the analysis of agricultural price reform

Journal of Public Economics 35 (1988) l-24. North-Holland

THE ANALYSIS OF AGRICULTURAL PRICE REFORM

David NEWBERY*

Churchill College, Cambridge, UK

Received April 1986, revised version received August 1987

1. Introduction

Cost-benefit analysis and tax reform analysis are intimately related [see, e.g. Ahmad and Stern (1984), Drbze and Stern (1985), Newbery and Stern (1987, Chs. 2,3,6)]. The first seeks to value a change in net supplies produced by a project, the second to value the changes induced by a change in a tax rate, or, more generally, some policy instrument. In second-best economies, there are a set of assumptions under which the exercise is reasonably simple. Diamond and Mirrlees (1971) give conditions under which producer prices are the appropriate set of shadow or accounting prices to use in cost-benefit analysis. Ahmad and Stern (1984) give a similar set of assumptions under which the value of tax changes reduce to simple formulae. When these assumptions do not hold, the formulae include terms involving shadow tax rates - the difference between shadow prices and market prices. If shadow prices are proportional to produce prices the shadow tax terms vanish [Stern (1987, Ch. 3, eqs. 3-48-3-50)]. The conditions under which shadow prices are equal to producer prices are well known but clearly restrictive. The formulae for calculating shadow prices when these conditions do not hold appear formidable and do not inspire confidence in their applicability. It is easy to become pessimistic about the prospects for either project appraisal or policy reform analysis.

The main aim of this paper is to argue that the reform of agricultural prices presents an important example where the standard assumptions for the equality of shadow and producer prices fail, and yet where policy reform analysis is practical. It is therefore intended as a constructive contribution to the debate on the applicability of the techniques of social cost-benefit analysis and policy reform analysis. At this stage in the debate further

*Paper presented at the AUTE Conference, Cambridge, April 1986. I am indebted to comments by A. Braverman, N. Stem, and two referees, as well as the seminar audience at the AERC, Karachi.

0047-2727/88/%3.50 0 1988, Elsevier Science Publishers B.V. (North-Holland)

2 D. Newbery, Analysis of agricultural price reform

theoretical refinements are arguably less valuable than empirical demon- strations of the applicability of the method. The agricultural sector is important for a variety of reasons.

Government intervention in the agricultural sector is pervasive in both developed and developing countries. The distortions, measured as the devia- tion of domestic from world prices, are often impressively large [Bale and Lutz (1981), FAO (1984, tables B4,2)] and vary, often dramatically, between crops, between countries, and over time. Their diversity reflects the various ways governments trade-off competing objectives - of raising revenue, holding down urban food prices, providing producers with adequate incentives, redistributing income to the rural sector, stabilizing prices, achieving self-sufficiency in food production and the like.

Since the distortions are often large, and the performance of the agricultural sector, especially in sub-Saharan Africa, often leaves much to be desired, there is a growing belief that many, perhaps most of the distortions would be hard to justify by any reasonable set of social objectives. Instead these objectives could be better realized by radically reforming the whole pattern of agricultural policies. [For a strong statement see Schultz (1978), for a more cautious view see the World Bank (1982), or FAO (1984).]

Agricultural policy is therefore very much on the agenda for reform. The agricultural sector does not, however, satisfy the condition under which shadow prices are equal to market prices. For this it has to be possible to confront consumers and producers with different prices, and to set consumer prices (or taxes) optimally, and also either for there to be no profits, or for these to be optimally taxed. Agriculture price changes will have impacts on profits (land rents) and wages, in addition to the usual direct effects on consumers and/or producers. As it is typically difficult to set the producer and rural consumer prices of food crops independently, changes in food crop prices will involve both supply and demand responses, breaking the link between efficiency or accounting prices and producer prices. Finally, some agricultural goods, notably vegetables, are often non-traded (because of perishability and/or transport costs), and their prices are thus determined by supply and demand, rather than being set on exogenous world markets. Collectively, these amount to circumstances in which policy reform analysis may appear to be dauntingly difficult.

2. Policy reform analysis and optimal taxation

In principle, given a clear statement of the government’s objectives, and enough information about technology, trade possibilities and taxes, it would be possible to calculate the optimal set of agricultural taxes, subsidies, and price policies. In practice, the information requirements are formidable - not only does one need to know the constraints limiting the set of policy

D. Newbery, Analysis of agricultural price reform 3

interventions to those which are cost effective, but one also needs information about subtle and hard to observe features of the utility functions, such as their third derivative calculated at the optimum [Deaton (1981)]. There would seem to be two possible responses to these informational difficulties. The more ambitious approach would be to seek robust ‘satisfactory’ policies - policies which would achieve a reasonably high proportion of the maximum achievable level of social welfare for a plausibly wide range of utility functions and production functions consistent with the available data. This has yet to be systematically attempted.

The alternative, more modest objective, is to attempt to identify desirable directions of policy reform which are very likely to increase social welfare, provided the policy change is not ‘too large’. Here one can distinguish two types of approach, and two criteria for desirability. One approach calculates the effect of a possibly substantial reform, and evaluates the consequences. King (1983) estimates a model of housing demand and predicts the effect of eliminating the tax concession to owner-occupiers and rent subsidies to tenants in local authorities, and handing back the extra revenue as lump sum transfer proportional to initial household income. In the present agricultural context Braverman, Hammer and Ahn (1987) have calculated the impacts on producers, consumers, imports, exports, and government revenue of various agricultural price reforms in Korea. In each case, the object is to see whether the proposed reform is attractive, or which of a number of possible reforms is the most attractive. If the alternatives studied involve single interventions then these single interventions can be evaluated, but if, as is typically the case with sectoral policy reform, the alternatives are complete policy packages, then it may be hard to identify the elements of the package which are most desirable, and those which should be dropped.

