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SOKOINE UNIVERSITY OF AGRICULTURE

FACULTY OF AGRICULTURE DEPT: NAME: DEGREE: REG: AEA 609: AGRICULTURAL ECONOMICS AND AGRIBUSINESS ZUNGO, MUHIDINI SALEHE MSc. AGRICULTURAL ECONOMICS HD/T/SUA/FOA/43/2011 AGRICULTURAL PRICE ANALYSIS

INDIVIDUAL ASSIGMENT-1 THEME: A REVIEW OF PRICE DISTORTIONS

INSTRUCTOR: Prof: E. MBIHA

PRICE DISTORTIONS 1.0 MEANING OF PRICE DISTORTIONS Price distortions can be defined as the situation whereby prices of commodities deviate from the equilibrium/ruling prices due to several disturbances of the market systems such as government interventions in economic activities. 2.0 PRICE DISTORTIONS IN AGRICULTURE Price distortions in Agriculture have the following implications: i. ii. iii. Stagnation of Agriculture in LDCs. Squeeze on Agricultural incomes. Exhaustion of government budgets in MDCs. For example, favoring farmers through provision of subsidies as a result it leads to heavy taxation on consumers. iv. N: B:In dealing with price distortions, the first and foremost thing is to identify the magnitude of distortion(s). This is done by setting an array of Indicators through the use of Partial Equilibrium Analysis (PEA) framework. 3.0 REFERENCE PRICES These are the benchmark prices (mainly border prices) in which domestic prices are compared with. Examples of sources of price distortions are: Export taxes Import tariffs Producer and Consumer subsidies Taxes and subsidies to factors Over-valuation of exchange rate Trade policy interventions to internalize environmental externalities Also in LDCs, food subsidies create heavy drains on government budgets.

Trade quotas

Reference prices are categorized into: A. Reference prices for tradables B. Reference prices for non-tradables 3.1 REFERENCE PRICE FOR TRADABLES Pb=eP$ Where: e=Official exchange rate Pb= Reference/ border price for tradables. P$= World market price in dollars/ any other foreign currencies. 3.1.1 Important considerations in estimating border price for tradables 1. Exchange rate to be used In this case, either official or equilibrium exchange rate can be used. However, this depends on the purpose of estimating border price. This is due to the fact that official exchange rate in many cases is over-valued. Therefore estimation of border price using official exchange rate will underestimate the border price. 2. Foreign price to be used Selection of foreign exchange also should be done carefully. For example, if you select to use a foreign exchange of the country whereby its economy is not stable, obvious the results that you are likely to get are misleading. Indeed, in order to make appropriate selection of the foreign exchange to be used, a thorough understanding on other international prices of the commodity of interest is required. 3. At which geographical point to measure border price

For example, you may be in need of comparing farm-gate price with the border price. In this case, border price should also be calculated at the level of farm-gate price. Hence; Farm-gate border price for products sold by the farm is thus: Pb=eP$(1-t1) (1) Pb=eP$(1+t3-t2) .... (2) Where: t1 =between harbor and farm t2=between city and farm t3=between harbor and city Indeed, there are other expenses/costs that are involved in between such as processing, quality changes, transport loses, storage costs and seasonality effects. Therefore, for this matter, the border price must be adjusted for these marketing and processing costs. Pb=eP$(1-t1- V) ..for exports Pb=eP$(1+t3-t2-V) .for imports 3.2 FOR NON-TRADABLES For non-tradables, the market clearing price is used as the border price (PbNT). In addition, in this case no government intervention is required. Market clearing price(s) can be predicted /forecasted using the existing system of models for demand and supply of the product of interest. Also, it should be noted that these market clearing prices are valid if and only if the distortions have already been removed. If you opt to use the market clearing prices estimated using the models for demand and supply; then Input-Output coefficient(s) should be used. For tradables (Export) For tradables (Import)

