in terms of the effect of incremental price changes on the quantity consumed. Each small change multiplied by its respective consumption level gives the resulting change in consumer surplus.
Figure 4.4. Change in producers' income resulting from a price change.
Figure 4.5. Change in consumer surplus resulting from a price change.
In algebraic terms, changes in producer income and consumer welfare can be roughly estimated by multiplying the absolute difference between any two prices (P1 and P2) by the average of the quantities produced (S1 and S2) or consumed (D1 and D2) at these prices. That is:
Effect on producers' income = (P2 - P1) x (S1 + S2)/2Effect on consumers' surplus = (P2 - P1) x (D1 + D2)/2
where the symbols have the same meaning as in Figures 4.4 and 4.5.
We are also interested in the impact of policy on a government's budget and on net economic welfare. The budget effect, assuming that all differences between domestic and border equivalent price arise from taxes, subsidies or the profits and losses of government corporations, is best calculated as follows:
Budget effect = (DPP-BPP) x S - (DCP-BCP) x D
where
DPP = domestic producer price
BPP = border producer price
DCP = domestic consumer price
BCP = border consumer price
S and D = supply and demand.
If the resulting number is positive, the policy instrument results in net government expenditure. If it is negative, there is a net income to the government. In cases where quantitative restrictions (in contrast to tariffs) allow those with import licenses to capture all or part of the difference between border equivalent and domestic prices as excess profits which do not accrue to the government (section 4.4.1), the calculation must be adjusted accordingly.
The net welfare effect of a policy is the sum of the effects on producers, consumers and the government budget. Figure 4.6 demonstrates how the net welfare effect of an export tax can be derived.
Before the imposition of an export tax, the domestic price is equal to the border price equivalent at P1. At that price, domestic consumer demand Q1 and the balance of production (Q4 - Q1) is exported.
The government now imposes an export tax (P1 - P2). After the tax, the producer receives only P2, which becomes also the domestic price. At that price, producers decrease their supply to Q3 and consumers increase their demand to Q2. The balance (Q3 - Q2) is still exported.
The welfare effects are as follows. The fall in the after-tax price reduces producers' incomes by the area AEFH. This income loss is partially offset by gains made by consumers and by government. Consumers gain a surplus represented by ABGH. The government gains revenue represented by CDFG. The net welfare effect is an uncompensated loss represented by the two triangles BCG and DEF. This is the cost of the government's intervention.
Because they distort domestic resource use away from the economic optimum, interventions of this kind usually have a negative effect on net economic welfare. The price decrease resulting from the tax has reduced domestic production below what could have been competitively produced at the international price. At the same time, consumers benefitting from lower prices have been led to believe that the commodity is less scarce than it actually is. In other words, when policies disrupt market forces, prices no longer convey the appropriate signals to producers and consumers.
Figure 4.6. Net welfare effect of an export tax.
Sometimes, there may be sound reasons for government interference with free market forces, and some of these reasons are discussed in the next section. In such cases, the benefits of intervention should always be set against the overall welfare losses which result. These would be measured in the way just described. Moreover, we need to remember that net economic welfare may not be a complete indicator of all the welfare aspects of change within society. This is because our definition weighs all incomes in the economy equally (i.e. regardless of income distribution). If, however, consumers in the export tax example given above are poorer than producers, the government may want to give their gains more weight (per nominal $) than the producers' losses.
The analysis of policy effects, as presented, has a number of limitations. For example, the analysis is partial in the sense that it is applied to individual commodities, without taking into account the linkages which might exist between different commodities. In reality, however, such linkages may be very important to both production and consumption. While these limitations can be overcome, the methods adopted will not be discussed here.
Exercise 4.3: The effect of price and exchange rate policies at consumer, producer and national levels.
Example 1. National effects of price policy. The effects of price and exchange rate policies on maize production and consumption, foreign exchange and foreign trade are summarised in Table 4.3. Relevant data from Exercise 4.2 are given and the price elasticities of demand and supply, and 1986 national consumption and production levels are also stated. From these data, the following policy effects can be calculated for maize priced at the shadow rate of exchange:
· Production: At the official exchange rate, the NPC for the farm-gate price is 0.65, showing that producers are paid 35% below the border price equivalent. Given a supply, elasticity of 0.3, this means that the existing price policy lowers production by 10.5% (i.e. 0.3 x 35.0). Aggregate maize production is thus reduced by 115,500 t (1.10 million t x 0.105).· Consumption: Consumers, on the other hand, pay 6% lesthan the border price equivalent at the official exchange rate. At a price elasticity of demand of -0.1, this price depression has increased maize consumption by 7500 t.
