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Estimating Social Prices for Domestic Factors
Given sufficient information about world prices for tradables and technologies of production, social prices for factors could be calculated by direct evaluation of the marginal physical products at world prices. But without such information, less direct evaluation strategies must be pursued. The alternative strategy begins with observed private prices for domestic factors and adjusts those prices to take account of the effects of divergences.
In practice, the principal adjustments to domestic factor prices are corrections for the effects of factor market divergences. The remaining sources of change-output price distortions and input substitution effects-are usually assumed to be small enough to ignore. Ignoring output price effects is reasonable only if the pattern of output price distortions does not demonstrate a bias toward particular factors. If protection is given to commodity systems that span the range of factor intensities, the impact of one output distortion on factor prices (and factor use) will be offset by the countervailing impact of another output distortion. The aggregate impact of all output price distortions will then be small.
If output prices are systematically biased to favor a particular factor, factor price effects are usually assumed to be slight magnifications of the net bias in output protection. The zero-profit condition shows that the proportional changes in factor costs, each one weighted by its share in total cost, must equal the proportional changes in price. Therefore, the proportional factor price changes will magnify the net protection pro= vided to outputs. If policy systematically protects capital-intensive commodities, for example, private rates of return to capital will be above social rates of return by an even larger proportion. Private prices for some other factor, such as labor, will be below their social values. Justification for ignoring input substitution effects on factor prices
Box 11.1. What Is the Social Value of Rice?
The commodity system for analysis involves rice production in Mali, a landlocked country in West Africa. The problem for social valuation is to determine an appropriate social price for Malian rice. The analyst begins by assembling marketing year price data for various qualities of rice traded on world markets. The choice of a social price of rice depends on assessments of quality and the likelihood that recent prices will continue into the future.
Malian rice has a "brokens" content, on average, of about 35 percent. Thai Al super, a higher percentage broken variety, is selected as a variety that represents quality comparable to that of the Malian product. The next decision is whether the recent prices are representative of expected future prices. On the basis of a review of the market literature the analyst selects $175 per metric ton fob Bangkok as a measure of the long-run world price.
The next step in the valuation process is to analyze the costs of moving the rice from Bangkok to Bamako, the capital and main consumption center in Mali. This movement involves ocean transport from Bangkok to Abidjan, Ivory Coast, and then shipment by rail to Bamako. Because fob Bangkok and cif Rotterdam quotes are available, international transport cost margins can be estimated. These margins have ranged between $40 and $60 per metric ton in recent years, and the Bangkok-Rotterdam route is roughly comparable in costs to the Bangkok-Abidjan route. The analyst chooses $50 per metric ton as the ocean transport cost. Inquiries to Bamako importing firms reveal that shipping costs from Abidjan to Bamako are an additional $25 per metric ton. The long-run social price for rice cif Bamako is then estimated as $175 + $50 + $ 25, or $250 per metric ton.
The next task involves conversion of the dollar price into Mali's local currency (the CFA). To illustrate the principles of calculation, a number of hypothetical and unrealistic assumptions are made in this example. The official exchange rate is assumed to be 700 francs per dollar at the beginning of the year. The government is assumed to depreciate the exchange rate by 10 percent, thus reaching 770 francs per dollar at the end of the year, or a midyear value of 735 francs per dollar. But if Malian inflation is 20 percent higher than foreign inflation, the franc should depreciate to 840 francs per dollar, or a midyear value of 770 francs per dollar. Hence, the inflation adjustment factor is 770/735, or 1.05. The midyear social value of foreign exchange is estimated as the official rate multiplied by the adjustment factor: 735 x 1.05 = 772. The social value for Malian rice in Bamako is thus $250 per metric ton x 772 francs per dollar = 193,000 francs per metric ton.
The value 193,000 francs per metric ton represents the social value of rice in the wholesale market. But the social value must be further adjusted for the social costs of internal transportation in order for social values for rice in the farm, farm-to-processor, and processor activities to be determined. It is assumed that all these other activities are located in the same area, 200 kilometers from Bamako. Transport costs are estimated at 15,000 francs per metric ton for that distance. The social price of rice for the processing activity becomes 178,000 francs per metric ton. Similar adjustments can be made to derive representative farm and farm-to-processor values (although these prices will need to be converted into paddy-equivalent prices). All of these prices reflect social values for a system that delivers rice to Bamako. If, instead, the competitiveness of rice production for consumption at the farm gate is to be analyzed, domestic transport costs will be added to, rather than subtracted from, cif Bamako values in order to generate estimates of social value.
arises from second-best situations and from the envelope theorem result: marginal responses to changes in costs of production are the same whether input-output coefficients are fixed or variable. But if factor price changes are very large, input substitution will have exerted some measurable impact on factor prices. Consideration of these more general circumstances requires information about the input demands of each commodity system of the economy; adequate data to measure the effects of input substitution do not exist in most empirical situations. In these circumstances, an analyst has little choice but to resort to sensitivity analysis to test whether the PAM results change much within ranges of assumed parameters.
