Section II: Sector Guidelines and Case Studies for Project Appraisal 17
Case 3: A Project Using a Nontradable Intermediate Goods Where
• Distortions exist in the market for that intermediate goods;
• No distortions exist in its factor, substitute or complement markets; and
• Inputs used for the production of that intermediate goods have tradable component.
When a project purchases a nontradable input in a market where prices are competitively set, the price of the input will in general be bid up due to the additional demand. As the price of the nontradable input increases, consumers will reduce their purchases of the input, and at the same time, the higher prices will provide an incentive for suppliers of the input to expand production.
Estimation of the Economic Price of an Intermediate Goods used as an Input of a Project
In the absence of distortions in the factor markets of an intermediate goods and in the markets for its complements and substitutes, and if all inputs used in the production of the nontradable goods are also nontradable, then
the economic cost of the input used by the project is a weighted average of the value of the additional supply (as measured by the supply curve) and the value of the consumption given up by demanders (as measured by the demand curve). However, if some of the inputs used in the production of the nontradable intermediate goods are tradable goods, then the supply price will need to be adjusted to reflect the economic cost of the tradable components.40
The economic price per unit of intermediate goods purchased expressed in domestic
currency (Pe), can be broken down into two main parts: the first, is a weighted average of the value of the resources used in the production of the additional supply as measured by the
competitive supply price and the value of the consumption given up by the demanders as measured by the competitive demand price.
The second part is the premium on the foreign exchange spent on the tradable inputs used in the increased production of the nontradable intermediate goods.
Combining both parts, the economic price per unit of nontradable input used by the project and expressed at the domestic price level (Pe) is calculated as follows:
Pe = Wdx * Pdx + Wsx * Psx + Wsx * %T * Psx * (Ee/OER - 1)
where, W sx+ W dx= 1
x = intermediate goods purchased by the project
%T = undistorted tradable goods component of the nontradable intermediate goods
used by the project expressed as a % of the financial supply price of the
intermediate goods Ee = economic exchange rate OER = official or market exchange rate
The first two terms on the right hand side of the equation yield the weighted average of the demand and supply prices. The last term reflects the adjustment for the foreign exchange
premium attached to the undistorted tradable components of the inputs used in the
production of the nontradable intermediate goods. This part will be positive, indicating a greater cost to society, if the economic value of the foreign exchange is larger than its market value, i.e., the economic value of the tradable inputs is greater than their financial value. Note that the adjustment for the tradable component pertains only to the proportion of the project’s demand for the intermediate goods (Ws) that is met through additional production. The
proportion of the project’s demand that is accommodated through a reduction in the purchases of other consumers (Wd) should not be adjusted to reflect the distortions in the input markets. Since the production of this proportion will be carried out regardless of whether the project is undertaken, the adjustment is applied to only the additional supply to this market.
In the presence of distortions in the market for an intermediate goods, the estimation of the economic price (Pe) of the good will also require the determination of the following: (i) the intermediate input’s supply price (Ps); (ii) its demand price (Pd); (iii) the relative weights of demand and supply (Wd and Ws); and (iv) the
40 The nature and mechanics of the adjustment are explained in detail in an earlier section where we estimate the economic price of a nontradable output produced by a project when some of the inputs used in the production of the output are tradable goods.
proportion (%T) of the undistorted tradable goods component in the costs of production of the intermediate input.
After the estimation of the economic price of the intermediate input, a commodity-specific conversion factor (CSCFd) based on the financial demand price of the input can be calculated as follows:
CSCFd = Economic price per unit / Financial (demand) price per unit
Illustrative Example 3: A project using bricks as an input
Consider the competitive market for clay bricks where at present, there is a 25 percent sales tax (ts) on the market price of bricks and a 15 percent subsidy (K) on the suppliers’ cost of production. The quantity demanded and supplied in the market is 7 million bricks per month at a market price (Pm) of 7 rupees per brick. Now, we introduce a project to construct low-cost housing. During the later stages of the construction, it is expected that the project will require 300,000 bricks per month. Assume that the impact of the project demand on the competitive market price is small and that the proportion of the undistorted tradable goods component (%T) used in the production of bricks is estimated to be 70 percent of the supply price (Ps). The official exchange rate (OER) is 45 rupees per US rupee and the economic exchange rate (Ee) is 50 rupees per rupee.
Let
Ps = the supply price per brick;
Pd = the demand price per brick; and Pm = the market price per brick.
Consider the estimation of the economic cost of bricks in domestic currency used by this project.
Illustration: Estimation of the Economic Price of Bricks
(The figures in this example are assumed for illustrative purposes only)
Step 1: Estimate the demand price Pdx = Pmx * (1 + ts)
= 7 * (1.25)
= 8.75 rupees
Step 2: Estimate the supply price Psx = Pmx/(1 - K)
= 7/(0.85)
= 8.24 rupees
Step 3: Estimate the supply and demand weights For such production activity, the expected supply response will be small in the short run as most brick making kilns are usually operating close to capacity.41 Although the supply response will be larger in the longer run, it will still not be as large as the demand response. In other words, a larger proportion of the bricks required by the project will be obtained by existing demanders’ postponing their
consumption, rather than from new production.
Hence, assigning a weight of 0.67 to the
demand-side and a weight of 0.33 to the supply- side seems plausible.
Now, substituting the economic cost per brick at the domestic price level (Pe)
= Wd * Pd + Ws * Ps + Ws * %T * Ps * (Ee/OER - 1)
= 0.67 * 8.75 + 0.33 * 8.24 + 0.33 * 0.7 * 8.24 * (50/40 - 1)
41 In the case of existing excess capacity, more weight should be assigned to the supply side. As the situation of excess capacity will likely be temporary, however, no generalizations can be made about the economic cost or the conversion factor of this nontradable input.
= 8.79 rupees
If the value of the foreign exchange adjustment for the tradable component of the intermediate goods used by the project were to be ignored, the economic cost per brick would be 8.58 rupees per unit. In other words, the economic cost would be underestimated by
approximately 2 percent of the true economic cost per brick.42
The commodity-specific conversion factor (CSCFd) for bricks used by this project is given by:43
CSCFd= Pe/Pd
= 8.79/8.75
= 1.0045