· Foreign trade: The net foreign trade effect of this price policy is simply the increase in consumption and the decrease in production, i.e. 7500 + 115,500 = 123,000 t of maize which, in the absence of current policies, would not have had to be imported.
· Foreign exchange: These additional imports, valued at the current US$ price/t c.i.f (i.e. US$ 150), result in an extra foreign exchange expenditure of US$ 150 x 123,000 t = US$ 18.45 million.
Table 4.3. The effects of government policy on consumption, production, foreign trade and foreign exchange earnings of maize, beef and milk.
|
|
Item |
Unit |
Maize |
Beef |
Whole milk |
|
|
i) Data: |
Producer price |
L$/t |
30.00 |
|
|
|
|
Retail price |
L$/t |
50.00 |
|
|
||
|
Import price |
L$/t |
45.00 |
|
|
||
|
Export price |
L$/t |
- |
|
|
||
|
Protection coeff. Production |
(Official exch. rate) |
0.65 |
|
|
||
|
Protection coeff. Consumption |
(Official exch. rate) |
0.94 |
|
|
||
|
Level of national production |
'000 t |
1100.00 |
152 |
580 |
||
|
Level of national consumption |
'000 t |
1250.00 |
115 |
680 |
||
|
ii) Assumptions: |
Price elasticity of supply |
(%) |
+0.30 |
+0.50 |
+0.60 |
|
|
Price elasticity of demand |
(%) |
-0.10 |
-1.20 |
-1.20 |
||
|
iii) Calculated results: |
|
|
|
|
|
|
|
Policy effects on: |
|
|
|
|
||
|
|
- production |
'000 t |
- 115.5 |
|
|
|
|
|
(%) |
(-10.5) |
|
|
||
|
|
- consumption |
'000 t |
+7.50 |
|
|
|
|
|
(%) |
(+0.60) |
|
|
||
|
|
- foreign trade |
|
123.00 |
|
|
|
|
|
(%) |
|
|
|
||
|
|
-foreign exchange1 |
US$ million |
+18.45 |
|
|
|
1 Refers to savings or losses in foreign exchange as a result of policies adopted, i.e. foreign trade effect multiplied by border price policies.
Example 2. Farm-level effects of price policy. Table 4.4 presents data on changes in the maize gross margin per ha and per person-day for maize produced by the agropastoral farm used in module 3. The border price equivalent for maize at the official rate of exchange is taken from the example in Exercise 4.2. At the official exchange rate, the border price equivalent farm-gate price is L$ 0.046/kg, compared with the current producer price of L$ 0.03/kg. At the shadow exchange rate, it is L$ 0.060. Gross margins per ha and per person-day are, thus, considerably higher at the shadow foreign exchange rate.
Exercise: (estimated time required: 3 hours).
Question 1. Using data from Exercise 4.2, complete Table 4.3 for beef and whole milk, using the border price equivalent at the official exchange rate.Question 2. Using data from Exercises 3.1-3.2 and 4.2, complete Tables 4.4 and 4.5. Note that for hybrid maize seed, the price per unit used should remain unchanged. Ignore the cost of manure in Table 3.3.
Question 3. For both sets of tables, comment briefly on the results.
Question 4. Discuss in qualitative terms how the results change when the border price equivalent at the shadow exchange rate is applied. If time is available, compute the pure effect of currency overvaluation for beef.
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Important points (4.6) · The concept of elasticity expresses the responsiveness of supply and demand to changes in commodity prices. · Price elasticities of demand and supply vary significantly between commodities. Elasticity increases with substitutability of commodities, · The effect of a policy on the quantity of a commodity is calculated by multiplying nominal protection, rate by its elasticity. · The net trade effect of a policy is expressed in terms of gross exports minus gross imports. · The effect of price changes on producer income is computed by multiplying the change in price by the change in quantity produced. · The concept of consumers' surplus shows how price changes affect consumers. · The effect of policies on the government budget is best calculated as: Budget effect = {(domestic producer price - border producer price) x supply}-{(domestic consumer price - border consumer price) x demand} · The net welfare effect of a policy is the sum of effects on producers, consumers and the government budget. · Government interference in prices usually results in a net welfare loss. |
