Price Shocks, Volatility and Household Welfare: A Cross-Country Inquiry

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1 Understanding and coping with food markets volatility towards more stable World and EU food systems. POLICY BRIEFING No 05 April 2015 Objectives 1. Measuring the welfare consequences of price changes and volatility across developing countries; 2. Mapping which typologies of households are more vulnerable to price shocks; 3. Anticipating the welfare consequences of policyinduced price movements Price Shocks, Volatility and Household Welfare: A Cross-Country Inquiry During the last decade, the spikes in staple food commodities have made once again price behavior a relevant topic for the development agenda. There have been concerns about the welfare consequences of extreme price increases as well as the resulting price fluctuations in low and middle income countries (LMIC), especially after the two major cereal price spikes in and in Net consumers have been heavily affected by higher prices because food typically constitutes a large share of their total expenditure while net producers did not fully exploit the expected benefits because more volatile prices increased production risks and lower potential profits. This policy briefing analyses consumer behavior in five LMICs showing that the effects of price shocks are heavily determined by the countryspecific structure of the economy. Countrywide, households are likely to benefit more from public actions preventing or limiting price increases than untargeted stabilization policies, even if targeted policy interventions for reducing the exposure of the poorest quintiles to volatile prices could be effective to cope with some of the risks. 1

2 Methodological Approach & Data Sample Five least-developed countries and six food groups are analyzed estimating demand systems at household level Based on the well-established economic literature, the authors use the so-called Quadratic Almost Ideal Demand System model (QUAIDS) to estimate food demand systems to measure how consumption of specific food items varies as response to price or income changes. We study four Sub-Saharan countries - Ethiopia, Tanzania, Malawi, and Niger and one South Asian country Bangladesh using household-level data. These least developed countries are representative of the diversity of the most vulnerable regions of the world (Africa and Asia), where the food budget share accounts for more than 70% of the total consumption expenditure (Table 1). Table 1. Budget Shares for Food Ethiopia Tanzania Niger Malawi Bangladesh Food Expenditure Share 78.78% 70.60% 71.58% 78.11% 56.13% Budget Shares Cereals 47.15% 30.03% 46.32% 32.21% 40.15% Livestock and Liv. Products 14.16% 19.78% 19.84% 20.34% 24.30% Fruits and Vegetables 3.64% 13.48% 4.59% 13.88% 15.38% Tubers and Plantains 4.71% 9.22% 7.32% 5.76% 3.17% Pulses and Oils 10.57% 9.92% 8.68% 10.44% 7.91% Other Foods 19.76% 17.57% 13.25% 17.36% 9.09% Number of Households Reference Year 2011/ / / /12 Survey provider WB WB WB WB IFPRI Note: WB=World Bank IFPRI= International Food Policy Research Institute Six broad food groups are analyzed for each country: cereals; livestock and livestock products; fruits and vegetables; tubers and plantains; pulses and oils; and other foods. Table 1 reports the budget shares for each food groups. Not surprisingly, the most important food category is cereals - mainly composed by maize, rice, wheat, sorghum and millet which cover from 30% of the total food expenditure in Tanzania to 47% in Ethiopia. 2

3 How does demand react to price and expenditure changes? Table 2 reports the expenditure and own-price elasticities for the five countries under analysis 1. Positive expenditure elasticities indicate that the food groups are considered normal goods. Cereals appear as a necessity good in all cases which is explained by the fact that they are the main staple food consumed by the households - especially by the poorest quintiles - in the five countries. On the contrary, the livestock and livestock products are always considered as luxury goods. Products like meat, milk and eggs are not affordable to the poor and a large share of livestock is kept for other uses than food such as, for example, draught power or capital assets to be sold in case of emergency. Fruits and vegetables are necessities even if they are less affordable than cereals. Tubers and plantains are necessities for Bangladesh, Ethiopia and Malawi; while they are luxury goods for Niger and Tanzania. Table 2. Expenditure and Own-Price Elasticities Ethiopia Tanzania Niger Malawi Bangladesh Expenditure Elasticities Cereals Livestock and Liv. Products Fruits and Vegetables Tubers and Plantains Pulses and Oils Others Own-Price Elasticities Cereals Livestock and Liv. Products Fruits and Vegetables Tubers and Plantains Pulses and Oils Others Source: Authors' elaboration 1 The expenditure elasticity measures the percentage change in the consumption of a food group when the food expenditure changes by 1%. When it is above 1, it indicates that consumption over-reacts to changes - a luxury good - while when it is between 0 and 1, it indicates that the good is a necessity for the household. The own-price elasticities measure the percentage change in the consumption of a food group when its own price changes by 1%. The demand for a food group is price-elastic if the absolute value of the elasticity is greater than one, and inelastic if it is between zero and one. 3

