The Basic Policy Analysis Matrix Manual For Regional Workshops

The Basic Policy Analysis Matrix Manual For Regional Workshops A Computer Tutorial by Scott Pearson Carl Gotsch May, 2002

CHAPTER 1. THE POLICY ANALYSIS MATRIX TUTORIAL...1 Introduction...1 A Single Commodity Budget at Private Prices...1 CHAPTER 2: Additional COMMODITY BUDGETS...5 Additional Input-Output Tables...5 Additional Commodity Prices...6 Additional Budgets...7 Budget Analysis...8 Summary...10 CHAPTER 3: FARM BUDGETS AT SOCIAL PRICES...11 Adding Social Prices...11 Constructing Farm Budgets at Social Prices....12 CHAPTER 4: THE POLICY ANALYSIS MATRIX...14 A Brief Introduction to PAMs...14 Creating a PAM for High Yielding, Wet Season Paddy...15 Single Commodity PAMs for Irrigated Soybeans and Rainfed Corn...16 A Farming Systems PAM...17 CHAPTER 5: COMPUTING SUMMARY RATIOS...19 The Ratio Table...19 Sensitivity Analysis...21 CHAPTER 6: ESTIMATING SOCIAL PRICES...23 Social Prices for Tradable Goods...23 Determining Import Parity Prices...27 Determining Export Parity Prices...28 Linking Tables in the Spreadsheet...29 Sensitivity Analysis...29 Summary...30 CHAPTER 7: COMPUTING ADDITIONAL PARITY PRICES...31 Import Parity Prices...31 Export Parity Prices...32 Nontradable Good Prices...33 CHAPTER 8: ANALYSIS OF NONTRADABLE SERVICES...34 Decomposing Tractor Costs...34 Modifications to the Spreadsheet...35 Sensitivity Analysis...39 Summary...39 CHAPTER 9: ESTIMATING CAPITAL RECOVERY COSTS...40 Estimating Capital Recovery Costs...40 Modifications to the Spreadsheet...40 Sensitivity Analysis...43 CHAPTER 10: SENSITIVITY TO MACROECONOMIC ASSUMPTIONS...44 Modifying the Spreadsheet...44 Sensitivity Analysis...49 Final Comments Regarding the Workbook Method...50

CHAPTER 1. THE POLICY ANALYSIS MATRIX TUTORIAL Introduction This tutorial provides a hands-on demonstration of the procedures used to create a policy analysis matrix (PAM) as described by Monke and Pearson their book, The Policy Analysis Matrix for Agricultural Development. According to M-P, The PAM is composed of two sets of identities - one set defining profitabilities and the other defining the difference between private and social prices.... The methodology is based on the formulation of budgets for representative activities, farming, marketing, and processing --that compose an agricultural commodity system. The focus of this tutorial is at the farm level. Consequently, the budgets that are required are those associated with particular commodities. 1 When calculated using private (observed) prices, the budgets capture the incentives a farmer faces in a particular farming system. When re-calculated using social (economic) prices, the budgets evaluate the costs and returns of commodity systems from the perpsecive of the economy as a whole. The spreadsheet software used is in this tutorial is Microsoft Excel. (Any modern spreadsheet such as Quattro Pro would work equally well.) The calculations can be organized on a spreadsheet in a variety of ways.the exercises in the following chapters use the idea of worksheets contained in a workbook. For example, major items such as private and social budgets, PAM calculations, non-tradable disaggregation, etc. are entered as separate worksheets whose names show up as tabs along the status bar at the bottom of the page. This procedure helps keep track of the various components of the PAM computations and facilitates sensitivity analysis. The tabs provide a visual reminder of the logic of the calculation sequence. A Single Commodity Budget at Private Prices The commodity budget used in this initial example is based on rice. Production and price data are used to calculate the returns to high yielding paddy in Indonesia s wet season. The physical components of the budget are laid out in the Input-Output table shown in Table 1.1. (The level of disaggregation depends on the data available. Disaggregating as much as possible makes it easier to do meaninful sensitivity analyses later on.) Subsequent tables provide data on private prices and compute the commodity budget at private prices. To create the table on a spreadsheet, start a new a workbook (file) and rename (right mouse button) the first worksheet tab to P-Budget (no quotes). Type in the labels and data for Table 1.1.After constructing the I-O table, select the table and copy it below itself. Label the new table Table 1.2. Private Prices. Make the necessary changes in the labels and units.type over the cell values to enter data for prices instead of physical input-output coefficients. 1 In Chapter 8 (Constructing PAMs for Commodity Systems), Monke and Pearson provide a detailed discussion of the problems associated with developing empirical estimates of commodity systems. The discussion in Chapter 9 (Farm Level Budgets and Analysis) is also essential reading before undertaking the data collection that precedes the construction of actual budgets. 1