The second approach, which addresses this issue directly, is to identify the set of policies which are welfare improving rather than preselecting the policies and then evaluating them. The change of emphasis is slight but potentially important, especially for the analysis of a complex issue like agricultural policy reform. Most studies in this vein consider small (strictly, infinitesimal) policy changes, rather than discrete changes. This has the significant practical advantage that only local knowledge about production possibilities and preferences are needed, rather than knowledge possibly outside the range of observational experience.

The weakest criterion of desirability is to look for directions of reform which are Pareto improving - that is, make no one worse off and some better off. Guesnerie (1977) Dixit (1979) Guesnerie and Tirole (1981), and Smith (1983) discuss this problem for a simple production economy, whilst Sah and Stiglitz (1987) examine the possibility of Pareto-improving agricultural price reforms. Obviously, if Pareto improving reforms can be identified, they are likely to have strong appeal.


If the government’s social welfare function can be specified (perhaps not very precisely) in terms of measurable quantities (most obviously, standards of living of various individuals) and if the effect of various policy instruments on these quantities can be calculated, then it becomes possible to rank alternative directions of reform in terms of their increase in social welfare per unit of public revenue cost. Ahmad and Stern (1984) develop a simple but powerful method for doing this for a simple production economy, and apply it to Indian data to see which broadly aggregated commodity taxes should be raised or lowered given varying attitudes to inequality aversion. They also identify Pareto improving tax reforms (distinguishing 9 commodity groups and first 9, then 28 groups of consumers. Clearly, as the number and variety of groups of consumers increases, it becomes harder to find Pareto improvements.)

Their approach, which serves as a model for that developed in this paper, is quickly described. Consider an economy in which producer prices are fixed and with constant returns, so that the constraints on production feasibility are represented by the government budget constraint. Let t be a vector of policies, and let Vh(t) be an indirect utility function for household h: the maximum level of welfare achievable given resources, production possibilities, and preferences, when the policy choice is t. Government revenue, R(t), is also a function of t. Consider an infinitesimal feasible change in instrument ti, that is, a move to a new equilibrium in which aggregate demand does not exceed supply. Let social welfare be a Bergson-Samuelson function of individual welfare, and examine the impact of the change on social welfare, w and government revenue:

(1)

The social marginal cost of raising a unit of government by changing instrument ti is

A,= _ aWla4 I aRlati .

If for the set of tax instruments which may be varied, the values of li differ, then socially desirable tax reforms are possible. If not, then the tax structure is optimal for the specified social welfare function. If the &‘s are ranked with &>;I,> . . . >A,, then a revenue-neutral change which increased t, and


reduced t, would generate a social gain of 1, -A, per % of revenue switched. This would be the largest gain per $ switched, and in that sense it is ‘the most desirable’ reform. As t, and t, are further adjusted, there will come a time at which A1 is driven down to & and/or 1, is taised to &-l, at which point t,, t, and/or tn_l, and t, should thereafter all be adjusted. It may well be that the larger improvement in social welfare may come from a lower ranked policy (because, for example, it has a larger base), and it may be that if only two (or a few) taxes could be changed, then these lower ranked alternatives may be preferable. All this means to say is that there is no natural metric of desirability of policy reforms, and the ranking proposed here is only one piece of information useful in proposing reforms [this point is elaborated in Ahmad and Stern (1984, p. 261)].

Ahmad and Stern (1984) modelled the Indian economy on the assumption that producer prices, pi, were fixed and there were constant returns to scale, so that consumer prices, qi = pi + ti, responded in a particularly simple way to changes in the tax rates, ti. Specifically, aqj/ati=O, j# i, and aqi/8ti= 1. If x: is the consumption of good i by household h, and ah is the private marginal utility of income to h, then, by Roy’s identity

(4)

where b” is the social marginal utility of income of household h, Xi is aggregate consumption of good i, and Di = I,, /?h~)/xA XT is Feldstein’s (1972) distributional characteristic of good i. Di is a measure of the extent to which the good is i relatively heavily consumed by the socially more deserving (those with high bh).

Given the simple responses of consumer prices to tax changes, the revenue impact is easily calculated, for if R = Ci tiXi, then

li=Di

(5)

(6)

The 2’s may be calculated from household budget data (which allows one to calculate the D’s), tax information (for the t’s) and estimates of demand elasticities (about which more later).

The main difficulty with extending this tax reform approach is that the proposed reform must be feasible. In general, if any tax is changed, then all


demands, supplies, and marketing clearing prices will respond, the distribution of income will alter, and government revenue will change. For traded goods, the balance of trade will typically alter, requiring either an equili- brating change in the exchange rate, an offsetting government response, or an intertemporal adjustment by lending or borrowing. The reform must therefore specify how the government reacts to these changes, and how the extra government revenue is to be spent (or the shortfall financed). There will typically be a large number of possible answers to this question, and hence a large element of arbitrariness to the evaluation of any reform. The same problem arises in cost-benefit analysis, where a public sector project will require the government to take some accommodating action to preserve feasibility, making the shadow prices depend on the nature of government policy responses to the project [see Sen (1972), Blitzer, Dasgupta and Stiglitz (1981), and the response by Dinwiddy and Teal (1987), Hammond (1986), and Dreze and Stern (1985)]. Nor is it enough to argue that where the project or reform has a second order effect on prices outside its area of direct impact, these price changes can be ignored, for their total impact can be significant [Bradford (1978)].

The close connection between tax reform analysis and project appraisal has already been noted, and the constraints on the public sector which ensure the feasibility of a tax reform or project can be captured by a set of

accounting prices. The difficulty, of course, is to calculate these shadow prices for the case in which they are not equal to producer prices.