4 This cross-country heterogeneity could be explained by several factors: the different importance of the root and tuber crops in the dietary patterns; the different weight of the single items composing the food group; and the shifts from fresh to processed products which changed the status of some crops - such as cassava from inferior to normal and even luxury goods. Cereals vs Livestock Cereals are a necessity good in all the countries and the demand is quite inelastic. On the contrary, livestock is always a luxury good with a more elastic demand Pulses and oils are a necessity for Tanzania, Ethiopia and Niger while they are considered a luxury in Bangladesh and Malawi. Finally, the residual category other foods is always a luxury good - except for Niger and it is not surprising because it mainly includes processed, lessaffordable and not essential items for the household daily diet. Consistent with consumption theory, all the own-price elasticities are negative and significant, meaning that an increase in the price leads to a reduction of the quantity demanded for each food groups. As general comment to Table 2, we observe that all the food groups - with the exception of pulses and oils - appear to be price inelastic. In particular, cereals are inelastic in all the cases with the lowest intensity of response to price shocks. Except for Tanzania, also livestock and livestock products show an inelastic demand to price changes even if in some cases the response is not too far from being unit-elastic (Niger and Malawi). Similarly, for fruits and vegetables the demand is inelastic for all the countries except for Malawi but the estimates are quite close to one also for Ethiopia, Niger and Tanzania while it is quite low for Bangladesh. Tubers and plantains are price-inelastic in all the cases with the higher responses registered in Ethiopia and Tanzania. Finally, the residual group shows that the demand is price inelastic for Ethiopia, Tanzania and Niger while it is elastic for Malawi and Bangladesh. What are the welfare effects of an increase in cereal prices? Using the estimated expenditure and price elasticities, we calculated the effects of a price change on welfare, measured as the proportion of total consumption expenditure needed to make the household indifferent between the old and the new prices. We simulated the same shocks across the five countries using the change in the international cereal price. In particular, we used the variation of the Cereal Price Index calculated by FAO between 2010 and 2011, which shows an increase of 35%. Table 3 reports the results of the simulation. A positive change indicates a welfare loss while a negative change corresponds to a welfare gain. 4

5 As it can be seen in Table 3, the results vary significantly across countries. To explain this heterogeneous response to the same price shock for economies with a similar structure in terms of food expenditure, several reasons can be invoked. First of all, countries with higher budget shares devoted to cereals tend to suffer more. However, this is not enough to explain all the results and there are at least two additional key factors including (a) the differences in the substitution effect which allows households to better switch from cereals to other cheaper food groups; and, (b) the differences in the share of net food sellers which partially offset the welfare losses experienced by net food buyers. Table 3. Welfare effects of a 35% increase in the cereal price Ethiopia Tanzania Niger Malawi Bangladesh Total 5.75% 6.16% 12.76% 3.81% 7.86% Urban 9.50% 7.30% 10.39% 3.20% 8.61% Rural 5.21% 5.61% 14.26% 5.50% 7.41% 1st quintile 5.03% 4.86% 14.62% 4.35% 12.14% 2nd quintile 4.84% 5.75% 14.19% 3.22% 8.89% 3rd quintile 5.54% 6.73% 13.67% 3.64% 7.61% 4th quintile 5.94% 7.20% 12.36% 3.87% 5.58% 5th quintile 7.38% 6.24% 8.94% 4.00% 5.09% Net Buyer 13.77% 9.35% 13.45% 8.22% 12.24% Net Seller -1.44% -2.52% -0.69% -1.23% -4.20% Source: Authors' elaboration As for the geographical distribution of the impact, we notice that except for Niger the urban areas would experience higher welfare losses than rural areas which enjoy the benefits of concentrating cereal production. We also investigated the distributional effects of the price change using the per-capita consumption expenditure quintiles. For Ethiopia and Tanzania, the lower quintiles would experience lower welfare losses with respect to the better-off households. However, the magnitude of the difference between quintiles is limited as well as almost null for Malawi. Moreover, the same shock has very different consequences for Niger and Bangladesh where an increase in the cereal price would result in much higher welfare losses for the poorest quintile than the richer ones. 5