Table 1.1. Physical Input-Output I-O HY Paddy Quantities Wet Season Tradables Fertilizer (kg/ha) Urea 200 KCL 100 Chemicals (kg/ha) 10 Seed (kg/ha) 35 Fuel (liters/ha) 64 Factors Labor (hr/ha) Seedbed Prep 200 Crop Care 830 Harvesting 275 Threshing 154 Drying 24 Capital Working Capital (Rp/ha) 413,000 Tractor Services (hr/ha) 18 Thresher (hr/ha) 95 Land (ha) 1 Output (kg/ha) 6,250 Table 1.2. Private Prices HY Paddy P-Prices Quantities Wet Season Tradables Fertilizer (Rp/kg) Urea 120 KCL 120 Chemicals (Rp/kg) 1,200 Seed (Rp/kg) 400 Fuel (Rp/liter 500 Factors Labor (Rp/hr) Seedbed Prep 237 Crop Care 215 Harvesting 150 Threshing 130 Drying 130 Capital Working Capital (%) 30% Tractor Services (Rp/hr) 621 Thresher (Rp/hr) 950 Land (Rp/ha) 225,000 Output (Rp/kg) 175 Copy Table 1.2 below itself, and identify the new table as Table 1.3. Private Prices Budget. Make the necessary changes in the labels (units). 2

. Table 1.3. Private Prices Budget P-Budget HY Paddy Quantities Wet Season Tradables Fertilizer (Rp/ha) Urea 24,000 KCL 12,000 Chemicals (Rp/ha) 11,400 Seed (Rp/ha) 14,000 Fuel (Rp/ha) 32,000 Factors Labor (Rp/ha) - Seedbed Prep 47,400 Crop Care 178,450 Harvesting 41,250 Threshing 20,020 Drying 3,120 Capital - Working Capital (Rp/ha) 123,900 Tractor Services (Rp/ha) 11,178 Thresher (Rp/ha) 90,250 Land (Rp/ha) 225,000 Output Total Revenue (Rp/ha) 1,093,750 Total Cost (excluding land) (Rp/ha) 608,968 Profit (excluding land) (Rp/ha) 484,782 Net Profit (including land) (Rp/ha) 259,782 Compute the cells in Table 1.3, the Private Prices Budget table, by multiplying the elements of the Prices table times the elements of the I-O table. To minimize typing as much as possible, compute the first cell, either by typing in the formula or by creating it with the aid of the mouse, then drag the formula down across the other rows. (The first element might be something like =C5*C27; this becomes =C6*C28 in the second row, =C7*C29 in the third row, etc.) Because the tables have the same number of rows, the value for all elements of High Yield, Wet Season paddy up to and including Total Revenue can be obtained by copying. (If you are unclear about how to copy in Excel, look up the topic under Excel Help.) The Private Prices Budget contains three additional rows, Total Costs, Profits, and Net Profits. To compute Total Costs excluding Land, write a formula that sums the relevant cost elements, i.e., Urea through Thresher services. (e.g., =SUM(C49:C63). To compute Profits (excluding Land), subtract Total Costs from Total Revenues. To compute Net Profits (including Land), subtract Land from Profits (excluding Land). The distinction between profits that include or exclude returns to land is important. Whereas rental values can be observed and included in a private budget, the same is not true for social budgets. Land is unique because it is the only truly fixed factor in agriculture. In suburban locations, agriculture might not be the only use for land, and prices and rental values will be influenced by off-farm opportunities. But in most areas, the only alternative to agricultural use is no use at all (if forestry is included as an agricultural activity). In these cases, land acts as a residual claimant on the profits from farming. 1 1 Further explanation can be found on pp. 207-209 in Monke-Pearson. 3

Save the three-table file under the heading chap1.xls. Save again to create chap1.bak. 4

CHAPTER 2: ADDITIONAL COMMODITY BUDGETS The previous exercise resulted in a single commodity budget for high yielding paddy production. This is a great simplification of the options available to farmers. In reality, their crop choice depends on their assessment of the expected profitability of a particular production strategy given the season, their agroclimatic zone, as well as the cost and availability of technologies such as irrigation. The comparative advantage of a given farming strategy within a production environment suggests what commodities farmers will find profitable to produce. Given the complementarity and competition between the various crops, the farmer's response to price changes (i.e., the supply response) can be quite complex because of multiple commodities, permanent crops, or technological change. 1 The first step in analyzing additional alternatives is to develop the data for more commodity systems. In this section, additional paddy production systems as well as systems for soybeans and corn will be added to the spreadsheet. Once the budgets for the alternative crops are constructed, sensitivity analysis can be performed to gauge the potential impact of policy prices on profitability within farming systems. Additional Input-Output Tables The first step in computing multi-commodity budgets is to collect additional input-output information. Return to the worksheet containing the single commodity calculations. Rename the existing input-output table and add the data for additional commodities shown in Table 2.1. Also, add additional rows to the table and label them Shelling and Drying. The physical data for the paddy and non-paddy crops shown in Table 2.1 contain numerous assumptions. The paddy growing environments are distinguished by different soil types, water control methods, and drainage regimes. (It is important to note that, at this stage, the commodity systems are not assumed to be different technologies for growing rice under the same environmental conditions.in other words, farmers who grow rice cannot choose between the high yielding or average yielding regime.) Irrigated soybeans and irrigated corn are grown in the average yielding agroclimatic environment during the dry season. Rainfed corn competes with rainfed rice. These data also incorporate technical information about crop production. For example, rainfed paddy does not utilize any fuel input, although diesel fuel is required to operate the tractor and power thresher. Such fuel, however, is supplied by the rental operators of these farm machines, and its cost is included in their rental rates. Fuel for the farmer-owned irrigation pump, on the other hand, is included as a tradable input in irrigated paddy production. 1 A detailed discussion of the problems associated with modeling more complex commodity systems can be found on pp. 161-169 of the Monke and Pearson book. 5