Capital
Estimation of the social rate of return begins with observed interest rates in the capital market. The first adjustment to these rates involves a correction for inflation. If inflation rates are nonzero, savers and finanncial intermediaries will require a financial premium on their savings and ]endings, so that the real value of these transactions does not deteriorate over time. A consumer, for example, will not be much interested in saving if the savings will buy fewer commodities in the future than in the present. Observed (nominal) interest rates will thus reflect compensation for inflation as well as the real rate of return. The real rate of interest, 1B, is estimated as follows:
where iN is the observed interest rate and f is the inflation rate. At low rates of interest and inflation, the real rate of interest is well approximated by the simple difference of observed interest rates and the inflation rate, iN-f. But this approximation worsens as the interest-rate levels increase, requiring use of the formula.
Real interest rates are then adjusted for divergences to derive real rates of return. The simplest divergence (for analytical purposes) is a tax on capital. If the tax can be represented as a simple proportional tax of rate t, the rate of return to investment (r) can be estimated from observed real interest rates with the following formula:
r - (r)(t) = iB
The social and private rates of return must be higher than the real interest rate so that the investor can pay both the lender and the government.
Analogous calculations occur in the presence of proportional subsidies to capital investment (- t). These policies are most commonly found as industry-specific credit or interest subsidy programs, and they affect only the private rate of return in subsidized systems. The interest-equivalent value of the subsidy (measured in percentage points) is subtracted from the economywide private rate of return in the estimation of the private cost of capital for the system. This procedure presumes that the potential borrower has access to investments that earn the economywide private rate of return and can use unsubsidized credit (not necessarily from banks) to pursue these investments. The investor will use subsidized credit for government-specified investments only if the net return from subsidized credit use equals the private marginal rate of return from unsubsidized credit use.
Typically, divergences in the capital market will be far more complex than a tax. Perhaps the most common policy distortion involves quantitative restrictions on the supply of capital or controls on interest rates; these controls are usually linked to macroeconomic distortions. The most common market failure involves institutional imperfections, in which capital markets for particular regions or sectors are isolated from one another. Interest rates set by the government and market failures destroy the linkage between observed interest rates and the private rate of return. Instead, rates of return depend on the allocation of financial capital among investors and are likely to reflect excess profits as well as the cost of borrowing. The social rate of return could be higher or lower than the private rate of return.
In this circumstance, other sources of information about the return to capital investment are needed. One source is specific research studies of the return to investment. In national aggregate studies, attempts are made to estimate the value of the economy's total stock of capital equipment. Total national income is then allocated between labor and
capital. The income for capital divided by the value of capital stock is a rough measure of the rate of return to capital. Industry-specific studies proceed in a similar manner. The value of the capital stock is compared to an income measure, such as profits plus the annual payments to capital. Comparisons across a number of these industry studies can provide a rough idea of the private rate of return in the economy. Ratios of rental rates to sales prices of agricultural land may give an indication of agricultural sector rates of return, because land usually is a non-depreciating asset. But such comparisons depend on the absence of substantial demands for speculative or consumptive purposes; these demands could cause land prices to exceed the capitalized value of rents. As in the case of exchange-rate adjustments, researcher calculations can be supplemented by expert advice from macroeconomists or institutions involved with investment projects, such as the country's ministry of planning or the World Bank. Box 11.2 provides an illustration of a rate of return calculation.
When information sources are unavailable or unreliable, rough rules of thumb must be used. Countries with higher per capita income levels usually have larger amounts of capital stock. If rates of return to investment behave similarly across countries, higher-income countries will have lower rates of return to investment. Because their capital stocks are small, low-income countries have unrealized investment opportunities that are lucrative compared to those in high-income countries. Empirical estimates of real rates of return are usually in the ranges of 10 to 15 percent for low-income countries, 6 to 10 percent for middle-income countries, and 2 to 6 percent for high-income countries. Of course, the application of such rules of thumb is highly discretionary, and substantial emphasis must be given to the results of sensitivity analyses under such circumstances.
Labor
The greatest complication for labor market evaluations involves recognition of the many types of labor and the choices of private market prices to represent differences in sex, age, and skill levels. Once these choices are made, the price-equivalent value of divergences is added to generate estimates of social labor costs.
