Nontradable Goods and Social Valuation

The general model solution for social factor prices is based on the assumption that all commodities have world market prices. But in almost all economies, a large class of goods is not traded on international markets. Nontradable goods such as electricity and water have high international transport costs. Nontradable services such as marketing activities and legal services are impossible to supply from foreign sources for logistical reasons. For the valuation of social factor prices, these commodities are considered redundant goods. Because nontradable outputs do not face international competition, the domestic market price will alter to any degree necessary to cover costs. The factor prices paid by the tradable-goods sector must also be paid to factors used by the nontradable-goods sector.

However, social prices for nontradables remain complicated by the impacts of domestic demand shifts. For tradable commodities, domestic demand shifts are usually ignored because they affect only the magnitude of imports or exports, not the world price. For nontradable goods, demand shifts from changes in incomes or relative prices-in turn caused by the elimination of commodity market or exchange-rate divergences-will directly affect social output prices and production costs.

Figures 6.3 and 6.4 demonstrate this result for the case of exchangerate depreciation. In Figure 6.3, production is initially represented by point A; the initial exchange rate is e. This production point is not sustainable because the exchange rate is overvalued. Consumption of nontradables equals production, but consumption of tradables (point C) exceeds the production. To resolve this disequilibrium, the exchange rate depreciates to e', raising the domestic currency price of

tradables. Production shifts to point B. If deflationary policy forces total expendture to decline at the same time so as to become equal to production income (through reduced government spending, higher taxes, or higher interest rates that reduce consumption), this point represents a sustainable equilibrium for the economy. Tradable-goods production has increased from Q to _Q’, whereas nontradable-goods production has declined from Q_NT to Q’_NT,

Figure 6.4 provides a partial equilibrium interpretation of the effect of an exchange-rate change on a nontradable-commodity market. Initial equilibrium at point A is accompanied by price _PD and output _QD. A change in the exchange rate from a distorted to a social value will cause tradable-input prices to rise, shifting the supply curve upward in the short run. In the long run, the supply curve must shift upward even further, reflecting increases in domestic factor costs, and leftward, because of the exit of resources from the sector. The new long-run supply curve becomes S'. Because the relative price of nontradables must decline in the new equilibrium, the reductions in total expenditure must shift the demand curve to more than offset the shift in the supply curve. The new equilibrium (point B) results in a lower price, Ps, and a smaller quantity, _Qs, than in the initial situation. The new price represents the social value of the nontraded output. Because of the effects of demand shifts, evaluation of an observed system in terms of social input prices may not be sufficient. In Figure 6.4, such a procedure results in a social price for output of P", above the true social value of Ps.