Table 2.1. Physical Input-Output Data I-O Table High Yield Paddy Rainfed Irrigated Irrigated Rainfed Quantities Wet Paddy Soybeans Corn Corn Tradables Fertilizer (kg/ha) Urea 200 250 200 350 300 KCL 100 75-50 40 Chemicals (kg/ha) 10 9 4 12 8 Seed (kg/ha) 35 35 50 35 35 Fuel (liters/ha) 64-16 16 - Factors Labor (hr/ha) Seedbed Prep 200 250 140 60 50 Crop Care 830 950 674 370 260 Harvesting 275 225 150 224 200 Threshing 154 125 60 93 Shelling - - 95 - - Drying 24 24 60 - - Capital Working Capital (Rp/ha) 413,000 254,000 135,000 167,000 121,000 Tractor Services (Hr/ha) 18 - - - - Thresher (hr/ha) 95 40 65 - - Land (ha) 1 1 1 1 1 Output (kg/ha) 6,250 4,250 1,200 3,500 3,000 Additional Commodity Prices Rename the Prices table as Table 2.2 and add columns containing the prices of the new commodities. also add the rows Shelling and Drying. Note that the prices for inputs are the same for all commodities and hence the initial column (HY Paddy, Wet Season) can be copied into the rest of the matrix. Only the Land and Output entries have different values for each commodity. (Redundancy of data at this point facilitates creating the budget in the next step.) 6

Table 2.2 Additional Commodity Price Data P-Prices High Yield Paddy Rainfed Irrigated Irrigated Rainfed Quantities Wet Paddy Soybeans Corn Corn Tradables Fertilizer (Rp/kg) Urea 120 120 120 120 120 KCL 120 120 120 120 120 Chemicals (Rp/kg) 1,200 1,200 1,200 1,200 1,200 Seed (Rp/kg) 400 400 1,000 1,000 1,000 Fuel (Rp/liters) 500 500 500 500 500 Factors Labor (Rp/hr): Seedbed Prep 237 237 237 237 237 Crop Care 215 215 215 215 215 Harvesting 150 150 150 150 150 Threshing 130 130 130 130 130 Shelling 130 130 130 130 130 Drying 130 130 130 130 130 Capital: Working Capital (%) 30% 30% 30% 30% 30% Tractor Services (Rp/hr) 621 621 621 621 621 Thresher (Rp/hr) 950 950 950 950 950 Land (Rp/ha) 225,000 150,000 225,000 175,000 165,000 Output (Rp/kg) 175 175 560 150 150 Additional Budgets To compute the cells in the Budgets table, copy the HY Paddy, Wet Season column into the rest of the matrix. The result is a table that shows the Gross Revenue budgets for a number of crops prominent in a typical, rice-based, Indonesian farming system. 7

Table 2.3. Addditional Budgets at Private Prices Private Budgets High Yield Paddy Rainfed Irrigated Irrigated Rainfed Quantities Wet Paddy Soybeans Corn Corn Tradables Fertilizer (Rp/ha) Urea 24000 30000 24000 42000 36000 KCL 12000 9000 0 6000 4800 Chemicals (Rp/ha) 11400 10200 4800 14400 9600 Seed (Rp/ha) 14000 14000 50000 35000 35000 Fuel (Rp/ha) 32000 0 8000 8000 0 Factors Labor (Rp/ha) Seedbed Prep 47400 59250 33180 14220 11850 Crop Care 178450 204250 144910 79550 55900 Harvesting 41250 33750 22500 33600 30000 Threshing 20020 16250 7800 0 12090 Shelling 0 0 12350 0 0 Drying 3120 3120 7800 0 0 Capital Working Capital (Rp/ha) 123900 76200 40500 50100 36300 Tractor Services (Rp/ha) 11178 0 0 0 0 Thresher (Rp/ha) 90250 38000 61750 0 0 Land (Rp/ha) 225000 150000 225000 175000 165000 Output Total Revenue (Rp/ha) 1093750 743750 672000 525000 450000 Total Costs (excluding land) (Rp/h 608968 494020 417590 282870 231540 Profits (excluding land) (Rp/ha) 484782 249730 254410 242130 218460 Net Profits (including land) (Rp/ha 259782 99730 29410 67130 53460 Budget Analysis The budget figures shown in Table 2.3 can be used to develop a graphic analysis of comparative private profitability. Creating such a graph requires a table drawn from Table 2.3. Immediately below Table 2.3, create a table with the row and column labels shown below, e.g., H-W means High Yielding, Wet. H-W R-P I-S I-C R-C Land 225000 150000 225000 175000 165000 Total costs (excluding land) 608968 494020 417590 282870 231540 Net Profits (including land) 259782 99730 29410 67130 53460 To complete the column H-W, Land cell, click on = in the formula bar and then click on the similar cell in Table 2.3. Copy across columns. Then click on the H-W, Total Cost cell and repeat the process. To create the graph, select the entire table and click on the Chart Wizard icon in the main toolbar. Under the Column options, choose the Stacked Column with 3-D Effect (center, 2nd row). Follow the directions for creating the graph. It should look something like the following: 8