The identification of labor market failures usually begins with comparisons of regional wage rates, specified by sex and type of worker, over time. If wage levels for similar types of labor vary substantially among regions or if wages change in a very different manner over time,
Box 11.2. The Rate of Return to Capital in Portuguese Agriculture
The problem is to determine the 1983 rate of return to capital in Portugal. Markets for financial capital are highly distorted in Portugal. The control of credit has been an important tool of macroeconomic policy; by limiting total credit supplies, the government has been able to limit aggregate demand and inflation. At the same time, concern for the borrowers' ability to pay has led to interest-rate controls. These controls have allowed negative real interest rates for borrowers in many of the years preceding 1983. In these circumstances, financial markets are not a useful source of rate of return information.
Instead, use was made of aggregate economic studies of gross domestic product (GDP) distribution and studies that evaluated the stock of capital. The following data were assembled for the 1978-1981 period.
These data can be used to estimate the marginal rate of return to capital. Under competitive conditions, the ratio of marginal to average value products is equal to the share of the factor in total income. Capital's share of GDP was about 40 percent. Marginal rates of return are therefore 40 percent of the average rate of return; 6 percent is the estimate of the private marginal rate of return.
This rate is then adjusted to account for the impact of various distortions. Because investments were heavily influenced by government directives, alternative investments with potentially higher rates of return were excluded from the capital market. If credit were allocated competitively, rates of return would increase. The effect of this distortion was assumed to equal two percentage points; 8 percent was thus the estimated social marginal rate of return.
The next adjustment to the private rate of return involved accounting for capital market segmentation. In Portugal, low interest rates on savings discourage the use of savings accounts; people are encouraged to invest directly in businesses or assets. Because small-farm agricultural families are major recipients of emigrant remittances and because large farms enjoyed substantial profits, 4 percent was chosen as the private marginal rate of return in agricttltu re.
Finally, the private rate of return had to be adjusted for producers who had access to special lines of credit. These lines of credit subsidized the costs of borrowing between two and six percentage points. The unsubsidized borrowing rate in 1983 was 28.5 percent. But if the loan was used for particular types of machinery or other farm equipment, borrowing rates were between 22.5 and
26.5 percent, depending on the input. Because such loans required substantial numbers of forms and long time periods for evaluations, the transactions costs for such loans were high for borrowers. Two percentage points were used as the average net value of the subsidy.
In summary, three private rates of return were used in the analysis: 2 percent for users of subsidized agricultural credit, 4 percent for unsubsidized agricultural producers, and 6 percent for producers outside the agricultural sector; 8 percent was used as the social rate of return. These numbers are approximations at best. Although the analyst might have some confidence in the identification of divergences and the direction of their effects on the rate of return, exact quantification is implausible in most cases. Because of the approximate nature of the adjustments, sensitivity analysis of the PAM results, based on a range of assumptions for the private and social costs of capital, was an important portion of the subsequent analysis.
nonessential market fragmentation and monopsony power may be present. But wage-rate comparisons are not by themselves sufficient to justify adjustment of private prices. First, the cost of living can differ across regions, and real wage differences can be much less than nominal wage differences. Second, wages may adjust only slowly across regions, because labor does not respond instantaneously to changes in relative earning opportunities. Third, migration from region to region is costly. If relative wages rise in a particular region, labor from another region may choose not to migrate to the new higher-wage area because the costs of migration are larger than the net gains. Therefore, even if labor markets are well integrated, regional wages can be expected to demonstrate some independence.
If any of these circumstances can account for wage differentials, no adjustment of private wages is necessary to approximate social prices for labor. But if market imperfections are present in a particular region, social wage rates will be somewhere between those in the monopsony power region and those in the other regions of the country. When monopsonistic regions use a small share of the total labor market, this equilibrium wage will lie very close to the wage in the non-monopsony region, which can then be used as an estimate of the social price without significant error.
Policy distortions usually entail legislated wage rates or taxes and subsidies on the use of particular categories of labor. Evaluation of distortions must determine whether the regulations are binding. When the labor market completely ignores a legislated minimum-wage rate, for example, the private wage equals the social wage; both prices are
Box 11.3. The Social Wage Rate in Portuguese Agriculture
Investigations about the social wage rate begin with inspection of agricultural wages by sex and region. The following table lists daily agricultural wage-rate data for Portugal for the 1978-1982 period (in escudos).
The data appear to be consistent for an integrated labor market. Wages for females and males nationally and for within regions appeared to move in a similar manner. However, relative wages are by no means constant. North and central region wages began at similar levels; by the end of the period, northern wages were 9 percent higher. But these differences are not large relative to costs of migration. Further, no evidence of migratory barriers could be found; to the contrary, indications of mobility were common. For example, hired female labor was found to substitute to an increasing extent for tasks that were traditionally the domain of hired male labor. These adjustments reflected the growing scarcity of hired male labor.
The chief distortion in the labor market involved the effect of social security payments, mandated by law after 1974. Because most agricultural employers did not pay such taxes, private and social wages were considered equal for agriculture. The key issue was determination of the effects of legislation on the industrial and service sector wages.