The approach suggested here is a direct application of the Little and Mirrlees (1974) method of cost benefit analysis. The economy is divided into two sectors - the modern sector (effectively the urban sector), which is assumed to produce competitively under constant returns with one non- produced factor and faces fixed world prices for traded goods, and the rest of the economy (the rural sector). Any policy change may lead to price changes in the rural sector, but since urban prices are fixed, will only lead to quantity changes there. Further, as in Little and Mirrlees, the government budget constraint is equivalent to the balance of payments constraint (measured in appropriate prices) and, as in Ahmad and Stern (1984) encompasses the urban production constraint. The strategy is to follow the impacts of any policy change to the point at which it affects the urban sector budget constraint, at which point it can be consistently valued. Welfare impacts will be valued by determining the various price response, as in (1). The strategy is akin to the Little and Mirrlees approach of tracing all project impacts through to their final impact on the balance of payments.

The rural impacts of any policy change will differ from the (4) in two ways. The first point is that for farm households, a change in a producer (and rural consumer) price pi will lead to a change in net trade, with production typically adjusting as well as consumption. If ~3 is production of good i by h,


then xf in (4) is replaced by zf =x) -y:, or by net purchases. (For production goods, Zi will typically be negative, corresponding to net sales.) The revenue response, aR/&, will in turn depend on net trade elasticities rather than simple demand elasticities, but overall the model is formally equivalent to treating the farm-household just as a more complicated consumer with net trades generated by its production and consumption, rather than endow- ments and preferences.’

The second modification is that most agricultural policy interventions (such as changing the price of an agricultural input or output) will lead to changes in other prices and in the wage rate. Eq. (4) thus becomes

aw api=y j h CD( 2,?4’+(,.-1”)aw = _

api aPi ) ( p)Z.a4j+D,Z,W J JaPi > aPi ’ (7)

j

where Zj is aggregate net purchases, Dj-c /?“zt/Zj, p is the vector of producer prices (equal to rural consumer prices for grains), q is the vector of prices facing consumers, Z“ is the demand for farm labour, so z = I”- Ih is demand for net hired-in labour, whose distributional characteriitic is D,.3 The revenue response aR/ap, can similarly be evaluated, but will take a rather complex form without further simplifying assumptions. If only net trades 2 can be taxed and if the vector of shadow prices is p (where these are the opportunity cost to the government of meeting the net demands Z from imports or reduced exports) then

(8)

where q is the vector of prices facing agents, equal to the producer prices for rural goods. Thus, q-p is the implicit tax on net purchases, the counterpart to t in (5). When pi changes, the wage rate and some of the qj’S will also change, and net trades Z will change because prices q change, wages change, and rural money incomes change. If taxed goods are either traded at fixed world prices, or produced under constant returns in the non-agricultural sector with unchanged producer prices, and if non-traded rural goods are untaxed, then atj/dpi = 0, j # i. In this case

‘Diamond and Mirrlees (1971, p. 25) demonstrated that defining the production sector as the set of activities whose consumer prices could be. varied independently of producer prices, and by including all non-taxed activities in the consumer sector, their model could be reinterpreted and applied to economies with an untaxed agricultural sector.

*The convention is that superscripts refer to households (h), agriculture (or the rural sector) (a), or the urban sector (u).

sDj and Dr are defined as before, but over net trades, to show the essential similarity of approach. For non-traded goods, however, Z will be zero and it is necessary to either work with ~/3*z” or divide by aggregate consumption.


(9)

The second term in (9) is the supply response of output to changes in the wage rate, and can be calculated from the profit function, for aYJaw= a*ZI/awap,. The last term is the extra tax revenue collected as a result of the increased expenditure on taxed goods caused by the change in (rural) incomes. This in turn can be evaluated, for

where Jo is the marginal propensity to spend out of extra (rural) income, bj: is the marginal expenditure share on good k, y: is output of good j, and Pj is the output price facing the farm household for production goods. If the farm sells labour, then q will be the net sales of labour services, and p,= w, the wage. In the case of Korea these labour services are assumed to be transformed one-for-one into rural handicrafts, and in that case the labour sales are equivalent to the output of rural handicrafts.

Finally, if the bh’s are the same for all rural households, (equivalent to assuming parallel linear Engel curves for all goods, as in the Linear Expenditure System) then the final term in (9) becomes pr’bxj yaapj/8pi where r is the vector of implicit or shadow tax rates, zl,=(q,--pJq,.

The next step is to evaluate the price responses aqj/api, j# i, for the untaxed non-traded goods (which, given the simplifying assumptions, are the only goods whose prices respond to policy changes). If N is the set of non- traded goods, then Z, = 0, k E N defines the market clearing conditions, and

7: ?=O, k, jEN, all i. J 1

Under normal circumstances given the aZ,/aq, these equations can be solved for aqj/dpi.

3. An application to Korea4

In 1979, the year chosen for the analysis, Korean agriculture accounted for

4The analysis reported here relies extensively on the analysis and estimates of Braverman, Ahn and Hammer (1983) and Braverman, Hammer and Ahn (1987). A fuller account of the assumptions and data manipulation is contained in Newbery (1987).


about 16% of GNP and 30% of the labour force. The dominant crop was rice, but despite a rapid increase in production during the 197Os, rice imports were still needed to meet domestic demand. Barley is a much smaller crop, but also normally in deficit supply. The Korean government, aiming to reduce rice and barley imports and protect the incomes of rural farmers, set the farm purchase price of barley and High Yielding Variety rice (HYV), substantially above import parity. The urban sales prices of both crops were also fixed by the government at a level below the cost of domestic supply, but above the import cost. Although the Grain Management Fund (GMF) makes a profit on selling imported grain, the losses made on domestic purchases far outweigh these profits, and amounted to about 0.7% of GNP in the late 1970s. Fertilizer is domestically produced at high cost and sold under long-term contract to the government, which sells it to farmers at a loss. Surplus fertilizer is exported at a loss and as a result of these losses the Fertilizer Fund ran a deficit of about 0.2% of GNP in 1979. Finally, farmers also grow traditional varieties of rice (TV), which account for 30-50x of total rice production, and which are freely marketed but non-traded. Consumers prefer TV to HYV rice, and pay a sufficient premium over the urban sales price of HYV rice to induce farmers to produce the lower yielding (and hence more costly) TV rice as well as the subsidized HYV rice. The government controls imports (and exports) of grain and fertilizer and sets the urban and rural prices to stabilize prices through the crop year. The effect of this is to make private storage of HYV rice and barley unattractive and forces the government to bear most of the cost of storage. Since TV rice is freely marketed (and storage costs are thus privately borne) it seems likely that TV rice will be sold and consumed in the first part of the crop year, whilst HYV rice will be stored until demanded later in the year.