Cost and Returns in Indonesian Food Crops 1,200,000 1,000,000 800,000 Rupiahs 600,000 400,000 200,000 - H-W R-P I-S R-C Crop Production Systems Land Total costs (excluding land) Net Profits (including land) Sensitivity Analysis It is often helpful in farming systems analyses to do a sensitivity analysis of the most important parameters. Make the following changes, noting the results in the Budget window. Compare the relative profits for the different systems with the original results in Table 2.3. Consider whether some changes make certain crops money losers. After each change, return the data to their original values. Use the space provided below to note results. 1) Fertilizer prices double from Rp120/kg to Rp240/kg for urea and Rp120/kg to Rp240/kg for KCL. 2) Fertilizer prices remain at their original values, but all labor costs double. 3) Output prices rise to Rp300/kg for paddy in all seasons. 4) Output prices fall to Rp100/kg for paddy in all seasons. 5) Yields for all crops double. Questions 9

1. Which of type of change has the greatest impact on farmer incentives: input prices, output prices, or productivity? Why? Changes in the costs of inputs have much smaller effects on profits than changes in the prices of outputs because each input makes up only a fraction of the cost, whereas the output price applies to the whole of revenues. Likewise, changes in productivity also apply to the whole of revenues. 2. What are the implications of this kind of sensitivity analysis for data collection efforts? If resources for research on agricultural policy are scarce, do these results suggest the types of empirical work a ministry or planning unit ought to focus on? The results of the sensitivity analysis strongly suggest that the highest research priority is to obtain the best possible data on output prices and yields. The next highest priority would be the largest item in costs, say, labor. Only after the larger cost items have been determined should minor costs be investigated. The what-if feature of spreadsheets makes it possible to determine quickly exactly how much impact a particular price has on the overall results. Efforts to improve the database can be organized accordingly. 3. In many countries, different government agencies administer output and input prices. What are the policy implications of these results for farmer incentives? The total effect of all price and production policies influences farmer incentives to grow crops -- the farmer responds to changes in profitability, regardless of the source of these changes. Given the possibility that various policies could amplify or counteract one another, it is essential that different government agencies coordinate their efforts to ensure consistency. 4. What can be said about the competitiveness of the various production systems? Significant private profits in a system mean that rents accrue to the owners of domestic resources such as land. In a perfectly competitive system, there are no profits, i.e., in equilibrium, factors are paid the values of their marginal product. Consequently, the positive profits observed in these systems imply incomplete adjustment toward a zero-profit equilibrium, especially as regards irrigated rice production. This result is typical for most economies, particularly those in developing countries. Summary The current farming system covers three commodities (rice, soybeans, and corn) produced under varying technologies (irrigated, rainfed) in different agroclimatic regimes (high, average) and in different seasons (wet, dry). Some of these crop choices are complements, grown in alternate seasons or on different lands. Others are direct substitutes, competing for the same agricultural resources. The values obtained in the private budget permit the analyst to understand how farmers might react to changes in agricultural prices or technologies in light of their farming options. Graphs are used to compare the revenues, costs, and profits for the major commodities. Sensitivity analyses are used to compare the relative profitability of the different commodities under varying price scenarios. 10

