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FAO - GOVERNMENT OF ITALY COOPERATIVE PROGRAMME PROJECT GCP/SYR/006/ITA – Phase II

FAO - GOVERNMENT OF ITALY COOPERATIVE PROGRAMME PROJECT GCP/SYR/006/ITA – Phase II “Assistance for Capacity Building through Enhancing Operation of the National Agricultural Policy Center” course in Partial equilibrium analysis of policy impacts Part II, September 21 – October 3, 2002

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FAO - GOVERNMENT OF ITALY COOPERATIVE PROGRAMME PROJECT GCP/SYR/006/ITA – Phase II

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  1. FAO - GOVERNMENT OF ITALY COOPERATIVE PROGRAMME PROJECT GCP/SYR/006/ITA – Phase II “Assistance for Capacity Building through Enhancing Operation of the National Agricultural Policy Center” course in Partial equilibrium analysis of policy impacts Part II, September 21 – October 3, 2002 Piero Conforti - The National Institute of Agricultural Economics, Roma, Italy

  2. Aim of this part of the course Allow the trainees to familiarise with partial equilibrium analysis of agricultural policies, within • the single market static frameworks • (hints on) multi market, dynamic PE frameworks, and on GE frameworks Special emphasis on: • price policy analysis • welfare analysis • technical change analysis Special emphasis on the applications: mostly exercises in Excel

  3. Content 1. Equilibrium within a single market partial equilibrium computable model • isolated markets and regional integration in a closed economy with transport costs • the partial equilibrium computable model of an open economy: the effect of trade on supply demand and welfare • price policy analysis: impacts on supply, demand and welfare • technical change analysis with MODEXC

  4. Content 2. Beyond the single market model • relating interdependent markets: hints on multi-market analysis in a partial equilibrium framework • hints on dynamic partial equilibrium frameworks • hints on the GE approach: basic structure, computation, calibration and estimation, applicability and limitations

  5. Single market PE: introduction Partial equilibrium: only some parts of the economy (some markets) are taken into account. What happens in one sector in terms of demand, supply and price does not significantly affect what happens in other sectors it can be applied: to a single market (e.g. wheat) or to a set of markets (e.g. a set of agricultural products) within a so-called multi-market framework. In the second case it will take into account the interactions between e.g the wheat and the barley markets, but it will not take into account the effects of a change in the cereal market on fertilizers

  6. Single market PE: isolated markets production center production center C D Three isolated regional markets with no trade; region 1: consumption center Y We want ot represent this in a demand-supply graph

  7. inverted demand & supply 1. Demand derived from (1): 1a. CPy(D) = -Dyo/Ay + Dy/Ay 2. Supply of C derived from (2) (with and without transport) 2a. CPy = -Sco/Ac + Sc/Ac (without transport) 2b. Cpy = (Tcy*Ac - Sco)/Ac + Sc/Ac (with transport) 3. Supply of C and D (with transport) CPy = [(Tcy*Ac+Tdy*Ad) -(Sco+Sdo)] / (Ac+Ad) + (Sc+Sd)/(Ac+Ad)

  8. isolated market, graph We want to calculate the equilibrium point

  9. equilibrium quantity and price production center C only Demand = Supply of C -Dyo/Ay + Dy/Ay = (Tcy*Ac-Sco)/Ac + Sc/Ac since Dy = Sc = q q = [(Tcy*Ac-Sco)/Ac) + (Dyo/Ay)] / (1/Ay - l/Ac) q= 1554 p = 361 production centers C & D Demand = Supply of C and D Dy = (Sc+Sd) = q q = {Dyo/Ay + + [(Tcy*Ac+Tdy*Ad) - (Sco+Sdo)] / (Ac+Ad)} / [(1/Ay) – l/ (Ac+Ad)] q = 1796 p =301 (from 2a); qc = 1192 qd = 604 deducting transport costs pc = 282 pd = 276

  10. equilibrium quantity and price Isn’t there a simpler way to calculate the equilibrium point? Yeeees!! Take the price first, instead of the quantity; consider the direct functions and solve directly for the price to get Cpy = (Dyo-Sco-Sdo+Ac*Tcy+Ad*Tdy) / (Ac+Ad-Ay)

  11. isolated market: comments The equilibrium point is obtained when total production in the two centers equals the amount demanded by the consumers at the equilibrium price To calculate producer prices in the two areas we have to subtract the transport costs The inclusion of transport costs causes an upwards shift of the supply curve, i.e. a fixed increase in the price per each given quantity The inclusion of a second production center causes a shift of the supply curve towards the right, i.e. a change in the price-quantity relation