4. Policy analysis

We are now in a position formally to specify the problem, which is to calculate the social cost of increasing government revenue by one unit by changing one of the policy instruments in the appropriate direction. Goods are numbered 0, 1, 2, 3, 4, 5, 6 for fertilizer, barley, HYV rice, TV rice, other crops, rural handicrafts, and other goods. The convention is that producer prices are p, and consumer prices, where different from the producer prices, are q. The policy instruments are the price of fertilizer (p,,), the rural producer prices of barley (pr) and HYV rice (pZ), and the urban consumer prices of barley (ql), and HYV rice (qJ. Table 1 summarizes the relevant prices, policy instruments and their determination, and rests on a number of assumptions which will be briefly mentioned [a fuller account is available in Newbery (1987) and Braverman et al (1983)]. Barley and rice are assumed


Table 1

Determinants of market prices.

Good Type

Rural Urban price price How determined

Fertilizer Barley HYV rice TV rice Other crops Rural handicrafts Other goods Rural labour

Exported Imported Imported Non-traded Non-traded Non-traded Traded Non-traded

PO Pl PZ P3 P4 P5 q.5

w

41 q2 q3 q4 45

qs

Policy instrument Each a policy instrument Each a policy instrument

~3 = kp,, q3 = ~3 + cj= P4=Pl> q4=p4 P5’W> 45=p5

Fixed by world price and tax system Fixed or endogenous

‘cs is the handling cost from farm to urban consumer. k= 1.114 is the ratio of the production cost of TV to HYV rice.

non-competitive for land, as they are grown in different seasons. The two kinds of rice, HYV and TV are perfect substitutes in production in that the yield of HYV is k times that of TV, or the production cost per kg of TV is k times that of HYV. In equilibrium they yield equal expected profit per hectare, and the lower yield of TV is compensated by a higher farm gate price. These assumptions have strong implications for the cross price

responses Qj/8pi. Specifically, raising the producer price of barley has no direct effect on the supply of rice and vice versa. TV rice is treated as non tradeable, though this appears to be a policy decision - at present imported rice is apparently stored until its quality has declined to that of local HYV rice. In the long-run equilibrium, the producer price of HYV rice determines that of TV rice (to make each equally profitable), and also the consumer price of TV rice. Given the consumer price of HYV rice (fixed by the government), the demand for TV rice then determines the equilibrium supply of TV rice. The remainder of the rice land is then used to produce HYV rice, and the excess demand for HYV rice is met by imports.

Other food crops are assumed to be competitive with barley for land. A rise in the producer price of barley is assumed to raise the supply price of other crops by an equal proportional amont (because, in the absence of any information on the structure of costs for those other crops, they are assumed to be the same as for barley).

The response of wages to food price changes will be important in determining the desirability of policy changes, and a wide range of alternatives might be defended under various assumptions about the time frame of the analysis. The two extreme cases considered are either that the rural money wage does not respond at all to rural price changes (corresponding to a perfectly elastic supply or demand for rural labour at a fixed money wage) or that the rural labour supply is completely inelastic, and the wage is deter-


mined by the demand for rural labour, which will respond to price changes. Braverman et al. (1983), who consider the same two cases, argue that reality presumably lies between these extremes. We also follow Braverman et al. rather than van Wijnbergen (1987) in assuming that the urban money wage does not change in response either to changes in the rural wage (i.e. the supply price of labour) or the urban food prices (i.e. to changes in the urban real wage).

Finally, farmers supply a significant fraction of their labour to off-farm activities, and it is assumed that this labour is used to produce rural non- agricultural goods (handicrafts) under constant returns to scale using no other inputs, so by a suitable choice of units the output of rural handicrafts can be measured by its labour input. Again we suppose that those goods are non-traded and untaxed, and so its unit (producer and price) will be equal to the wage rate w.

For the present illustrative exercise, all goods produced outside the rural sector will be aggregated into a composite ‘modern sector’ good, and all remaining indirect taxes averaged to give the rates of taxes to the tax- inclusive price of 15.3% [Newbery (1987, table 18.3)]. All modern goods are assumed to be produced by a single factor under constant returns (or traded at constant world prices) so that their prices do not respond to agricultural policy reforms. Table 1 indicates that the only non-zero cross-price responses aqjfapi are:

5. The choice of policy instruments

When studying the reform of a system of indirect taxes, the natural policy instrument is the tax on a particular good as specified in the tax laws. In Korea, as in many other countries, the prices of grain and fertilizer are set by government agencies, and the difference between these prices and the border price (adjusted for transport and handling costs) is the implicit tax or subsidy. It is therefore simpler and more logical to treat these prices as the policy instruments, rather than the implicit (and potentially very variable) taxes. These domestic prices are announced at the start of the crop year and held constant regardless of movements in the world market price. One can either investigate the expected social cost of increasing revenue by changing the regulated prices appropriately, given the level of world prices expected at the start of the crop year, or one can ask what the actual social cost was, given the prevailing world prices and exchange rates. The difference between the two may be large, as the coefftcient of variation of the real export price of Thai rice was 38% over the ten years 1970-79.