CHAPTER 3: FARM BUDGETS AT SOCIAL PRICES The preceding commodity budgets were based on private prices, those that farmers face in the market place. In many instances, private prices do not reflect the true scarcity value of a good to the economy. Market failures and policy interventions may drive a wedge between the true opportunity cost, or social price of a good, and the observed market price. For example, an overvalued exchange rate may decrease the cost of tradable inputs (such as fertilizers or machinery) and tradable outputs (such as corn). In such cases, social prices diverge from private prices, thus altering the relative profitability of various economic activities. Because they are not directly observed, social prices must be estimated from other economic data. The process can be quite elaborate, depending on the extent to which a good is traded. To simplify the initial calculations, this chapter provides social prices for the tradables and nontradables needed to set up the basic PAM discussed in Chapter 2 of Monk and Pearson). The process of calculating those social prices and the sensitivity of those prices to economic policies are discussed in M-P s Chapter 6. Adding Social Prices The first step in adding social prices is to retrieve the workbook saved at the end of the last chapter (chap2.xls). Insert a new worksheet and rename it S-Budget. Select Table 2.2 under the P-Prices tab, copy and paste into the upper left hand corner of the new worksheet, i.e., into S-Budget. Change the table name and enter the data shown in Table 3.1. As with previous examples of price data, copy the same entries in Column C (High Yield, Wet Season) into columns that represent other cropping activities. Prices are the same for all columns including Land (see below). Note that many of the output prices differ and will need to be entered separately. Table 3.1: Social Prices for Additional Commodities S-Prices High Yield Paddy Rainfed Irrigated Rainfed Quantities Wet Paddy Soybeans Corn Fertilizer (Rp/kg) Urea 304 304 304 304 KCL 326 326 326 326 Chemicals (Rp/kg) 7,093 7,093 7,093 7,093 Seed (Rp/kg) 387 387 219 254 Fuel (Rp/liters) 365 365 365 365 Labor (Rp/hr): Seedbed Prep 237 237 237 237 Crop Care 215 215 215 215 Harvesting 200 200 200 200 Threshing 200 200 200 200 Shelling 200 200 200 200 Drying 200 200 200 200 Capital: Working Capital (%) 30% 30% 30% 30% Tractor Services (Rp/hr) 493 493 493 493 Thresher (Rp/hr) 650 650 650 650 Land (Rp/ha) 0 0 0 0 (Rp/kg) 355 355 502 151 11

Note that the Land price is 0. In the absence of clearly specified cropping alternatives, imputing social opportunity costs to fixed factors within a single commodity budgeting framework is arbitrary. Consequently, the land price, and thus cost, equals 0 and all returns to land are included in the Profits residual, i.e., Profits and Net Profits are the same. Social profits thus measure the returns to land and management when all commodities are priced at their efficiency prices. The rationale for this approach will be examined in greater detail in a future chapter. Constructing Farm Budgets at Social Prices. To create the social prices budgets, Insert a new worksheet and rename it S-Budget. Copy the private budgets table (Table 2.3 under the tab P-Budget.) to the new worksheet. Compute the cells in the social budgets table using the method employed to create the private budgets table. Select the cell under High Yield, Wet and delete its contents. Click on the = sign in the Formula Bar. Click on the same cell in the S-Prices worksheet. Type in an asterisk (*) and then click on the same cell in the I-O table (Table 2.1 under P-Budgets). The result of the multiplication will be the cost of Urea per hectare. Table 3.2: Additional Budgets at Social Prices S-Budgets High Yield Paddy Rainfed Irrigated Rainfed Quantities Wet Paddy Soybeans Corn Tradables Fertilizer (Rp/ha) Urea 60,800 76,000 60,800 91,200 KCL 32,600 24,450 0 13,040 Chemicals (Rp/ha) 67,384 60,291 28,372 56,744 Seed (Rp/ha) 13,545 13,545 10,950 8,890 Fuel (Rp/ha) 23,360 0 5,840 0 Factors Labor (Rp/ha) Seedbed Prep 47,400 59,250 33,180 11,850 Crop Care 178,450 204,250 144,910 55,900 Harvesting 55,000 45,000 30,000 40,000 Threshing 30,800 25,000 12,000 18,600 Shelling 0 0 19,000 0 Drying 4,800 4,800 12,000 0 Capital Working Capital (Rp/ha) 123,900 76,200 40,500 36,300 Tractor Services (Rp/ha) 8,874 0 0 0 Thresher (Rp/ha) 61,750 26,000 42,250 0 Land (Rp/ha) 0 0 0 0 Output Total Revenue (Rp/ha) 2,218,750 1,508,750 602,400 453,000 Total Costs (excluding land) (Rp/ha) 708,663 614,786 439,802 332,524 Profits (excluding land) (Rp/ha) 1,510,088 893,965 162,598 120,476 Net Profits (including land) (Rp/ha) 1,510,088 893,965 162,598 120,476 12

Check to be sure that the correct cells have been multiplied, then copy the formula into all rows including Total Revenue. When that has been completed successfully, copy the High Yield, Wet column into the columns representing other activities. To compute Total Costs, sum the entries from Urea to Thresher, then copy the formula into the other columns. Compute Total Profits by subtracting Total Costs from Total Revenues; copy the formula into the other columns. Save the spreadsheet as chap3.xls. Save again to produce chap3.bak 13