6 Differences in the effects The heterogeneous consequences of price changes are mainly explained by differences in the budget shares, the substitution effect among food items and the number of net sellers/buyers accessing the market This suggests that the consumption and production patterns significantly influence the distributional effects of the price shocks and their relative consequences on poverty and food insecurity. Finally, we compared the welfare effects of the price change looking at the net position of the households. As expected, cereal net buyers experience significant welfare losses while net sellers report welfare gains. However, the magnitude of the effects for each group relative to the total average impact matters. For example, in Ethiopia the welfare losses for net buyers would be more than double (13.77%) the national average (5.75%), which includes net sellers and self-sufficient households. This difference raises two important considerations. Firstly, cereal producers in Ethiopia are able to reduce the negative impact of the price shock because a substantial part of the domestic production is marketed. Secondly, it is likely that a sub-group of the population (e.g. net-buyers) will be heavily affected by the price change, even if the aggregate results may suggest otherwise. This last point is particularly important for policymakers interested in setting up national policies to control prices and support food security. The other countries show approximately the same pattern, except for Niger where the impact on net buyers corresponds to the total average because the production effect is very limited and cereals are mainly bought on the market. and what about a full cereal price stabilization? Level vs Volatility The households would benefit more from preventing or limiting an increase in the level of the cereal prices more than in reducing their volatility The impact of price volatility on household welfare is measured in terms of willingness to pay (WTP), i.e. the proportion of total consumption expenditure the household would be willing to pay for stabilizing the food prices. Table 4 reports the average WTP for a full stabilization of the cereal price in the five countries. The first interesting result is that households would be willing to pay a limited portion of their total consumption expenditure to eliminate price uncertainty, i.e. 2.14% in Niger, 1.17% in Malawi, 1.15% in Ethiopia, 0.49% in Tanzania and only 0.06% in Bangladesh. Considering that the Table 4 figures can also be interpreted as the welfare losses resulting from domestic market price volatility, they can be compared with those obtained in the previous exercise and we can infer that households would benefit more from preventing or limiting an increase in the level of the cereal prices more than in reducing their volatility. 6

7 This conclusion is not too surprising if we consider that the impact of the price changes has multiple and direct effects on the daily life of the agricultural households influencing their production and consumption strategies. On the contrary, the impact of price volatility is less evident and tangible because it is connected to the dynamic concept of risk and the unobservable household capacities to manage and cope with it. Table 4. Welfare effects of a full stabilization of the cereal price Ethiopia Tanzania Niger Malawi Bangladesh Total 1.15% 0.49% 2.14% 1.17% 0.06% Urban 1.29% 0.55% 1.22% 1.32% 0.06% Rural 1.12% 0.45% 2.75% 0.96% 0.05% 1st quintile 2.24% 0.85% 3.42% 3.63% 0.13% 2nd quintile 1.14% 0.56% 2.65% 1.47% 0.07% 3rd quintile 1.07% 0.46% 2.22% 0.91% 0.05% 4th quintile 0.79% 0.43% 1.66% 0.64% 0.03% 5th quintile 0.78% 0.25% 0.87% 0.42% 0.01% Net Buyer 1.62% 0.68% 2.16% 1.51% 0.09% Net Seller -0.16% -0.49% -0.23% -0.50% -0.05% Source: Authors' elaboration The heterogeneity we observe between countries is chiefly determined by the observed cross-sectional cereal price fluctuations, which differentiates the African countries from Bangladesh where it is extremely low. As a consequence, households in Bangladesh are willing to pay a very small fraction of their consumption expenditure to eliminate the residual variability still present in the cereal prices. Urban households seem to benefit more from reducing price volatility, except for the case of Niger. Moreover, the distribution of the welfare gains among different quintiles of the population suggests that (a) price volatility harms the poorest households most and (b) the inter-quintile difference between the poorest and the richest can be quite pronounced, such as for Ethiopia, Malawi and Niger. 7

8 Conclusions and outlook Farmers welfare is determined by the interaction of several complex and interconnected factors, namely, consumer and producer price dynamics, the market structure, and the policy environment. Understanding how these factors operate together is essential for policy makers engaged in delivering food security as part of their mandate. Hence, a deeper understanding of the forces influencing household responses to price shocks at micro level is a necessary step to better support policy intervention with evidence-based suggestions. This policy briefing has three main conclusions. Firstly, the impact of price changes and price volatility on welfare should be analyzed at domestic level because the country-specific structure of the economy plays a fundamental role. The heterogeneity depends on differences in the share of food expenditure over total consumption, the specific budget share devoted to cereals, the substitution effect among food items and the relative number of net sellers and net buyers accessing the market. Secondly, given the more pronounced welfare impacts resulting from a price increase compared to price volatility at consumer level, it appears that poor households are likely to benefit more from policies preventing or limiting cereal price increases than untargeted stabilization policies. Therefore, the policy recommendation is to focus the resources more on policies mitigating and coping with the effects of price surges. This may be compelling although it does not reflect the policy decisions adopted in the recent past by many developing countries. Thirdly, the paper calls for systematic targeting of policy measures. Indeed, our results suggest that targeted policy interventions could effectively hedge the poorest quintiles which are likely to be more affected by volatile prices than other groups. This point may be particularly important for policymakers interested in targeting vulnerable households. Authors and affiliation Emiliano Magrini, Food and Agriculture Organization (FAO) of the United Nations, Agricultural Development Economics Division, Rome, Italy Cristian Morales Opazo, Food and Agriculture Organization (FAO) of the United Nations, Agricultural Development Economics Division, Rome, Italy Jean Balié, Food and Agriculture Organization (FAO) of the United Nations, Agricultural Development Economics Division, Rome, Italy 8