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Shadow pricing of Tradables and NonTradables and Use of ConversionFactors

Lecture 8

Chapter 4

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Why economic prices differ from

financial prices?

Taxes

Externalities Quantity Controls

Controlled Prices (floors or ceilings)

Tariffs and Trade Controls Imperfect Information, Transaction Costs and

missing markets

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Re-valuation of Inputs and Outputsfrom financial prices to economic

prices..

1) Base the value of all traded goods (whether

directly traded or indirectly traded) on theirborder prices. For traded goods the sociallyrelevant opportunity cost is the possibility ofgains from trade. Border prices represent the

values at which the economy can buy from orsell to the international market.

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1).. Difference between a) Border Prices and b) Border Parity Pricea) The border price of a good or service is the price of this good at the

point of entry (for imports) or exit (for exports) from the country. This is

the FOB price for exports and the CIF price for imports, whetherintermediate inputs or import substitute products.

b) The import parity price of a product is equal to its border price plustransport costs (including any processing and transformation costs)and all expenses (other than taxes and subsidies) intervening betweenthe point of entry and the place of consumption.

The export parity price of a product is equal to its border price minustransport costs (including any processing and transformation costs)and all expenses (other than taxes and subsidies) intervening betweenthe place of production and the point of exit.

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2) Remove the value of direct taxes and

subsidies from the prices of all items. Taxesand subsidies are transfer payments.Although they represent financial paymentsthey are not the cause of any associated

resource use, thus do not represent a socialopportunity cost.

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3) Make an adjustment to allow for the divergence betweeninternational and domestic prices caused by taxes, quotas,

subsides and licensing controls on international trade. To bringthe two prices to a common base, we use a shadow exchangerate.

Economic Analysis can be carried out using different units ofaccount of numeraires domestic prices numeraire and worldprice numeraire. The difference between a world and domestic

price numeraire arises because in most economies thedomestic prices are which traded goods are sold differ fromtheir prices in the world market (at OER) by more than themargin for domestic transport and distribution costs.

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4) Make allowance for the fact that the wages

of some kinds of labour, especially formalsector unskilled labour, will be higher thantheir opportunity cost Use appropriate

conversion factors for unskilled labour

Similarly value other non-tradable items likeLand according to its opportunity cost.

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5) Estimate the value of all consumer surpluses

gained and lost in the with project situation

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a) Traded Goods

Traded goods are those that are imported or

exported. The opportunity cost of tradedgoods to an economy is the border price (CIFfor imports and FOB for exports).

Import substitution eg: If a country is

producing sugar to satisfy local consumption,what is the opportunity cost? The next bestto local sugar production would have been toimport the sugar. The shadow price of the

sugar being produced is then the CIF that

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a) Traded Goods

Inputs

The cost to the society of importing an input is the value of the

resources used in getting the input to the project. There are twocomponents of this cost.

The first is the border price of the input known as the CIF price(cost, insurance and freight) which is simply the overseaspurchase price or cost. This price is converted into domesticcurrency at the official exchange rate.

The second cost component is the local cost of transporting thegoods from the port of entry to the project site. This costcomponent needs to be shadow-priced as a non-traded service.

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Traded Goods

Outputs

The benefit of a project output to society is the value of the new

resources created. The first step in determining this value is toobtain the border price of the output. The border price of atraded output is its FOB price (free on board); assumed to becompetitive on the world market. The true benefit to society isthus the border or FOB price converted at the official exchangerate if prices are denominated in foreign currency units.

Where a project produces import substitutes, a similar valuationprocedure to that outlined above is to be followed. The benefitto society is the saving of not having to import the goods i.e. theCIF price plus possible transportation costs.

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Traded Goods Vs Tradable goods in

some cases, a good may be tradable but nottraded, for example when the import of itemswhich are also locally produced isdiscouraged.

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Also, some goods may not be directly traded

but their economic price is derived from atraded goods. Eg perishable commoditieslike sugarcane derive their economic valuefrom the price of processed sugar.

Another example: fresh milk Value these commodities at their border

prices less processing and marketing costs.

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Example: Export Replacement

Suppose a textile project set up in Faisalabad uses up locallyproduced cotton yard as raw material. The cotton lint is

manufactured in a subsidiary of the textile factory located nextto it. The local cotton lint used up for the product can otherwisefetch an export price of $100 per ton in the world market. Thetransportation and handling costs in getting the locallyproduced cotton lint from the factory where it is produced to the

border are $10 a ton. Find the shadow price of the cotton lintinput per ton.

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Note: the economic price of traded goods is based on theirborder prices which is ultimately a foreign exchange value.

Thus the opportunity cost of traded goods depends on theopportunity cost of foreign exchange.

i.E if an extra unit of foreign exchange is used for purchasinginputs for a project, what is its opportunity cost? This isdetermined by the next best alternative use of foreign

exchange. (More on this when we cover shadow exchange ratevs the official exchange rate)

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b) Non traded goods

The most common non- traded goods and services include electricity,transportation, construction, labour and land. These can be both inputsand outputs to a project. Labour and land are primary factors of

production and their economic evaluation must be treated separatelyto that of others. One way of carrying out the economic valuation of non-traded goods is

to break down the composition of each non-traded good into tradedand non-traded components until the stage is reached where the onlynon-traded components are labour and land.

This method of shadow pricing is tedious and time consuming and

consequently rarely followed. Instead non-traded goods are generallyvalued at economic prices by the use ofconversion factors. Aconversion factor is a short-cut method for converting prices of non-traded goods and services into border prices.

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Using Conversion Factors for Valuing

Non-traded Goods

A conversion factor is a short-cut method for convertingprices of non-traded goods and services into border prices.

At the most aggregated level a single conversion factor,the standard conversion factor (SCF) is used for this

purpose. The SCF is derived by taking the ratio of allexports and imports at border prices to their value atdomestic prices. Shadow prices of non-traded items are

then obtained by multiplying the SCF with the marketprices. This reduces the market prices to their realeconomic value.

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Standard Conversion Factor

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CF is a reflection of the relationship of the shadow priceof a commodity with its market/financial price.

CF>1 : social cost of an item is higher than the marketprice.CF

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Labour as a Non Traded Input

Labour is a project input and like any other

project input it must be valued at itsopportunity cost which may well differ from itsmarket value. This opportunity cost, oreconomic value of labour, is equivalent to the

output foregone elsewhere in the economyas a result of employing that labour in theproject.

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Labour as a Non Traded Input

For most projects two broad categories of labour should be shadow priced:

i) unskilled labourValuation of unskilled labour begins with an assessment of the degree of unemployment and/or

underemployment of such labour. Where extensive unemployment and /or underemployment exist, thepractice adopted is to take a fraction of the current wage rate as the shadow price of unskilled labour.The arbitrary figure of 50% of current market wage rate or the minimum wage rate is often selected asan estimate of the opportunity cost of labour. The only underlying argument for the selection of thisarbitrary figure is that for economies with high rates of underemployment the opportunity cost willgenerally be significantly less than the market wage rate.

ii) Semi Skilled LabourConventionally we use a SCF of 0.7 for semi skilled labour.

iii) Skilled LabourIn most instances skilled labour in developing countries is in short supply and would in all probabilitybe fully employed without the project. As a result, wages paid to such personnel are generally taken asrepresenting the true economic value to the society. We can also use an internationally approved CF of 0.9 for

skilled labour.

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Land as a Non traded input

In economic analysis land is valued at its

opportunity cost which is its net value ofproduction foregone when the use of land ischanged from its without project use to its

with project use.

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