1. Economic Analysis under World and Domestic Price System
(C&W Chapter 5, 6)
R. Jongeneel

2. Lecture Plan World price system analysis
inputs/outputs (tradable/non-tradable)
labour
land
capital (discount rate)
domestic price system analysis
shadow exchange rate
traded/non-traded goods
(land, discount rate)

3. World Prize System-Analysis
Main objectives:
efficient utilization & existing resources
growth of resources
improving distribution (equity)
Trade-offs
short-run optimization
long-run optimization

4. World Price System-Analysis
Main focus: efficiency analysis  focus on efficient resource utilization
Opportunity costs: defined in terms of benefits foregone from the use of existing resources in one project rather than in their most likely alternative use

5. World Price System-Analysis
World price numeraire choice
Focus is on projects that produce traded goods and whose main benefits are in foreign exchange (trade efficiency)

6. Assessing Costs and Benefits
tradable
Non-tradable
outputs
Project
inputs
labour
land
capital

7. Traded and non-traded goods
Tradables  project affects country’s balance of payments
 classification depends on government’s trade policy
non-tradables  goods may be non-traded for various reasons

8. Valuation of traded goods
Border parity pricing: use border prices and add domestic margins (transport, distribution) to obtain border prices at project level
export output: fob price - value T + D
import input: cif price + value T + D

9. Value of traded goods T1+D1 Project size Production centre
domestic proj. inputs
Border
Port
T2+D2
T4+D4
T5+D5
T3+D3
Cons. Centre
project outputs

10. Value of traded goods
Price: convert world prices into local currency at official exchange rate
Shadow price:
SPi = (Wpi x OER) + (Ti CFT + Di CFD)
CFi = SPi / DPi

11. Valuation of non-traded goods
Variable supply
increase supply
(price )
Fixed supply
Replacement, subst.
price 

12. Non-traded inputs: variable supply
Shadow price: long-run marginal costs of additional supply (in world price equivalents)
traded non-traded labor
input input

13. Example: non-traded electricity production

14. Non-traded inputs: fixed supply
Use average conversion factor for the whole economy since more detailed info is absent
ACF = M + X _
(M+TM-SM)+(X+TX+SX)
Limitations: “average” instead of “marginal”, relies only on traded goods, omits effect of trade controlls (quota)

15. Labour valuation Possible distinctions skilled vs. unskilled
workers in excess supply vs. workers in excess demand
Problem: ill-functioning labour market, immobility of labour

16. Labour: workers in excess supply
Opportunity costs: value of the output produced in the alternative occupation (which may offer only part-time work or underemployment)

17. Labour: workers in excess demand
Two options: 1: attract labour from other activities 2: increase labour supply by training or immigration
Option 1:
Option 2:

18. Land
Comp. Land market price: equal to the expected future gain from the land purchased / rented
problem: land market subject to regulation / speculation

19. Example: land valuation cotton/sugarcane

20. Capital: discount rate
Where do funds come from...?
 Determines relevant opportunity costs
Opportunity costs (examples)
return on the marginal project
return obtained in the private sector
weighted average of discount rates (real) in domestic and foreign markets

21. Capital: discount rate
r = q . CFq or
r = a1i1+a2i2

22. Domestic price system-analysis
Choice of price unit in itself does not determine the opportunity cost of an item
Using DPS does not mean that domestic prices determine opportunity costs of (non-traded) goods
The difference between WPS and DPS arises because in general Pwm and Pdom differ by more that the margin for T+D-costs

23. Shadow exchange rate
If domestic prices are the numeraire allowance must be made for any general divergence between domestic and world prices in the economy
Solution: use shadow exchange rate

24. Shadow Exchange Rate

25. Shadow Exchange Rate
A more perfect approach is:

26. Example: Shadow Exchange Rate

27. Approximations in DPS-Analysis
Classification
foreign exchange (F)
domestic resources (N)
unskilled labour (LU)
skilled labour (LS)
transfer payments (T)
(F): traded goods valued at Pwm (OER)
(N): non-traded goods valued at Pdm

28. NPV and DPS-analysis At project level NPV=F+N+LU+LS+T
At national economic level ENPV=F.CFF+N.CFN+LU.CFLU+LS.CFLS
More detail: further decompose N

29. Traded goods: valuation at DPS
Derive CF (conversion factors)
DPSPi=(WPi.OER).CFF+(Ti.DPCFT+Di.DPCFD)
but CFF=SER/OER
thus DPSPi=(WPi.SER)+(Ti.DPCFT+Di.DPCFD)

30. Non-traded goods in DPS
Principle: value inputs in variable supply at long-run MC

31. Labour valuation at DPS
Labour: shadow wage is based on output foregone
Unskilled:
Skilled:

32. Comparing DPS with WPS Identical decisions are made in both systems
NPVDP>0 when NPVWP>0
and
NPVDP = NPVWP x CFF
with CFF = SER / OER

33. Comparing DPS and WPS analysis
NPV
DP System analysis
WP System nnalysis
Discount
rate