  12. other regions Calculation for region 2

  13. other regions, summary region 3, all regions

  14. other regions, graphs Region 1 Region 3 Region 2

  15. isolated markets, comments Prices in the isolated markets are widely different: from 146 of Region 2 to 604 of Region 3. This reflects the different production and consumption characteristics of the three regions strong production capacity in region 2 and the strong demand in 3. Isolated markets do not allow consumers of Region 3 to benefit from production capacity of Region and its low prices. Isolation can be due to natural reasons (e.g. distance, lack of communication facilities) or to political reasons (e.g. custom banners or other policies (prohibitive barriers) that eliminate trade)

  16. market integration region 2 region 3 A Suppose that region 3 and region 2 are connected by a road which allows trade Z X E B

  17. market integration Transport costs are given by CPz = CPx – Tzx PPa = CPx – Tzx – Taz PPb = CPx – Tzx – Tbz PPe = CPx – Tex total demand = total supply, i.e. Dx + Dz = Se + Sa + Sb where: Dx = Dxo + Ax * CPx Dz = Dzo + Az * (CPx -Tzx) Sa = Sao + Aa * (CPx- Taz- Tzx) Sb = Sbo + Ab * (CPx- Tbz- Tzx) Se = Seo + Ae * (CPx-Tex) solving for CPx

  18. market integration we obtain

  19. market isolation and integration, prices region 3 region 1 X Y CP = 604 CP = 301 region 2 Z CP = 146 region 1 region 3 Y X CP = 301 CP = 307 region 2 Tzx =65 Z CP = 242

  20. market integration, comments With integration, region 3 consumes 74% more, and region 2 consumes 18% less. Price decrease by almost 50% in region 3, while it increases by almost 68% in region 2. Production increases with integration in region 2, by more than 170%, while it decreases by almost 75% in region 3. Altogether there is an increase of 22% in total consumption, and an 8.7% decrease in production. With integration, the difference between the two prices is equal to the transport cost.

  21. market integration, welfare effects The impact of the integration of the two markets on producers and consumers can be measured in terms of surplus. This is a money metric welfare measure With linear functions welfare changes can be approximated as (p0 –p1) * (d0 +d1) / 2 (change in consumer surplus) (p0 –p1) * (s0 +s1) / 2 (change in producer surplus) where 0 and 1 are referred to time, p is the price, s is supply and d is demand The net change in welfare is the difference between the two above (p0 – p1) * [(d0 + d1) – (s0 + s1)] / 2 (net gain or loss)

  22. market integration, welfare effects Region 2 Region 3 F B A In graphical terms, consumer surplus in region 2 are the areas FCB and FDE, respectively before and after market integration. The difference is CBED, which represents the losses of the consumers. F D C E E A D B C G G The producer surplus is GCB and GAD in region 2 respectively before and after trade Since CBAD, gained by producers, is larger than CBDE, lost by consumers, trade has brought a net benefit to Region 2, equal to BEA.

  23. market integration, welfare effects The opposite will happen in Region 3: with integration consumers will gain and producers will loose. There will be also - a transfer of income from Region 3 to Region 2, equal to the amount of purchases made by the latter in the former, and - an increase in the business of the transport sector, equal to the transport cost. Summing up, the total welfare change will be

  24. market integration, summary of welfare effects

  25. welfare effects, comments Altogether both region have benefited from integration, although region 3 far more than region 2. The welfare effect is unevenly distributed among social groups: consumers in region 2 and producers in region 3 suffer a loss, which is smaller than the gain of consumers in 3 and producer in 2. The first statement rests upon the hypothesis that the welfare of all social groups is directly comparable, and equally weighted.

  26. full market integration Calculation of the equilibrium price for the three regions: supply Sc = Sco + Ac CPy – Ac Tcy Sd = Sdo + Ad CPy – Ad Tdy Sb = Sbo + Ab CPz – Ab Tbz Sa = Sao + Aa CPz – Aa Taz Se = Seo + Ae CPx – Ae Tex and given that Cpy = CPz + Tyz Cpx = CPz + Txz we have Sc = Sco + Ac CPz +Ac Tyz - Ac Tcy Sd = Sdo + Ad CPz +Ad Tyz – Ad Tdy Sb = Sbo + Ab CPz – Ab Tbz Sa = Sao + Aa CPz – Aa Taz Se = Seo + Ae CPz +Ae Txz – Ae Tex

  27. full market integration On the demand side Dy = Dyo + Ay CPy Dz = Dzo + Az CPz Dx = Dxo + Ax CPx using the relations among regional prices: Dy = Dyo + Ay CPz + Ay Tyz Dz = Dzo + Az CPz Dx = Dxo + Ax CPz + Ax Txz thus CPz = [ - (Sco + Sdo + Seo+ Sbo + Sao) + (Dyo +Dxo + Dzo) + (Ay Tyz + Ax Txz) + + Ac (Tcy – Tyz) + Ad (Tdy – Tyz) + Ae (Tex – Txz) + Ab Tbz + Aa Taz] / / (Ac + Ad + Ae + Ab + Aa – Ay – Ax – Az)

  28. full market integration region 3 region 1 X Y CP = 309 CP = 294 region 2 Tzx = 65 Tzy = 50 Z CP = 244

  29. full market integration region 1 region 3 Considering also consumer prices Y X CP = 294 CP = 309 Tcy = 19 Tex = 7 C PPc = 275 E PPa = 302 Tdy = 25 Tzy = 50 Tzx = 65 region 2 D PPd = 269 Z CP = 244 Taz = 15 Tbz = 7 A PPa = 229 B PPa = 237

  30. full market integration The gains of the consumers are greater than the losses of the producers and the costs of transport => market integration is beneficial to the country, although not for everybody.

