AAMP Training Materials Module 4.2: Import & Export Parity Pricing Steven Haggblade (MSU) blade@msu.edu This is the second section of the Trade Module which is part of the AAMP Training Materials Exercises for this module are found in AAMP Module 4.2 – Import and Export Parity Pricing.xls

Module Contents Objectives Background material Exercises Conclusions

Objectives Understand border prices’ ability to moderate food price fluctuations Import parity price (IPP) Export parity price (EPP) Be able to compute border prices Examine policies that undermine the moderating effects of IPP and EPP

Background Material Discuss domestic price under two scenarios Scenario 1: Drought reduces maize supply below normal Scenario 2: Bumper harvest expands maize supply above normal Examine the impact of these two scenarios with and without open borders

Domestic Price D S0 Price $ / ton Quantity 300 200 100 Assume we’re talking about the maize market in a Southern African country and that the domestic price in an average year is $200 / ton. This graph represents the country’s market-clearing scenario.

Scenario 1: Drought D S0 Price $ / ton Quantity S1 300 200 100 In a drought year, weather shocks disrupt the harvest and dramatically reduce the total output of maize in the country. Supply drops from S0 to S1.

Drought + Closed Borders Price $ / ton Quantity 300 200 100 S1 If the supply of maize is disrupted by drought, prices will inevitably rise. If the country does not allow imports of maize, the price rise will be dramatic. In this case, prices rise from $200 to $300 in response to the supply shift from S0 to S1.

Drought + Open Borders D S0 Price $ / ton Quantity S1 300 Pm 200 100 However, if the country does allow trade, the price rise will be less disruptive. Because of the drought, the price of maize in our example country is higher than in neighboring countries. With open borders, importation of maize at a lower price will allow more consumers to purchase it. End of scenario 1.

Domestic Price D S0 Price $ / ton Quantity 300 200 100 In this scenario, we begin with the same Southern African country.

Scenario 2: Bumper Harvest D S0 Price $ / ton Quantity 300 200 100 S2 This time, there is a bumper harvest. Growing conditions are excellent, and rather than producing S0, farmers in the country produce S2.

Bumper Harvest + Closed Border Price $ / ton Quantity 300 200 100 S2 This outward shift in supply drops price from $200 to just $100 / ton if the country does not permit exports. Closed borders are potentially a big problem for farmers. For many, $100 / ton is not enough to recoup their costs of production.

Bumper Harvest + Open Border Price $ / ton Quantity 300 200 100 S2 Pe Opening borders helps minimize the damage of an abnormal supply shift to maize producers. If traders export maize to the world market, the price of maize to the farmers rises (from $100 to Pe).

Border Prices Reduce Price Volatility $ / ton Quantity 300 200 100 S2 S1 Pm Pe These two scenarios illustrate how trade can reduce the volatility of maize prices. If prices are abnormally high in the country, opening the border can bring them down. Pm (called the import parity price, or IPP) sets an upper limit on domestic prices. If prices are abnormally low, opening the border can bring them back up. Pe (also called the export parity price, or EPP) sets a floor below which nobody will sell, given the alternative of exporting at Pe.

Discussion Questions When will IPP influence domestic price? When will EPP influence domestic price? When borders are open and traders and millers can import freely, IPP will set the maximum domestic price. No one can charge a price higher that IPP, because if they tried, then a competing trader could import and sell at IPP. Conversely, EPP will determine the minimum domestic price. Nobody would sell at a lower price, given the alternative of exporting at EPP. Crucially, however, IPP and EPP have no effect on domestic price if the commodity is not freely traded.

South Africa domestic and border prices for white maize, 1992 - 2006 Source: Lulama Traub (2008). SAFEX = South Africa Futures Exchange Since maize market liberalization, in 1996, South Africa’s domestic price is bounded by IPP on the top, and EPP on the bottom. However, for much of 1992-93, before the ANC government liberalized trade and domestic maize markets, the domestic price in South Africa exceeded IPP.

Zambia, domestic & border prices for white maize, 2000 - 2006 Drought Source: Dorosh, Dradri and Haggblade 2009. Government has a long history of involvement in the maize market in Zambia; setting pan-territorial prices, providing inputs, and nationalizing all large mills are some examples. Finally, in the early 1990’s, heavy subsidies proved unsustainable and the National Agricultural Marketing Board (NAMBOARD) was dismantled. Nevertheless, the Zambian government continued to play an active role in the maize market, influencing imports and exports to a great extent. As a result, domestic maize prices have exceeded IPP several times from 1994 – 2005. The two most notable price spikes illustrated above (highlighted in red) are a result of policy decisions following a severe drought. Government announced its intention to import 200,000 tons of maize and sell it at subsidized prices. However, a delay of several months meant the maize price skyrocketed, and upon arrival, was inadequate to keep prices down (only 130,000 tons arrived). Further exacerbating the problem, the imported grain was sold at below market price which kept private traders from importing. Inconsistent or confusing policies can severely restrict trade flows, having a direct, negative impact on consumers and producers alike. Opening the borders to trade should have limited the maize price spikes above to IPP.