A Brief Introduction to PAMs CHAPTER 4: THE POLICY ANALYSIS MATRIX The calculation of private profitability provides information on the competitiveness of commodity systems at actual market prices. The same computations using social prices provide information on profitability when commodities and factors are priced at their social opportunity costs. The divergences -- the differences between private and social valuations -- are caused either by policy interventions (in the form of taxes, subsidies, trade restrictions, and exchange rate distortions) or by failures in commodity and factor markets. The Policy Analysis Matrix (PAM) compares the data from the private and social budgets to facilitate the evaluation of policy effects and market failures on tradable inputs, domestic resources, and outputs. 1 The PAM format, shown in Table 4.1, contains data on revenues, costs, and profits for an individual crop at private and social prices. Table 4.1. The Policy Analysis Matrix Revenues Costs Tradable Inputs Domestic Factors Profits Private Prices A B C D Social Prices E F G H Divergences I J K L Private profits: D = A - B - C Input transfers: J = B - F Social profits: H = E - F - G Factor transfers: K = C - G Output transfers: I = A - E Net transfers: L = D - H L= I - J - K The PAM is made up of two accounting identities. One defines profitability, the other measures policy effects and market failures, i.e., divergences. Profits, shown by D and H in the right column, are calculated by subtracting all costs from revenues, in private and social terms for each respective row. Policy effects and market failures, shown by I, J, K and L in the bottom row, are calculated as the difference between the private and social values of outputs and inputs. The divergences represent transfers to or from the producers of the crop, resulting from policy interventions and market failures affecting revenues, tradable inputs, or domestic factors. Such transfers may be positive or negative. The net transfer to producers of a particular crop can be calculated as the aggregate effect of divergences. The net transfer is also shown as the difference between private and social profits for the commodity system. The final PAM table is constructed from the private and social budget tables. The top or private profits row is obtained from the worksheet P-Budget, the private budget. The middle or social profits row is obtained from the worksheet S-Budget, the social budget. The last row, divergences, is obtained by subtracting the social row from the private row. 1. Chapter 2 of Monke and Pearson provides the authoritative introduction to the logic of the Policy Analysis Matrix. 14

Creating a PAM for High Yielding, Wet Season Paddy The first PAM exercise focuses on a single commodity system for which complete information on competing alternatives is not available. In such cases, private land costs can be obtained from the private rental market. But, as noted earlier, in the absence of information on the social profits of competing commodities, social returns to land are difficult to define. Consequently, in both the private and social computations, Profits in this PAM equal Profits (Excluding Land). That is, profits represent returns to management and land. The first step in computing a single-commodity PAM for High Yielding Paddy, Wet is to retrieve the Excel file saved as chap3.xls. This should contain the calculations up to and including those needed to obtain social budgets. Insert a new worksheet in the workbook and rename it PAMs. Label the columns and rows to create a typical PAM table. (Table 4.2 below.) Table 4.2. High Yielding Wet Season Paddy PAM Tradables Domestic Resources Output Inputs Labor Capital Profits Private 1,093,750 93,400 290,240 225,328 484,782 Social 2,218,750 197,689 316,450 194,524 1,510,088 Divergences -1,125,000-104,289-26,210 30,804-1,025,306 To compute the elements of the PAM, utilize the methods used earlier to create the budget tables. Select the cell Private-Output cell and click on the equals (=) sign in the Formula Bar. Then click on the Total Revenue cell for High Yielding paddy in the Private Budget table (Table 2.3 under the P-Budget tab). Click on O.K. Go do the same for the social output entry. Completing the remaining entries requires slightly more effort. To compute the Private Inputs cell, select the cell and begin to write the summation function in the Formula Bar by first clicking on the = sign, then typing SUM and an open parenthesis. The completed entry is =SUM(. A dialog box will pop-up requesting the range over which the function should sum. Click on the P-Budget tab and select the input items (Urea through fuel) that constitute the High Yielding, Wet input costs. (If the dialog box obscures the view of the relevant data, drag it to the bottom of the page.) Complete the formula by adding a closing parenthesis. Then click on OK. Use the same procedure to compute the labor inputs cell and the capital inputs cell. Select the cell to be completed, click on the = sign, type SUM(, complete the range by going to the appropriate worksheet and selecting the relevant range, in this case labor and capital, typing in a closing parenthesis, and clicking on OK. Once data from the budget tables have been entered for Table 4.2, the profits column and the divergences row can be computed. To complete the profits column, subtract the sum of the Inputs, Labor, and Capital cells from the Output cell. To compute the divergences row, subtract social entries from private entries. Remember to utilize the copy command as much as possible. Questions 15

