SOKOINE UNIVERSITY OF AGRICULTURE

FACULTY OF AGRICULTURE

DEPT: AGRICULTURAL ECONOMICS AND AGRIBUSINESS

NAME: ZUNGO, MUHIDINI SALEHE

DEGREE: MSc. AGRICULTURAL ECONOMICS

REG: HD/T/SUA/FOA/43/2011

AEA 609: 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. Stagnation of Agriculture in LDC’s.

ii. Squeeze on Agricultural incomes.

iii. 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. Also in LDCs, food subsidies create heavy drains on government budgets.

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

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) For tradables (Export)

Pb=eP$(1+t3-t2) ………...……………………………. (2) For tradables (Import)

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.

Hence, production factors are decomposed into tradables and non-tradables. In this aspect, the

equilibrium domestic prices for both factors are used.

PbNT=∑ai

NT Pid + ∑aj

T 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/Pi

b

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/Pi

b)-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/Pi

b*=(e/e*)(Pid/Pi

b)=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/Vai

b=(Pid-∑aijPj

d)/(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)/Vai

b

4.1.4. Producer and Consumer subsidy equivalents (PSE and CSE)

PSE= (Pdih+Sih-Pi

b-tih)/Pib

CSE= (Pib+Sih-Pih

d-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 P i/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/Pd

NA)/(Pib*/PNA

b) -1

Where:

Pid/Pd

NA is the relative producer price with distortions

Pib*/PNA

b 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/PNA

d-Pib/PNA

d)/ (Pib*/PNA

b*)]+[(﴾Pib/PNA

d)/ (Pib*/PNA

b*))-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/Pi

b*)*( PNAb*/PNA

d)-1=[e/e**( PNAb*/PNA

d)]-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*/[Pi

b-∑aijPjb*]

Where:

j=1,2,…K For traded inputs

j=k+1,k+2, …n are the domestic resources and non-traded intermediate

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

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.

Equilibrium price = $6Equilibrium quantity = 50Producer surplus = ($5x50)/2 = $250/2

= $125Consumer surplus = $75 ($3x50)/2 = $150/2 = $75Total gains from exchange equals consumer surplus plus producer surplus Gains from exchange = ($8x50)/2 = $400/2

= $200

S

P

T-shirts 0 50

$6

$1

D

$9

Consumer Surplus

Producer Surplus

Producer and Consumer surplus

6.2. Partial Equilibrium indicators

i. Welfare effects i.e. ΔW

ii. Government budget effect i.e. ΔB

iii. Rent effect i.e. ΔR

iv. Balance of payment i.e. ΔBOP

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.