Saudi Arabia, domestic and border prices for wheat, 1980 - 2008 Here’s an extreme example of what can happen when governments want to protect inefficient farmers by paying high domestic production costs. Saudi Arabia has famously used desalinized water and imported inputs to ensure domestic food security by producing their own wheat, even at astonishingly high cost. As oil prices declined, they abandoned this expensive practice, beginning in the mid-1990’s.

Mechanics of computing border prices Domestic reference price = price in Country 1 Country 1 is the “home” country Import parity price = price from Country X Country X is a potential exporter to Country 1 Export parity price = price to Country M Country M is a potential importer from Country 1

Mechanics of Computing IPP IPP = the price at which purchases in Country X can be delivered to market in Country 1 Country 1 is home country Country X produces the good we want at a low price In this case, assume that Country 1 is the home country. You want to import goods from Country X. How much will the goods cost in Country 1 if they have to be imported from Country X?

To Calculate IPP, Need to Include Price in Country X = Transport to Country 1 + Duties and Fees Handling Costs IPP from Country X to Country 1 First, the good must be purchased in Country X, then it must be transported to Country 1. Duties and fees must be paid, along with handling costs. All of these things add up to the Import Parity Price. If the good can be purchased in Country 1 for less than the IPP, the good will not be imported from Country X.

For example… = + Price in Country X $200 Transport to Country 1 $100 Duties and Fees $ 50 Handling Costs $ 34 IPP from Country X to Country 1 $ 384 If the price of the good at home in Country 1 is higher than $384, the good can be imported and will reduce the price. Think back to the graphs depicting a drought. With reduced supply, prices rise above IPP. With open borders, importing reduces the price substantially.

Mechanics of computing (EPP) EPP = the price at which purchases would have to be purchased in Country 1 in order to be sold at market price in Country M Country 1 is the home country Country M is a potential importer of the good we have to sell The market price for a good produced in Country 1 is low, and you want to export to Country M. You need to calculate EPP in order to determine if it is profitable to export. Is the market price in Country M high enough to make up for the costs associated with getting your good there?

To Calculate EPP, Need to Include Price in Country M = Transport to Country 1 - Duties and Fees Handling Costs EPP to Country M from Country 1

For example… = - Price in Country M $275 Transport to Country 1 $ 60 Duties and Fees $ 0 Handling Costs $ 25 EPP to Country M from Country 1 $190 If the price of the good in Country 1 is less than $190, then it can be exported to Country M for a profit. Think back to the graphs depicting a bumper harvest of maize. An outward shift in supply cuts the normal price of maize in half. But, because the maize price is so low, it can be purchased in Country 1 and exported for sale in Country M (if there are open borders).

3 Exercises: Computing Border Prices Use Excel workbook entitled: Module 4.2 – Import and Export Parity Pricing.xls Exercise 1: Nairobi IPP & EPP Trends Calculate domestic maize price Compute and compare IPP Durban & EPP Durban Exercise 2: Nairobi IPP & EPP Graph Calculate and graph IPP & EPP Durban Calculate and graph IPP & EPP Uganda Exercise 3: Southern Malawi IPP & EPP Calculate and graph IPP & EPP from N. Mozambique Open the excel workbook. Read the NOTES page thoroughly to understand what it contains and how to use it. Exercise 1 is found under the [ex1 – ipp epp trends] tab. Exercise 2 is found under the [ex2 – nairobi ipp] tab. Exercise 3 is found under the [ex3 – s.malwai ipp] tab. For each exercise, fill in missing data (yellow boxes) to obtain the answer (green boxes). You will need to understand how to calculate IPP and EPP to obtain the correct answer.

Discussion Questions When, if ever, has import parity capped domestic price increases? Can domestic price ever exceed import parity? If so, when and why? If not, why not? See the text boxes in the Exercise worksheets for further discussion.

Empirical Conclusions Open borders reduce price volatility IPP becomes the upper limit to price fluctuations EPP becomes lower limit to price fluctuations

Policy Conclusions Openness to international trade is an effective way to reduce price volatility. Export bans harm producers by limiting their ability to gain maximum revenue from their sales Creates disincentive to produce in future Limiting imports harms consumers by requiring them to purchase high-priced domestic goods Unnecessary cut into household incomes

References Dorosh, P.A., Dradri, S. and Haggblade, S. 2009. Regional trade, government policy and food security: Recent evidence from Zambia. Food Policy 34 (2009) 350–366. Traub, L.N. 2008. South Africa Maize Trade Country Profile. Background report prepared for the World Bank under contract No. 7144132, Strengthening Food Security in Sub-Saharan Africa through Trade Liberalization and Regional Integration. Washington, DC: The World Bank. Tschirley, D. and Jayne, T.S. 2010. Exploring the Logic behind Southern Africa’s Food Crises. World Development 38(1):76-87.