Hence, production factors are decomposed into tradables and non-tradables. In this aspect, the equilibrium domestic prices for both factors are used. PbNT=aiNT Pid + ajT Pjb: The non-tradable component can further be decomposed in the sense that it is true that it is made up of tradable and non-tradable factors. This can further be done until you get the costs for primary factors in which its undistorted shadow price can be calculated/estimated. 4.0 INDICATORS OF PRICE DISTORTIONS 4.1. INDICATORS OF PROTECTION AND INCENTIVES 4.1.1. Nominal and real protection The Nominal Protection Coefficient (NPC) NPCi=Pid/Pib Interpretation of NPCi If NPCi>1; Producers are protected and consumers are taxed. If NPCi<1; Consumers are protected i.e. subsidized while producers are taxed. If NPCi=1; No distortions, i.e. the system is neutral to distortions. Also Nominal Rate of Protection (NRPi) = (Pid/Pib)-1 Interpretation of NRPi If NRPi>0; Producers are protected while consumers are taxed. If NRPi<0; consumers are subsidized while producers are taxed. If NRPi=0; No distortions or the system is neutral to distortions. N:B:NRPi can change from NRPi<0 to NRPi>0.

An increase in NRPi implies increasing in protection for producers and decreasing in NRPi implies decreasing protection for producers. If the official exchange rate is not at equilibrium, the border price against which the domestic price is compared should be adjusted so as to remove this additional distortion. If equilibrium exchange rate is likely to be used in calculating border price, then NPC becomes Real Protection Coefficient (RPC) and NRP becomes Real Rate of Protection (RRP).

Important note: MEASURING THE DEGREE OF EXCHANGE RATE DISTORTIONS; EDist=e/e* RPCi=Pid/Pib*=(e/e*)(Pid/Pib)=EDist.NPCi(a) In equation (a) above, NPCi measures direct distortions which are product specific while e/e* (EDist) measures the indirect distortions which are economy wide. 4.1.2. Effective and Real Effective Protection Price distortions affect both inputs and products (consumer products).Therefore, if producers are not protected in their products, hence this disprotection is usually neutralized or reduced by partial subsidization of some inputs such as fertilizers and fuels and of credit. Hence, it is very crucial to capture the net effect of these distortions. This is done by calculating at the farm level the Effective Protection Coefficient (EPC). Indeed, this is at farm level stand-point. In order to estimate EPC, first you are required to categorize inputs as follows: a) Traded Intermediate factors (T) such as fertilizers, chemicals and fuels. b) Primary factors such as land, labours and fixed capital such as Machinery and buildings. c) Non-traded Intermediate factors (NT): Services such as Insurance and transportation and other factors for which the international market fails. Estimation: Nominal Effective Protection Coefficient is given by:

NEPCi = Vaid/Vaib=(Pid-aijPjd)/(Pib-aijPj) Interpretation of NPECi: If NEPCi>1; domestic producers of product I are protected. If NEPCi<1; domestic producers of product I are disprotected. If NEPCi=1; the structure of prices is neutral on incentives. However, calculation for NEPC requires the knowledge on the status of technology used in production. Important note in calculating NEPC: a) Value added should be calculated as the return to primary factors. i. Using Simple corden Method.

Va=P-Unit cost of traded intermediate inputs directly used in production. In this case, value added is the return to primary factors and non-traded intermediates. ii. Using Simple Balassa Method

Va=P-Unit cost of traded intermediate inputs- Unit cost of non-traded intermediate inputs. In this formula, value added is the return to primary factors directly used in the production activity. However, this underestimates the true value added by the cost of the primary factors used in the production of intermediate factors. iii. Using sophisticated Corden Method

Va= P-Unit cost of direct traded inputs- Unit cost of traded component of non-traded intermediate inputs. This measures the actual return to primary factors i.e. both directly and indirectly used primary factors in the production of the output. b) Production technology This implies that production technology is independent of price distortions i.e. there is no substitution between traded and non-traded inputs due to price distortions.

