The Policy Analysis Matrix

A central theme of this book is that the PAM approach to agricultural policy analysis can provide decision-makers and analysts with both a helpful conceptual construct for understanding the effects of policy and a useful technique for measuring the magnitudes of policy transfers. Because the accounting matrix is simultaneously a teaching tool and a way of undertaking and reporting empirical analysis, PAM results can be communicated easily to policy-makers, who might not be specialists in economics.

Three related questions can be addressed with the PAM approach. Ministries of agriculture are concerned with the competitiveness of their countries' principal farming systems; actual income received by farmers is thus the first issue examined with the PAM method. Ministries of economic planning focus on the growth and distribution of national income, and planning agencies of agricultural ministries want to maximize agricultural income; the efficient allocation of resources in agriculture (and elsewhere in the domestic economy) is therefore the second issue addressed by the PAM. Decision-makers throughout the government-including those acting on agricultural price policy, others concerned with macroeconomic policy, and yet others dealing with the allocation of public investment to the agricultural sector-want to be informed about the effects of policy and of market failures. Each policy analysis matrix is thus constructed to address these three central issues of agricultural policy-competitiveness, efficiency, and policy transfers.

For PAM analysis to be carried out, an accounting matrix is constructed for each representative agricultural commodity system. An agricultural commodity system consists of a farm technology for producing a commodity (or set of commodities) in a given agroclimatic zone, a way of moving the crop from the farm to a processing site, a technology for processing the crop into marketable products, and a way of transporting the products to wholesale markets. Because all farms differ somewhat from one another, some aggregation needs to be done so that the empirical analysis becomes manageable. The identification of representative agricultural systems reflects differing aggregate combinations of commodities produced, technologies used, and agroclimatic locations of production. A study of one staple food commodity in a country might identify few or many representative systems for that commodity, depending on the complexity of technologies and agroclimatic conditions.

Each matrix is a combination of two accounting identities, one defining the rows and the other the columns. The first identity is the profits identity: revenues less costs equal profits. The second identity is a definitional statement of efficiency, or social valuations of revenues, costs, or profits. Actual market, or private, valuations of these entries are observed by surveying analysts. These private observations can diverge from the underlying social valuations for one of two reasons. The first source of divergence between private and social valuations is the category of market failures-factor market imperfections, monopolies or monopsonies, and externalities, including public goods. Any of these failures of markets to work efficiently can cause inefficient pricing signals. The second and more widespread source of divergence is the existence of distorting government policies. As noted earlier, efficient policies offset market failures; all other policies distort the economy, moving it away from its most efficient allocation of inputs and outputs.

Distorting policies are not necessarily inappropriate; they can be justified if their efficiency losses are more than offset by gains from the furthering of nonefficiency objectives. The two sources of divergences-market failures and distorting policies-cause private prices to differ from social prices of revenues, costs, and profits. The definitional identity for each column of a PAM is therefore known as the "effects of divergences" identity: private prices less social prices equal the effects of divergences.

The empirical estimation of PAMs proceeds from these two identities. Two fundamental steps are involved in preparing the research inputs into a PAM. The first is building budgets in private prices for the representative systems. To complete this step, the analyst compiles existing information on farm management studies and verifies and completes the farm budget data through field surveys. The farm budgets are then complemented with postfarm budget data on transporting and processing. This private budget information on revenues and costs is entered into the first row of PAM. Use of the profits identity allows calculation of private profits or competitiveness, the first research output of the PAM analysis.

The second step in building a PAM is to convert the entries for revenues and costs in private (actual market) prices into counterpart entries in social (efficiency) prices. The calculation of social prices is a combination of science, art, and guesswork, as all practitioners of social benefit-cost analysis are well aware. The approach followed in this book has been to explain fully why some dimensions of social valuations are extraordinarily complicated to handle empirically and then to suggest shortcuts that usually work well. The social valuations of outputs and inputs that would enter into international trade (in the absence of distorting trade policy) are given by their comparable world prices (cif import prices for importables and fob export prices for exportables). World prices, even if set in less than fully competitive international markets, provide a valuation standard of the choice the country has to use world markets or not. In the absence of distorting trade policy, the world prices determine the domestic prices of tradables and create efficient allocation.

