Effects of Divergences

The second identity of the accounting matrix concerns the differences between private and social valuations of revenues, costs, and profits. For each entry in the matrix-measured vertically-any divergence between the observed private (actual market) price and the estimated social (efficiency) price must be explained by the effects of policy or by the existence of market failures. This critical relationship follows directly from the definition of social prices. Social prices correct for the effects of distorting policies-policies that lead to an inefficient use of resources. These policies often are introduced because decision-makers are willing to accept some inefficiencies (and thus lower total income) in order to further nonefficiency objectives, such as the redistribution of income or the improvement of domestic food security. In this circumstance, assessing the tradeoffs between efficiency and nonefficiency objectives becomes a central part of policy analysis.

But not all policies distort the allocation of resources. Some policies are enacted expressly to improve efficiency by

Table 2.2: Expanded Policy Analysis Matrix
Tradable Inputs
Domestic Factors
Private Prices
Social Prices
Diverges and efficient policy
Effects of market failures
Effects of distorting policy
Effects of efficient policy

Table Notes:
Private profits, D, equal A minus B minus C. Social profits, H, equal E minus F minus G. 30utput transfers, 1, equal A minus E; they also equal M plus Q plus U. lnput transfers, J, equal B minus F; they also equal N plus R plus V. Factor transfers, K, equal C minus G; they also equal O plus S plus W. Net transfers, L, equal D minus H; they also equal I minus J minus K; and they equal P plus T plus X.

whenever monopolies or monopsonies (seller or buyer control over market prices), externalities (costs for which the imposer cannot be charged or benefits for which the provider cannot receive compensation), or factor market imperfections (inadequate development of institutions to provide competitive services and full information) prevent a market from creating an efficient allocation of products or factors. Hence, one needs to distinguish distorting policies, which cause losses of potential income, from efficient policies, which offset the effects of market failures and thus create greater income. Because efficient policies correct divergences, they reduce the differences between private and social valuations.

Interpretation of the effects of divergences can be clarified by the expansion of the PAM to include six rows, as shown in Table 2.2. In this expanded PAM, each entry measuring the effects of divergences (I, J, K, and L) is disaggregated into three categories-market failures (fourth row), distorting policies (fifth row), and efficient policies (sixth row). The introduction of efficient policies to offset market failures would change the entries in the first and third rows. To bring about perfect efficiency, a government would introduce efficient policies to offset the effects of market failures and avoid distorting policies, thereby ensuring equality of private and social prices.

In the absence of market failure in the product markets, all divergences between private and social prices of tradable output and inputs are caused by distorting policy. Because the principles are identical for all tradable products, the matrix entries for revenues (tradable outputs)

and tradable inputs can be considered together. Output transfers, I = (A - E), and input transfers, J = (B - F), arise from two kinds of policies that cause divergences between observed and world product prices: commodity-specific policies and exchange-rate policy.

Policies that apply to specific commodities include a wide range of taxes or subsidies and trade policy. For example, producer revenues per unit can be raised by producer subsidies (sometimes called deficiency payments in agriculture), tariffs or import quotas on outputs (which raise domestic prices), or domestic price supports enforced by government stockpiling (which require a complementary trade restriction for tradable products). Commodity-specific policies on inputs also affect private profitability. For example, per unit producer costs can be lowered by direct input subsidies or by subsidies on imported inputs.

Typically, PAM accounting is done in domestic currency, but world prices are quoted in foreign currency. Hence, a foreign exchange rate is needed to convert world prices into domestic equivalents. The social exchange rate may differ from observed exchange rates. Undervalued exchange rates reflect an excess supply of foreign exchange that is accumulating as excessive reserves and reducing potential income. Overvalued exchange rates correspond to conditions of excess demand; this demand results in extra foreign borrowing, excessive drawing down of exchange reserves, or rationing of foreign exchange among domestic users.

An overvalued exchange rate is an implicit tax on producers of tradable products because too little domestic currency is earned by exports or paid out for imports. In the absence of commodity policy, the world price of a tradable good determines its domestic price. When the exchange rate is overvalued, the domestic price is lower than its efficiency level and domestic producers are effectively taxed. Undervalued exchange rates exert the opposite effects. Correction for this distortion in PAM is done by conversion of world prices (E and F in the matrix) at the social exchange rate rather than at the official rate. Because exchange rates affect both product prices and factor prices, exchange-rate adjustments are limited to special circumstances-the appearance of multiple exchange-rate regimes or the government's failure to adjust the exchange rate enough to offset the effects of domestic inflation.

The social costs of domestic factors (G) reflect underlying supply and demand conditions in domestic factor markets. Factor prices are thus influenced by the prevailing set of macroeconomic and commodity price policies. In addition, the government can affect factor costs with tax or subsidy policies for one or more of the factors (capital, labor, or land)

that create a divergence between private costs (C) and social costs (G). Finally, market imperfections, arising from imperfect information or underdeveloped institutions-which are often characteristic of developing country economies-further influence factor prices. If factor market imperfections exist along with distorting factor policy, both O and S and possibly W are positive components of K. The net transfer, L, thus combines the effects of distorting policy (I, J, and the S part of K) with those of factor market failures (the O part of K) and efficient policies to offset them (the W part of K).

The net transfer caused by policy and market failures (L in the matrix) is the sum of the separate effects from the product and factor markets, L = (I - J - K). (Positive entries in the two cost categories, J and K, represent negative transfers because they reduce private profits, whereas negative entries in J and K represent positive transfers; hence, J and K are subtracted from I, a positive transfer, in the calculation of the net transfer, L.) The net transfer from distorting policy is the sum of all factor, commodity, and exchange-rate policies (apart from efficient policies that offset market failures).

The net transfer can also be found by a comparison of private and social profits. These measures of the net transfer must by definition be identical in the double-entry accounting matrix, L = (I - J - K) - (D - H). Disaggregation of the total net transfer shows whether each distorting policy provides positive or negative transfers to the system. The PAM thus permits comparison of the effects of market failures and distorting policies for the entire set of commodity and macroprice (factor and exchange-rate) policies. This comparison can be made for the complete agricultural system and for each of its outputs and inputs.