Given the way agricultural price policy is implemented, the natural approach is to calculate the ex ante expected social cost of alternative policies. If the government were to abandon its attempt to stabilize prices, and were instead to impose ad valorem or unit import tariffs on grain (together with subsidies to urban consumers), so that domestic prices fluctuated with world prices, then the ex post social cost would be the appropriate measure. This obviously raises the whole policy issue of how best to intervene in unstable markets - a large subject which is addressed in Newbery and Stiglitz (1981). Tolley, Thomas and Wong (1982) discuss the costs of the Korean seasonal price stabilization policy, which results in too much storage undertaken at excessive unit cost. It seems likely that one Pareto improving policy reform would be to switch from domestic price stabilization to one of allowing domestic prices to respond to world market prices, together with some kind of income insurance scheme for farmers, though it must be admitted that the issue of how best to stabilize ,food crops in poor countries requires further research. In the present paper this policy is not examined, and only the expected social costs of alternative fixed price policies are calculated (though it would be easy to calculate the ex post social costs).

Table 2 gives the estimated price structure and implicit tax rates on the maintained hypothesis that the government believed the relevant opportunity cost of imports or exports was the ten year average real border price (the ex ante assumption shown in column A) and the alternative ex post assumption of the actual border prices. The details of the cost structure are to be found in the cited source.

The shadow prices in table 2 measure the opportunity cost at border prices. Thus the urban shadow price of barley in column A is the assumed world price of 90 plus handling and storage of 22, giving 112. The excess of the market price over this shadow price gives the shadow consumer tax, i.e. the implicit tax on urban consumers.

Urban consumers are supplied both by imports and domestic production, and the value to the economy of both sources of supply must be the same at their point of common sale, i.e. at the urban wholesaler. The shadow value of farm gate grain is thus the urban shadow price less transport and handling costs from the farm to the urban wholesaler. Given the seasonal price stabilization, farmers will sell their surplus immediately after harvest, and its value or farm gate shadow price is then the import price plus costs from the port to the wholesaler, minus rural handling costs, and is also shown in table 2.5

‘The calculated subsidy rates are somewhat lower than shown in Newbery (1987, tables 18.1 and 18.6). The main reason is that domestic storage costs in table 1 are effectively calculated on the urban shadow price of grain, rather than on the actual rural purchase price. The present assumption is equivalent to assuming that domestic and imported grain compete in urban areas over the whole season. The assumed period of storage is also shorter than the 12 months of Newbery (1987).


Table 2

Market and shadow prices in Korea, 1979 (1979 won/kg).

Barley HYV rice Fertilizer

A B A B A B

Assumed world price Handling and storage Urban shadow price Urban market price Shadow consumer tax Consumer tax

consumer price Differential handling

costs Farm gate shadow price Farm gate support price Shadow producer subsidy Producer subsidy/

support price

90 (68) 242 (139) 117 (100) 22 (18) 72 (31)

112 (86) 314 (170) 132 404 20 (46) 90 (234)

0.15 (0.35) 0.22 (0.58)

10 10 15 80 (58) 232 (129) 132 (115)

260 375 109 180 (202) 143 (246) 23 (6)

0.69 (0.78) 0.38 (0.66) 0.21 (0.06)

Notes: Column A gives ten-year average real border price, Column B (figures in parentheses) gives actual world prices in 1979, and costs for efficient levels of storage. Barley and rice are imported, fertilizer is exported. Barley is assumed to be stored on average 6 months, HYV rice 9 months. (Ellicient storage levels are assumed to be on average 6 months.) Storage costs 3% per month, handling costs are 5 won/kg from farm gate to urban wholesaler, 15/kg from farm gate to urban wholesaler. Differential handling costs are the excess of costs from farm gate to urban consumer over cif to consumer, and are deducted from the cif price to give the Lrm gate shadow price. Fertilizer prices are for a weighted average of urea and DAP.

Source: Newbery (1987, table 18.1, 18.2).

6. Calculation of supply responses and wage changes

The response of net demand 2 to price changes will depend on output or supply responses and consumption or demand responses. The supply responses can be derived from the profit functions Z7”(p, w). With detailed microeconomic data it might be possible to estimate profit functions for the various crops and hence estimate the various supply responses as discussed by Deaton (1987). Fortunately, Braverman et al. (1987) report that they found little difference in their results when they replaced the estimated translog profit function by a Cobb-Douglas function, which has the great merit of only requiring data on average input shares. Since it considerably simplifies the formulae we shall follow them and assume a Cobb-Douglas production structure for each crop. The aggregate profit function is assumed to be

(11)


where Ki is land allocated to crop i. The supply responses can then be derived from the profit function in terms of the share parameters aie,qi,vi, as follows. Outputs (and inputs) can be recovered from the profit function by differentiation - yi= an/+, - and the response of output r;. to, for example the price of fertilizer, pO, is given by c?J~/c?P~. The same approach can be used to find the impact of prices on the wage rate and hence on the price of rural handicrafts.

Rural labour supply can be freely allocated to agricultural production or to the production of rural handicrafts, Y5, (i.e. to rural non-agricultural employment), produced under constant returns by labour alone and untaxed. By a suitable choice of units the output of handicrafts can thus be measured by its labour input, or conversely, and its unit (producer and consumer) price will be equal to the wage rate, w. The demand for agricultural labour (L”) can be found by differentiating the profit function, II. Thus if total inelastically supplied labour is L:

L=L”+ Y,=II,+X,. (12)

The effect on wages of changes in agricultural prices can be found by differentiating (12) with respect to pi and making use of the form and properties of the profit function (11). Provided the marginal expenditure share of rural households on rural handicrafts is constant across households at b,, as is the marginal propensity to spend out of income, p,

z ( = E,i) ,(I + VJ(l + 4slvJLi +EL;~(XL;IXS)LS 1 ~(l+vi)Lt+(-E~~-~b~)Ls

(13)

The data in Newbery (1987) give values for the parameters which, when substituted, give

p1 aw E =--0.09, ~,,=%=0.32. wlmwapl I

These figures would be substantially lower if rural handicrafts were tradeable (which would increase the price elasticity, sS5, substantially). The effect of fertilizer prices on wages can similarly be calculated, and shown to be negligible.