Social valuation of inputs that do not enter into international trade is more difficult on both conceptual and empirical grounds. Most problematic are the social prices of the primary factors of production-labor, capital, and land. In principle, the observed, private factor prices have to be corrected for the distorting influences of divergences in output markets, market failures in factor markets, and distorting government policies in factor markets-in short, for all divergences in the economy. This practically impossible task is therefore roughly approximated with a series of rules of thumb meant to guide the analyst in careful observation of key factor markets and policies. The other kind of inputs that are nontradable internationally are some intermediate inputs into farming, marketing, and processing. The nontradable inputs, such as electrical power and truck transportation, are disaggregated into their component costs of tradable inputs and primary factors. These indirect costs are then added to the direct costs of tradables and factors used in the system. For this reason, each PAM has only two cost column categories-tradable inputs and primary domestic factors.

The second research output from PAM analysis, the calculation of social profits or efficiency, follows easily from application of the profits identity-once the analyst has found social valuations for revenues (the world prices of outputs), tradable input costs (their world prices), and factor costs (their social opportunity costs, or the amounts of national income forgone from their not having been used in their best alternative occupations). Positive social profit is a measure of efficiency, or comparative advantage, because the value of the goods produced by the agricultural system exceeds the costs of production after all causes of inefficiency-distorting policies and market failures-have been (hypothetically) removed. Negative social profit indicates the opposite result; the country is wasting resources by allowing inefficient production, which occurs because of distorting policies (which might be serving other government objectives) or market failures (which the government is unable or unwilling to correct with efficient policy).

The third row of each PAM, which measures the effects of divergences, is determined by application of the second definitional identity: private prices less social prices equal the effects of divergences. Occasionally, an analyst has better information on a third row entry than on its second row counterpart; thus social valuation is an output of rather than an input into the analysis. Typically, however, the divergences are research outputs. The analyst's job is not always completed at this point. Sometimes policy-makers need to have the effects of divergences broken down into those associated with market failures and those caused by particular policies. For the product markets (in which private prices of tradable outputs and inputs are determined), the analyst should try to identify market failures; if none are found, product market failures can be assumed to be nonexistent, unimportant, or unmeasurable. For the factor markets, the opposite expectation is held, and divergences that cannot be associated with distortions in the output or factor markets are assumed to be the result of factor market imperfections. The measured divergences or transfers for outputs and tradable inputs will generally be the result of distorting policy, whereas those for factors will be caused by a combination of distorting policy and factor market imperfections.

The close linkages between exchange-rate policy and price policy are also observed readily in the PAM. When distorting policies cause private product prices to diverge from their social values under an appropriate exchange rate, all of the measured transfer in the third row of a PAM is caused by price policies. But when the exchange rate is over-valued, the social valuations of both tradable outputs and tradable inputs need to be adjusted to reflect the degree of overvaluation; for example, a 20 percent overvaluation would need to be corrected by a 20 percent increase in the amounts for social revenues, social input costs, and social profits. The third row would show exchange-rate policies taxing output revenues, subsidizing input costs, and taxing profits.

The construction of a PAM, therefore, normally entails the finding of information on private revenues, private tradable input costs, private factor costs, social revenues, social tradable input costs, and social factor costs. Application of the profits identity yields two research outputs-private profits (competitiveness) and social profits (efficiency). The four other research outputs-output transfers, tradable-input transfers, factor transfers, and net policy transfers-are found through use of the divergence identity. The net transfer-the difference between private and social profits or the combination of all three other kinds of transfers-results from the complete set of agricultural price and macroeconomic policies and market failures that influence the system.

Because the data for the PAM represent a chosen base year, the results are static and potentially applicable to only that year. Projections of changing future world prices, technologies, and factor prices can be made to simulate paths of dynamic comparative advantage, as social profits change in response to varying parameters. Investment policy analysis can be assisted by the construction of baseline PAMs, identifying social profits before any public investment, and by analyses of dynamic comparative advantage with and without the prospective investment. The PAM approach can thus be used to illuminate baseline conditions and then to measure the effects of changing price, macroeconomic, or investment policies on the private and social profits of agricultural systems in the base year or in the future as key parameters change.