The following table compares indexes of real wages for agriculture and manufacturing.
Although the index values do not change identically in each year, wage levels over time move in roughly similar patterns. The principal exception to this generalization involves the jump in real manufacturing wages during 1974-1975. This change was not matched by the agricultural sector, and it coincided with the institution of the social security laws. Moreover, urban unemployment became an increasingly serious problem during the period, suggesting that private market wages were above their social level. For these reasons, social labor costs in the industrial sector were evaluated net of social security taxes; private labor costs included these taxes, a difference of about 24 percent. These adjustments applied almost exclusively to postfarm activities.
below the minimum wage. If only some sectors observe the regulations, the wages in the unregulated sector provide a measure of the social price. Private prices used in the budget will vary according to whether producers in the commodity system observe the minimum wage. Within a commodity system, some activities could observe the regulation while others do not, so private wages can differ among activities.
Treatment of employer-paid taxes on labor follows a similar procedure. The issue is whether the regulation has actually raised the reward to labor or employers have simply lowered the money wage so that workers' total compensation remains unchanged. The presence of a globally binding regulation should be associated with some unemployment. If legislated wages are associated with full employment and all employers pay the tax, the analyst can assume that the legislation is
nonbinding. The private cost of labor then equals its social cost (money wages plus employer-paid taxes on labor use). Alternatively, full employment coinciding with large sectors of the economy that do not pay the legislated costs suggests that private and social costs diverge. Less labor is employed in the regulated sector; the unemployed portion is diverted to the unregulated sector, forcing down wages. Social wage rates then lie between observed wages in the regulated and unregulated sectors. Box 11.3 illustrates the procedures for determination of the social wage for agricultural labor in Portugal.
Land
Land is unique because it is the only truly fixed factor in agriculture. In suburban locations, agriculture might not be the only use for land, and prices and rental values will be influenced by off-farm opportunities. But in most areas, the only alternative to agricultural use is no use at all (if forestry is included as an agricultural activity). In these cases, land acts as a residual claimant on the profits from farming.
Divergences that affect the prices of agricultural outputs and nonland inputs have a direct impact on the rental valuc of land. If the prices of the principal outputs of a region increase, profits will increase. Ultimately, land values will increase because individual producers are willing (and able) to pay an increased amount for the right of access to farmland. Indeed, if agriculture is a price-taker in all other input markets (because agricultural demands for labor and capital are a small share of the total economy's demand for these factors), the rental price of land will absorb all of the change in the profitability of the farm activity. Only if arable land supplies are in surplus will the price of land remain unaffected (and presumably near zero).
To draw conclusions about the effects of policy distortions and market failures on the choice of agricultural activities, the social land rental value is usually measured as the value of the land in its most profitable alternative use. If oat production represents the only alternative to wheat production, for example, the social cost of land for the wheat activity is represented by the social profits (excluding land) from the oat activity. If the wheat activity did not generate returns at least as high as those available to oat production, farmers would choose to use their land to produce oats.
When private and social land are included in measures of domestic factor costs, the measure of factor market costs of divergences (K = C - G) requires careful interpretation. Because both the social and the private value of land are determined in relation to alternative uses, K will include some effect of the policies and market imperfections that influence the profitability of alternative crops. Moreover, the alternative crop might not be the same in the social and private cases. A second set of influences involves direct distortions in the land market. Governments sometimes try to alter the distribution of profits between tenant and landowner by imposing controls that limit the land rents paid by tenants. If such controls are binding, private market rental rates will be less than the full amount of private profit.
Two caveats may modify the use of social profits in alternative activities as proxies for the social rental rate. First, profits may include returns to some inputs not evaluated in the budget, such as managerial skill. One farm activity may show higher profits than another activity, but the difference may be explained by managerial skill. The returns to land then would vary little between the two systems. Second, systems can differ substantially in terms of riskiness, and variation in profitability may be important to the activity choice. For example, vegetable crops often provide higher returns on average than staple food crops. Yet many producers continue to grow food crops because of the greater
stability of returns from year to year. In this circumstance, land values will not rise so high that staple crop production will be eliminated, and land of identical quality will produce a variety of crops.
If risk effects and managerial requirements are thought to differ substantially among alternative systems, one must investigate the system alternatives as an explicit component of the analysis. By considering all major commodity systems in a particular region, the analyst can directly compare the relative profitabilities of alternative land uses without incorporating the rental cost for land into the PAM. The construction of the PAM proceeds without consideration of land costs, and domestic factor costs (C and G) include only labor and capital costs. Systems that do not generate revenues sufficient to pay the costs of tradable inputs, labor, and capital will be unattractive in the long run. But so may systems that offer low profits relative to alternative activities. Box 11.4 illustrates the two approaches to profitability calculations with examples from irrigated land in northwest Mexico and rainfed land in Portugal.
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