7. Demand responses

The net trade responses also depend on consumption or demand responses, i.e. elasticities. Own price and income elasticities for cereals have


been estimated from time series data, by Braverman et al. (1987). The budget shares oi are available from the Statistical Yearbook, whilst the expenditure elasticities ei can be estimated from the cross-section data. (Time series data are also available.) It remains to calculate the nature of cross-price responses or elasticities, and the simplest (and effectively, the only) method available is to suppose that cereals (goods l-3), non-traded rural goods (goods 4 plus 5) and other goods are additively separable. In that case the demand price elasticities are [from Deaton and Muellbauer (1980, p. 138)]

Eii = dei - eiwi( 1 f &+), i = C, n, 6,

Eij = - efBj( 1 + 4ej), i# j, (14)

where subscript c refers to cereals, the appropriate sub-aggregate of goods 1-3, n refers to non-traded rural goods (the sub-aggregate of 4 and 5) and the e, are expenditure elasticities. The parameter 4 can also be found from these equations, using the information for E,, and e,. The remaining demand elasticities can be calculated as follows. Weak separability between goods in group c (cereals) and the other two sub-aggregates implies that the elements of the substitution matrix sij satisfy sij=s:jxiei/(PjeJ, ~EC [Deaton and Muellbauer (1980, pp. 128-129) and hence the compensated elasticities .s$ are E$ = Sijpj/Xi = .s~jei/ec = - Ojeiej4 from (14). The uncompensated elasticities can then be found from sij=$-- eioj, and the remaining elasticities calculated.

8. The marginal social cost of raising revenue

We are now in a position to calculate the marginal social cost of raising revenue by suitable changes in the policy instruments. The easiest case to consider is raising the farm gate price of fertilizer, p,,. For this case a4j/apo = 0 except for j = 0 and dw/dp, is negligible. From eqs. (8), (10) and (11)

1 aRiap, -=-----= 10 (

~+z~o(Pi-Pi)~-@byO DfJyO. awlap, >I

The supply responses ax/ap, can be calculated from (11) and substituted to give

A,=D, (15)

where OS, is a weighted average fertilizer share.

16 D. Newbery, Andysis of agricultural price reform

Changing the rural producer price of barley changes the rural consumer price of barley, and both urban and rural prices of other crops (good 4) and rural handicrafts (good 5). The welfare impact is thus

where X7 is rural consumption of barley. Since 2, = 0= Z, the only welfare impact of these consequential price changes is the net distributional effect captured by the c/I huh terms, and since these are small they can virtually be ignored. It is convenient to aggregate goods 4 and 5 into a simple non-traded good (subscript n price p,), since there is little information that allows them to be accurately distinguished, and since as untaxed goods with zero aggregate net demand they play a minor role in the analysis. With this minor simplification the revenue impact of changing the rural barley price is

~=xT-yl+ f (Pi-&) az; az; apn

1 i=l [ ( dp+dpdp 1”l )

(16)

Again, superscript a refers to the agricultural sector, u to the urban sector, z::+x::=o,pn=qn, and urban and rural shadow prices are now distinguished. The producer price of barley affects only rural households directly, but all households via changes in the price of the non-traded rural good. The second to last term is the supply response induced by wage changes (since q= anlap,).

In the case of the producer price of HYV rice there is an additional impact, since both the urban and rural prices of TV rice will also change. The welfare impact is

- awiap, = z m.eh - ~9 + 2 ~uh-e waP2 + T bhzh, a4JaP2, (17)

where subscript r refers to total rice, and where indicated the aggregation is over agricultural, urban, or total households. The urban TV rice price response, aq3/apz = k( = 1.114). The revenue impact is

$=x;V;+i~l (pi-pp4) &-+(3pF [ ( az; azq apn 2 r n r >

D. Newbery, Analysis of agricultural price reform

+(qi-p;) x,+ax,ap, ( aq3 ah ah )I ( a-5 + 8x4 I 8x6 @” +t, _ _ apr aq3 84” ah >

17

(18)

Urban cereal price changes can affect the rural sector in two ways, for they can affect the demand for non-traded rural goods, and the relative attractiveness of migration (i.e. direct demand for rural labour). The second route is ignored by assumption (but may well be important) whilst the first is quantitatively negligible. The analysis of urban price changes is thus greatly simplified and the marginal social cost of raising revenue by increasing the urban barley and HYV rice prices are given by

p= Cs”“xT Xi + 1 tj aXj/aqi'

i= 1,2. (19)

where tj = qj - pr for cereals.

9. The calculation of social weights

For illustrative purposes we assume that the social weight is based on real per capita consumption. Three difficulties arise in comparing real consumption levels in the urban and rural sectors - there are substantial differences in hours worked (or recorded), there may be differences in savings rates, and possibly also in prices. Rural hours worked seem to be one-half urban hours, which reflects the seasonality of agriculture, and possibly the under-recording of other productive activity. Savings rates are 25% in the rural sector, but about 22% in the urban sector [Korea Statistical Yearbook (1980, pp. 97, 418, 423)] and hence the difference in savings rates is apparently not as large as might be expected.6 Even for urban daily labourers, reported consumption is 83% of income. Cereal prices may be somewhat lower in urban areas, because of subsidies, but, as table 2 shows, the subsidies largely offset transport costs, and for other agricultural goods the converse is probably true. Thus in the face of it the main difference between the two sectors lies in the number of hours worked. It is likely that a rural hour of work is more demanding or unpleasant than an urban hour, and so the difference in disutility may not be as great as the difference in hours observed.

