Domestic Price System of Economic Analysis Chapter 6 Domestic Price System of Economic Analysis

Unit of Analysis A WP analysis converts all DP for nontradables into WP equivalents, assuming that the economy wide ratio of SCF holds for each nontraded item This is directly comparable with the procedure in a DP system of valuing these goods at their Domestic financial prices, by converting all WP/BPP for tradables into local currency at Shadow Exchange Rate

Estimating Shadow Exchange Rate[SER] Its an economic price of foreign exchange SER is different from official exchange rate [OER] due to taxes and subsidies on the demand and supply of tradable goods. Shadow Exchange Rate Factor SERF is calculated as the ratio of shadow exchange rate to official exchange rate SERF= SER/OER This ratio gives the CF for foreign exchange

Shadow Exchange Rate Factor SERF expresses the difference between the economic cost of traded goods at the official exchange rate and at the domestic market prices actually paid for them SERF can be affected by changes in the structure of taxes and subsidies and trade controls

Standard conversion Factor SERF= SER/OER= [ M+Tm-Sm]+[x-Tx+Sx] M+ X This approach is used in case of calculating prices at DP Recall SCF= [M+ X] [ M+Tm-Sm]+[x-Tx+Sx] Thus SERF is inverse of Standard conversion factor which shows the ratio of WP to DP

Example SERF= SER/OER Then SERF x OER = SER 1/SCF = SERF replace in the second equation 1/SCF x OER = SER This was done because SCF is mostly known and its equal to 0.8 OER =Rs 80 to dollar SCF = 0.8 Then SER ???????

Comparison of two systems WP system DP system Converts domestic prices into world price equivalents Converts world prices into domestic price equivalents OER = Rs 80/ SER = 1/0.8 x 80 SER = Rs 100/

Equivalence of world and domestic prices Input or output World price system Domestic price system Traded good WP * OER WP * SER Non traded good DP * SCF DP* 1or [ SERF * SCF]

Valuation World Price system Domestic price system Output Traded Good WP* OER 100*80 = 8000 WP * SER 100*100=10000 Inputs Traded Goods 50* 80 = 4000 50 * 100=5000 Non traded goods 600*0.8 =480 600*1 =600 Or [600* 0.8*1.25] Or 600* SCF*SERF Net Revenues 3520 4400 Or simply net revenues at WP * SERF = 3520*1.25= 4400

Acceptance or rejection? When identical assumptions are made in both systems the project decision will be the same since NPV dp> 0 and NPV wp> 0 And NPVdp= NPV wp * CFf Where NPVdp is NPV at domestic prices NPVwp is NPV at world prices CFf is conversion factor for foreign exchange given by SER/OER

Traded good in dp system DPEP= [Wpi x OER] x CFf + Ti DPCFt + Di DPCFd] Where DPEP is the economic price of i. to a project in domestic price system Wpi is its border price OER is the official exchange rate CF f is the SER/OER T and D are the transportation , distribution cost per unit of I from port to project at financial prices DPCFt and DPCFd are CFs for transport and distribution in a domestic price system Since CF f = SER / OER then you can rewrite the first eq as DPEP= [Wpi x SER] + Ti DPCFt + Di DPCFd] DPCF= DPEP/DP , where DPCF is conversion factor in DP system and DP are the financial prices

Non traded goods in dp system Variable supply criteria applied here Costs in DP rather then WP DPEP = Σaij. Pi. DPCFi + Σanj. Pn. DPCFn +Σ alj. WL. DPCFL It’s the same formula on CF are in DP terms The new Conversion factor is DPCF= DPEP/DP

Example table 6.3 see footnotes Input Domestic Financial prices CF Case 1 economic prices domestic price numeraire Operating cost Fuel 30 1.068 32.04 Local Materials 60 1.00 0.744 44.64 Labor Skilled 80 1 Unskilled 10 0.5 5.5 0.55 5.55 Capital Cost Equipment 1.05 6.3 1.055 63.3 Buildings 0.819 49.1 Total 300 1.003 300.89 0.915 274.64 CF case 1 = 300.89/300= 1.003 CF case = 274.6/300= 0.915

Unskilled Labor in DP system Treatment is same in both WP and DP systems but the unit of account is in domestic price unit DPEWR = a. m. DPCF FWR= 10,000 Labor worked 150days at Rs 20 with CF = 1.38 The remaining days 215 worked at Rs 5 per day with SCF 0.8 Case 1 Both EP are converted Case 2 Export EP is converted only

Case 1 Both EP are converted Case 2 Export EP is converted only Example Case 1 Both EP are converted Case 2 Export EP is converted only DPEWR = {[150*30]*[1.38]*1.111 }+{ [215*5]*0.8*1.11} = Rs 5555 DPCFL= 5555/10000 =0.555 DPEWR = {[150*30]*[1.38]*1.111 }+{ [215*5]*1} = Rs 5675 DPCFL= 5675/10000 =0.568

Skilled Labor WP system use SCF for conversion DP use 1 for conversion factor

Foreign Workers If all local consumption component can be identified as a foreign exchange cost DPEWRf = [r.FWRF + [1-r]FWRF x CCF] x SERF Foreign labor consumption has 0 foreign exchange component DPEWRf = [r.FWRF x CF]+ [1- r]FWRF

Land and discount rate FP are converted to DP for land using SERF and no change for interest rare