  31. (small) open economy: production and trade Even if fully integrated, the previous setting can be considered as being closed to foreign trade. The country has only one port of entry, in Region 3. The import price is 275 (small open). Consumers of X will prefer the imported good, which is cheaper than the local, sold at 309, this is sold at the same price of 275. Since almost 3000 tons sold in X (region 3) is coming from Z (region 2), the maximum price in Z is the price in X minus the transport cost, i.e. 210. Similarly, the price in region 1, which was also importing from region 2, will be the price of region 2 (210) plus the transportation cost of 50, i.e 260.

  32. (small) open economy: production and trade Thus we have

  33. closed and open economy, comparison

  34. closed and open economy, comparison Opening to trade implies a small welfare gain for consumers, greater than the loss of the producers. The transport sector will be reduced, while foreign producers will be better off.

  35. pan territorial prices The Government guarantees the same price to all producers and to all consumers. It has to be assumed that the Government has a Marketing Board for enforcing the price regime: this pays producers, distributes goods to the consumers, and imports. The Government sets prices equal to the average of the open market solution: producer price is 275, and consumer price is 214. The effects on production and trade

  36. pan territorial prices

  37. pan territorial prices

  38. open ec and pan territorial prices, comparison Pan-territorial prices imply a net welfare loss compared to the open economy solution, despite prices were set at the same (average) levels. Moreover, the Marketing Board will suffer from a significant loss, that, in turn, will be suffered by taxpayers.

  39. pan territorial prices, comments Administrative costs must be added to the loss of the Marketing Board, suffered by taxpayers. The implementation of this policy would not be easy: it will be difficult to impose the prices to producers and consumers. In regions 1 and 3 the it will be more profitable selling directly to the consumers, because the difference between producer and consumer price (44) is greater that the local transport cost. Similarly consumers of region 2 will find more convenient to buy the product directly from the farmers. Implementation difficulties are likely to generate additional administrative costs.

  40. import parity prices The Government raises the producer price to the "import parity” level, e.g. to 275 for all producers in the country. This kind of provision can be adopted with several aims: e.g. • to promote an increase in the degree of self-sufficiency of the country • to support farmers income, if poor groups are mostly net food sellers. • in view of expanding the export capacity of the country. The effects on production and trade:

  41. import parity prices

  42. import parity prices

  43. open ec and import parity prices, comparison The country becomes an exporter. Gains for producers are larger than losses for consumers; but the high transport costs imply a significant loss for the Marketing Board. The transport business almost doubles its revenue.

  44. import parity prices, comments The overall welfare effect of the parity import price policy is negative, since the loss suffered by taxpayers (through the Marketing Board) are by far higher than the net welfare balance of producers and consumers. Consumption decreases by than 5.4% in terms of expenditure, and by 11% in physical terms. This can indicate that consumers are in a condition of relative abundance, since they reduced consumption rather than substituting food with cheaper alternatives.

  45. production and consumption subsidies The Government raises the producer price to the highest level in the country, i.e. to 268 (the level of region 3) for all producers in the country. The Government also wishes to support consumers, by fixing prices at the lowest level in the country, i.e. 210 (that of region 2). The country is a price taker, and world price is 275 This provision is adopted with the aim of supporting both agricultural producers and poor consumers, and to stimulate the growth of domestic supply. The effects on production and trade:

  46. production and consumption subsidies

  47. production and consumption subsidies

  48. open ec vs prod&cons subsidies, comparison Also in this case the country becomes an exporter, there are welfare gains for both producers and consumers; but the high transport costs and the price subsidies for both producers and consumers imply a significant loss for the Marketing Board.

  49. production and consumption subsidies, comments The overall balance of the policy is negative: the loss suffered by taxpayers (financing the Marketing Board) is greater than the net welfare gains of producers and consumers. There is a deadweight loss arising from resource misallocation. Both poduction and consumption increase significantly; in the long run this may give rise to investment in agriculture, and to further supply increases, while demand may slow down, as the population approaches satiety.

  50. adverse weather The same simplified model can be used to analyse other phenomena, like, e.g. supply or demand shocks. An example is that of weather condition, that affect agricultural supply. Bad weather affecting production can be represented through a supply shift. The effects on production and trade:

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