c) Factor subsidies tend to be highly socially discriminatory. Therefore, it is difficult to generalize the EPCs to all farmers/producers. d) If official exchange rate is differs from equilibrium exchange rate, the indirect price distortions due to exchange rate should also be taken into account. 4.1.3. Effective Subsidy Coefficient (ESC) This corrects the effective protection coefficient. ESCih=Vaid (Differential subsidies on primary factors per unit of product i)/Vaib 4.1.4. Producer and Consumer subsidy equivalents (PSE and CSE) PSE= (Pdih+Sih-Pib-tih)/Pib CSE= (Pib+Sih-Pihd-tih)/Pib Where: Sih and tih are subsidy and tax respectively in both cases above. 4.1.5. Direct, Indirect and Total nominal protection rates Instead of using product prices Pi, a better indicator of incentive is given by terms of trade Pi/PNA for that product, where PNA is a price Index of non-agricultural goods. Real rate of protection (RRP) is given as follows: RRPi=(Pd/Pb*)-1; but using terms of trade it becomes: RRRPi= (Pid/PdNA)/(Pib*/PNAb) -1 Where: Pid/PdNA is the relative producer price with distortions Pib*/PNAb is the relative border price measures at the equilibrium exchange rate e* and without trade distortions. This can be re-written as follows: RRRPi = [ Pid/PNAd-Pib/PNAd)/ (Pib*/PNAb*)]+[(Pib/PNAd)/ (Pib*/PNAb*))-1]

In the above decomposition, the first term is a function of trade policies on product I and thus measures the direct price interventions. The second term can be re-written as: (Pib/Pib*)*( PNAb*/PNAd)-1=[e/e**( PNAb*/PNAd)]-1 5.0. INDICATORS OF COMPETITIVE ADVANTAGE Domestic Resource Cost (DRC) is the ratio of the domestic Resources and non-traded inputs (Valued at their shadow prices) of producing the commodity domestically to the net foreign exchange earned or saved by producing the good domestically. DRCi=aijPj*/[Pib-aijPjb*] Where: j=1,2,K j=k+1,k+2, n inputs. Pib Is the border price of the traded output i measured at shadow exchange rate. Pjb Is the border price of the traded input j , also measured at the shadow exchange rate. Interpretation for DRCi is required. N: B:This measure is important in deciding which commodities should be produced domestically and what should not. However, it has some drawbacks such as its static nature and the like. 6.0. PARTIAL EQUILIBRIUM ANALYSIS (PEA) OF PRICE DISTORTIONS This traces out the efficiency, welfare, government budget, and the balance of payment of trade implications of the price distortions. This provides a snap-shot of the total effects even though it is not always acceptable. PEA is typically a static tool in the sense that it does not take into account the dynamism/dynamic nature of other sectors/ markets in the economy. In addition, it only For traded inputs are the domestic resources and non-traded intermediate

emphasizes the on static negative effects of distortions and ignore the positive side of the distortions. For example, trade taxes by the government can be used for delivery of public goods and hence improving the welfare of the societies. 6.1. The concept of consumer and producer surplus. According to Carrie, Murphy and Schmitz (1971) as cited by Sadoulet and Janvry (1995), consumer surplus is the excess of the price the consumer would be willing to pay for each unit consumed over the price which is actually paid. Producer surplus: The net gains to producers of a product, equal to the total revenue minus the sum of marginal (variable) costs. Consider the illustration below showing consumer and producer surplus.

6.2. Partial Equilibrium indicators i. ii. iii. iv. Welfare effects i.e. W Government budget effect i.e. B Rent effect i.e. R Balance of payment i.e. BOP

CONCLUSION In summary, price distortions have both advantages and disadvantages to the economy of a country. Indeed, the analysis of price distortions is very crucial in the sense that it enables us to identify weaknesses in the operation of the markets and sectors in the economy. Hence, understanding of price distortions in the sector/markets provides useful information to the policy makers on the effects of policies implemented and even the need for the copying strategies to be implemented.