Our solution is to consider two alternative assumptions. The first is to

6However, van Wijnbergen (1987) reports substantial differences in marginal propensities to save out of rural or urban incomes when estimated from aggregated time series data. The figures reported above are estimated from cross-section data, and hence are consistent with the other elasticity parameters.


value possibly enforced rural leisure at one-half the rural wage rate (of 411 won/hour), assuming a worker has 2,200 hours available per annum (urban workers average 59 hours per week). This leisure is calculated as the residual after deducting recorded agricultural hours worked (assumed at the going wage rate), and its value is shown in table 3. The alternative assumption is to ignore the differential rural leisure and this reverses the relative position of the average urban and rural consumers. (Average per capita urban expenditure is 372,000 won p.a., average rural expenditure is 421,000 won p.a. including leisure, 320,000 won p.a. excluding leisure.) The fact that migration is from rural to urban areas suggests that the second alternative may be more plausible, though it still seems true that the poorest urban group is poorer than the poorest rural group.

Three different sets of social weights were calculated, representing a range of views about the desirability of redistributing income. The social weight of household h, enjoying consumption eh, is given by Bh=(eh/4--E where C? is the consumption of the poorest rural group, or 371,OOB won p.a. (By coincidence this is almost exactly equal to the average urban consumption.) The parameter E measures the degree of inequality aversion [Atkinson (1970)], and values of E = 1, 2, and zero are taken. When E = 0, b” = 1 for all h, and the government is assumed to be uninterested in improving the distribution of income. It can be interpreted as identifying the pure efliciency effects of the policy reform. The various social weights are also shown in table 3.

10. Quantifying the social cost of raising revenue

The Korea Statistical Yearbook for 1980 gives most of the data needed to quantify the terms in the formulae, and the remaining data were taken from Braverman et al. (1983, 1987) (especially the supply elasticities, and the division between HYV and TV rice). The data are given in full in Newbery (1987). The implied values for the impacts and the social cost of raising government revenue are presented in table 4. The social costs (the values of &) take the full consumption per capita of the poorest rural groups as numeraire, and these values can be compared with the social benefit of giving a uniform lump sum transfer to everyone, shown in the last line of table 4. (These social benefits take account of the tax which is paid on the extra expenditure, as can be seen most clearly in the final two columns which ignore distributional considerations.) If the social cost of instrument i, &, is lower than this social benefit, then it would be desirable to finance an increased lump sum transfer by raising more revenue from policy i. (An alternative way of presenting the results would be to take the social value of the lump sum transfer as the numeraire.)

Eight alternative estimates are shown, and give some idea of the sensitivity

Tab

le

3

Exp

endi

ture

an

d so

cial

w

eigh

ts.

Rur

al

grou

ps”

Urb

an

grou

ps”

+ k Pe

r ca

pita

co

nsum

ptio

nb

292

299

316

353

433

248

321

412

604

a kz

incl

. le

isur

e 37

1 40

7 42

1 44

3 55

2 24

8 32

1 41

2 60

4 2.

Soci

al

wei

ghts

%

&

= 1

8”’

1 0.

91

0.88

0.

84

0.67

1.

50

1.13

0.

90

0.61

&

=2

1 0.

83

0.78

0.

70

0.45

2.

24

1.29

0.

81

0.38

excl

. le

isur

e E

= 2

1.61

1.

54

1.38

1.

11

0.73

j. 2

“Rur

al

grou

ps

are

defi

ned

by

size

of

far

m,

urba

n gr

oups

by

in

com

e.

h -u

%on

sum

ptio

n le

vels

ar

e ‘0

00 w

on

p.a.

fo

r 19

79.

‘Num

erat

or

is c

onsu

mpt

ion

of r

ural

gr

oups

1.

So

urce

: N

ewbe

ry

(198

7,

tabl

es

18.4

, 18

.5).


of the results to the social weights, the operation of the rural labour market, and the valuation of rural leisure. In one case the rural wage is assumed not to respond to any of the policy instruments, whilst in the other case it responds strongly, as calculated above. The extent to which the price of rural goods p,( =qJ responds also depends on the size of the wage response.

In all the eight cases considered in table 4, the most desirable way of increasing government revenue appears to be to reduce the support price of barley, pi, which has the lowest value of 1. The ranking of the next two most attractive policies depends on whether the rural wage is sensitive to agricultural price changes or not. If the wage does respond, then it is better to raise the price of fertilizer (p,,) rather than lower the support price of HYV rice (p2). If the money wage rate remains unchanged, then it is better to lower the rural rice price rather than raise the fertilizer price. It is always better to change agricultural prices than urban consumer prices, and, in the

Table 4

Magnitude of policy impacts.

Inequality aversion E

Wage response? Rural leisure valued? Alternative

1 2 2 0

No Yes No Yes No Yes No Yes Yes No n.a.

(1) (2) (3) (41 (5) (61 (71 (8)

Revenue impact $ g I L

pO fertilizer p, barley support pz rice support q1 urban barley q2 urban rice

1.480 - 2.354 - 2.243 - 1.084 -1.003

0.972 0.800

I aw Welfare impact - -

I: av, . . PO PI P2 40 q2

Social cost of revenue pO fertilizer p, barley support p2 rice support q1 urban barley q2 urban rice Social value of uniform lump sum benefit j?