Interpret the results of the high productivity, wet season paddy PAM. To what extent do policies affect paddy prices? What about input subsidies? 1 The negative divergence in tradable outputs indicates that farmers are receiving less than the social value for their crop. They are, in effect, being taxed by the amount of the divergence. The negative divergence in tradable inputs reflects a subsidy to farmers for use of these inputs. Farmers do not pay the full social cost of these inputs and the divergence represents the cost to the government. This somewhat offsets the effect on farmers of the divergence in tradable outputs. The higher social cost of labor is the result of the female labor component. Since women are paid less than the marginal product of their labor, private wages are lower than social ones for tasks performed primarily by women. The difference between the private and social interest rate causes the divergence in the capital column. Single Commodity PAMs for Irrigated Soybeans and Rainfed Corn Single commodity PAMs for irrigated soybeans and corn can be generated quickly by employing the notion of absolute cell addresses. A cell address is rendered absolute when the row and column address is preceded by a $ sign. For example, the cell address A1 would be $A$1. If this address is copied, it does not change to reflect a different position on the spreadsheet, but retains its abolute value, i.e., A1. To utilize this feature in computing additional PAMs, convert the data cell address in Table 4.2 to absolute values, e.g., outputs, inputs, domestic resources. Click on the address in the formula bar and then press F4. The requisite dollar signs will appear. After having converted Table 4.2 data cell address to absolutes, copy the table below itself and label it Table 4.3. Soybean PAM. Note that the numbers in the table are still the same because the addresses refer to the same absolute cells. The calculated cells are making the same computations. To compute the correct numbers for the Soybean PAM table, click on the P-Budget tab and observe that the Soybean activity is contained in column G. Convert the B in the formula of the copied table to G and the result will be the correct value for the first element in the Soybean PAM. Do the same for the remaining data cells and the Soybean PAM (Table 4.3) will be complete. Table 4.3 Soybean PAM Tradables Domestic Resources Output Inputs Labor Capital Profits Private 672,000 86,800 228,540 102,250 254,410 Social 602,400 105,962 251,090 82,750 162,598 Divergences 69,600-19,162-22,550 19,500 91,812 Create the Rainfed Corn PAM using the same procedure. The Soybean PAM will show absolute values for its cell address so it may be copied without additional preparation. Copy it below itself and label it Table 4.4. Rainfed Corn PAM. Change the letter addresses to I (Rainfed Corn data is contained in Column I of the Budget tables.) A completed Table 4.4 is shown below. 1. Chapter 12, pp. 226-236, of Monke-Pearson provides detailed interpretations of a number of PAMs that can serve as models for interpreting the high productivity paddy PAM. 16

Table 4.4. Rainfed Corn PAM Tradables Domestic Resources Output Inputs Labor Capital Profits Private 450,000 85,400 109,840 36,300 218,460 Social 453,000 169,874 126,350 36,300 120,476 Divergences -3,000-84,474-16,510 0 97,984 A Farming Systems PAM The three previous PAMs were created under the assumption that the social opportunity cost of land could not be identified. However, soybeans compete for the same land as rainfed paddy and rainfed corn. Examination of the Profit figures for rice show it to be superior to soybeans. This point is best demonstrated by creating a soybean PAM that includes a social cost for land in the form of the "next best alternative." To create such a farming systems PAM for Soybeans, first copy Table 4.3. Soybean PAM below the Rainfed Corn PAM table and label it Table 4.5 Soybean PAM (Farming Systems). Then add an additional column and label it Land indicating that an effort will be made to disaggregate Profits into a return to Land and a return to management. This step is required to obtain a correct understanding of comparative advantage within the farming system. The entry in the Private-Land cell comes from the cost of Land in the Private Budget table. Select the cell in which the entry is to be made, click on =, then click on the Private Budget tab (P-Budget) and click on the cost of land cell in the Soybean column. Calculate the social cost of land by referencing the cell that represents the highest value for Profits (Excluding Land) of the crops that compete directly for agricultural resources with soybeans. In this case, the crop is rainfed paddy. This value represents the opportunity cost of land to soybean growers because it describes what the returns to land would have been if it had been used in the next best alternative. To add the next best alternative (rainfed paddy) to Table 4.5, select the destination cell, click on the = sign, then click on the social budgets tab (S-Budgets). Locate the cell containing the Profits for Rainfed Paddy. Click on the cell and then click on OK. Complete the table by dragging the Divergences formula from Capital into the Land column. Table 4.5. Soybean PAM (Farming System) Tradables Domestic Resources Output Inputs Labor Capital Land Profits Private 672,000 86,800 228,540 102,250 225,000 29,410 Social 602,400 86,800 251,090 82,750 893,965-712,205 Divergences 69,600 0-22,550 19,500-668,965 741,615 Save the workbook as chap4.xls. Save again to create chap4.bak. Questions 17

1. Examine the resulting soybean PAM. Interpret the results from the perspective of private incentives. Is it profitable for farmers to grow soybeans? Where are the incentives for soybean production coming from? 2. Is soybean production socially profitable if within agriculture efficiency is considered, i.e., the opportunity cost of land is included as a domestic resource cost? What inferences can be drawn about the functioning of land markets on the basis of the evidence from the PAM? 18