-0.863 0.307 0.746 0.484 0.894

- 1.1545 - 1.256

0.58 0.58 0.13 0.33 0.45 0.89 1.19 1.19 1.57 1.57

1.22

-0.755 - 1.297 -1.0 0.076 0.472 0.747 1.351 0.75 1.24 0.257 0.567 0.788 1.388 0.39 0.78

- 1.400 - 1.0 - 1.554 - 1.0

0.51 0.51 0.88 0.88 0.68 0.68 0.03 0.21 0.32 0.60 0.32 0.55 0.24 0.56 0.73 1.38 0.36 0.78 1.44 1.44 1.44 1.44 1.03 1.03 1.94 1.94 1.94 1.94 1.25 1.25

1.38 1.58 1.26

Note: Blank spaces can be completed by repeating the appropriate number given in the row.


urban sector, it is better to raise the price of barley than rice. It is always better to reduce rural subsidies and use the money to finance lump sum transfers, but it is even better to reduce lump sum transfers in order to lower urban rice prices.

11. Sensitivity to other assumptions

Table 2 also gives the actual tax and subsidy rates for 1979, compared to the central estimates used in the calculations of table 4. If these are used then the revenue impacts change (but not the welfare impacts). With zero inequality aversion (i.e. ignoring distributional considerations) the ranking of policies pi and p2 is reversed when the wage response is ignored, and of pO and pZ is reversed where the wage is assumed to respond. At an inequality aversion of two, valuing rural leisure, there is no change in the ranking ignoring the wage response, but again policies PO and p2 switch when wages respond. If rural leisure is not valued, then the rankings are unaffected.

Thus the ranking of some policies does depend on the assumptions made about the expected import and export prices, though it remains true that it appears desirable to lower urban and rural cereals prices.

The next most sensitive assumption is that the price of other crops is assumed to move with the support price of barley. If instead its price does not respond at all, then the social cost of lowering the barley support price rises by an amount comparable to including the wage response, though this does not alter the policy ranking. Part of the reason for this is the strong cross-price effect implied by the additivity assumption, and if this is set at zero the effect is unsurprisingly about the same as assuming a zero price response.

Apart from this cross-price response, the other cross-price terms, which are so difficult to estimate, have a relatively small quantitative effect, and do not affect the policy rankings.

12. Conclusions and lessons

Several lessons emerge from table 4. First, though the numerical values of the 2s are quite sensitive to all three assumptions (on the social weights, the responsiveness of the rural wage and the valuation of rural leisure) the ranking of policies is fairly insensitive, as the only policy whose rank changes is reducing the fertilizer subsidy. In part, this robustness is illusory, for if a wide range of policies were also under consideration which were relatively insensitive to these assumptions, then the relative attractiveness of these agricultural price policies might depend quite sensitively on these assumptions. The ranking of the policies does not change with the social weights *


over the range considered (inequality aversion from zero to two) which means that the ranking of the desirability of policy interventions would be the same if it were judged solely on efficiency grounds. At least over the range considered, there is no obvious conflict between equity and efftciency. The reason is that the most distortive subsidies most benefit the relatively quite well off rural producers, and the most distortive taxes fall most heavily on the rural poor. At very high levels of inequality aversion this would change, for the poorest group is in the urban sector, and, although the data are not available, it seems likely that barley would have the highest distributional characteristic. Lowering the urban barley price might be the most desirable reform (the highest I), and lowering the producer price of rice (which lowers the urban price of TV rice) might be the least cost way of raising revenue (and, indeed, would have a negative cost).

Second, the rural policies are remarkably cheap ways of raising revenue, for the double reason that the distortions are large and the standards of living of the rural poor appear higher than those of the urban poor. Only if

rural leisure is not valued and the wage responds to agricultural price changes is the social cost of raising revenue from the rural sector ever greater than 1.0 in table 4. Even in this case it is still below the value of uniform lump sum subsidies to everyone, or the cost of a uniform lump sum tax. Conversely, raising taxes further on urban rice is a very costly way of raising revenue, or, equivalently, it is very desirable to lower these taxes.

The other main lessons to draw are first, that it appears reasonably straightforward to gain some feel for the determinants of desirable policy reform from the kind of data used here. Second, the typical form of

agricultural price policy is to set prices to farmers and consumers, while the import price fluctuates significantly from year to year. The effective tax or subsidy rate is the difference between these two, and is thus both variable, and hard to predict. Since the desirability of price reform depends on the size of the tax or subsidy, it will depend on one’s view of the likely future world price, which is uncertain (though futures markets both provide a prediction and the option of hedging that prediction). The implication is that agricultural price reform requires a careful study of world market prospects for tradeable goods, and raises wider questions about the best methods of intervening in volatile markets. Third, the exercise demonstrated the importance of identifying the structure and costs of operating the marketing system, including transport, handling and storage costs. Fourth, it was possible to extend the analysis to include other interactions and linkages in the demand and supply of non-cereals. These affect the distributional impact of reform and the impact on revenues, and hence it is useful to assess the importance of ignoring these interactions. Fifth, we confirmed the importance of specifying labour market behaviour and valuing leisure, both of which Braverman et al. noted as important for the results. Finally, this marginal


approach is very flexible in allowing for additional or alternative responses to the policy changes. Whilst a systematic exploration of the sensitivity of the results to the data and behavioural assumptions would be easier if the equations were put in a computer, the results reported here were all derived using no more than a pocket calculator. It would, however, be desirable to explore the sensitivity more systematically than attempted here, and this would rapidly identify those parameters critical for the policy advice. The next stage would obviously be to attempt to refine the estimates of the key parameters and to clarify important structural assumptions by discussions with knowledgeable Korean economists. It would be useful to know exactly what quantitative impact the rice support system has on farmers, and to clarify the various prices and handling costs between farmers and urban consumers. The rural labour market and the rest of rural economy would merit further investigation, as would the setting of the urban real wage, and the links between the wages rates in the two sectors. The main conclusion is that in Korea the main food grain is a traded good but the domestic price is well above its world price. Since this primarily benefits the larger farmers, and since if anything the urban poor may be worse off than the rural poor, eliminating some of these distortions improves efficiency without compro- mising redistributive objectives. This case for reducing agricultural distortions would not necessarily apply in countries where the support price is significantly below the world price.

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the analysis of agricultural price reform

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