CHAPTER 5: COMPUTING SUMMARY RATIOS To compare the profitability and efficiency of different crops, a common numeraire must be used throughout the analysis. The use of ratios is a convenient method of avoiding the problem of a common numeraire, particularly when the production processes and outputs are very dissimilar. Several useful ratios that provide information on private and social profitability can be derived directly from the data in the policy analysis matrix. Both the numerator and the denominator of each ratio are PAM entries defined in domestic currency units per physical unit of the commodity. Therefore, the ratio is a pure number free of any commodity or monetary designation. 1 In this part of the exercise, the results from the previous PAMs will be used to calculate the nominal protection coefficient (NPC), the effective protection coefficient (EPC), and the domestic resource cost coefficient (DRC). The ratios will be calculated in a summary table so that the results can be compared easily between crops. The summary table is also convenient for conducting sensitivity analysis on the results. To create the summary table, Insert a new worksheet in the workbook and rename it Ratios. The Ratio Table The summary table consists of four rows: high yielding paddy (wet), rainfed corn, irrigated soybeans (alone), and irrigated soybeans (system). The NPC, EPC, and DRC ratios appear in the columns. (The nominal protection coefficient is calculated separately on outputs and inputs in this example.) See Table 5.1 for the suggested format. The Nominal Protection Coefficient (NPC) The bottom row of the PAM indicates the extent of commodity and factor market divergences in the production of each crop. In the absence of market failures, this row measures the effects of distorting policy on inputs and outputs. The nominal protection coefficient, defined by the ratio of private commodity prices and social commodity prices, compares the impact of government policy (or of market failures that are not corrected by efficient policy) between different crops. 2 Calculate the NPC for tradable outputs (i.e., crop output) for each commodity shown in Table 5.1 from its corresponding PAM using the formula: NPCO = Revenue in Private Prices Revenue in Social Prices Select the cell to be completed, click on the = sign, then on the PAM tab. Click on the private output cell, type in /, then click on the social output cell. Click on OK. Utilize the same method to compute the NPCI. 1 For a more detailed discussion of various summary ratios including the DRC, see M-P pp. 25-29. 2 "Efficient" policies are interventions deliberately introduced to offset market failures. For a discussion of policies that promote food security in developing countries where imperfect capital and insurance markets make it difficult to obtain a desired protection against risk, see M-P, pp. 53-54. 19

An NPC for tradable outputs greater than 1 shows that the market price of the output exceeds the social price. The farmer receives an implicit output subsidy from policies affecting crop prices. Calculate the NPC for tradable inputs for each commodity shown in Table 5.1 from its corresponding PAMs. Cost of Tradable Inputs in Private Prices NPCI = Cost of Tradable Inputs in Social Prices An NPC for tradable inputs less than 1 indicates that market prices of inputs fall below the price that would result in the absence of policy. This ratio reveals the presence of input subsidies, taxes, trade restrictions or an inappropriate exchange rate. Table 5.1. Summary Ratios Ratios of protection and efficiency NPC EPC DRC Outputs Inputs High-Yield Paddy (wet, single commodity) 0.493 0.472 0.495 0.253 Soybean (single commodity) 1.116 0.819 1.179 0.672 Rainfed Corn (single commodity) 0.993 0.503 1.288 0.574 Soybean (farming system) 1.116 0.819 1.179 3.005 The Effective Protection Coefficient (EPC) The effective protection coefficient, defined as the ratio of value added in private prices to value added in social prices, more completely measures incentives to farmers. The EPC indicates the combined effects of policies in the tradable commodities markets. This is a useful measure because input and output policies, such as commodity price supports and fertilizer subsidies, often constitute part of a comprehensive policy package. For example, governments frequently reduce the price of outputs but then subsidize inputs in an effort to encourage the adoption of new technology. Calculate the EPC cell in Table 5.1 for each of the commodities using the formula: EPC = (Revenue - Cost of Tradable Inputs) in Private Prices (Revenue - Cost of Tradable Inputs) in Social Prices To compute the values for the EPC cells, use the methods described earlier for computing the values for the NPCs. Select the cell, click on =, click on the PAMs tab, and complete the formula. An EPC greater than 1 indicates positive incentive effects of commodity policy (a subsidy to farmers) whereas an EPC less than 1 shows negative incentive effects (a tax on farmers). Both the EPC and the NPC ignore the effects of transfers in the factor market and therefore do not reflect the full extent of incentives to farmers. The Domestic Resource Cost Coefficient (DRC) 20

The domestic resource cost coefficient measures the efficiency, or comparative advantage, of crop production. If the social returns to land cannot be identified clearly because full information about alternatives is lacking, the DRC may be calculated with respect to labor and capital only. The DRC serves as a proxy measure for social profits. It is calculated by dividing the cost of labor and capital by value-added at social prices. From Table 3.1, the DRC equals G/(E-F). Calculate the DRC for the single commodities as: Where the opportunity cost of land can be clearly identified, the DRC is calculated by including the cost of land (i.e., the social profitability) of the next best alternative crop. The resulting DRC reflects the country's comparative advantage, not only with respect to capital and labor, but within agriculture as well. Calculate the DRC for the farming system as: Use the methods described above to compute the values for Table 5.1 under the Ratios tab. The DRC will be positive unless the social value added in crop production is negative. However, DRCs greater than one indicate that the value of domestic resources used to produce the commodity exceeds its value added in social prices. Production of the commodity, therefore, does not represent an efficient use of the country's resources. DRCs less than one imply that a country has a comparative advantage in producing the commodity. Values less than one mean that the denominator (value added measured at world prices) exceeds the numerator (the cost of the domestic resources measured at their shadow prices). Save the spreadsheet as chap5.xls. Save again to create chap5.bak. Sensitivity Analysis (Labor Cost+ Capital Cost) in Social Prices DRC = (Revenues- Cost of Tradable Inputs) in Social Prices DRC = (Labor Cost+ Capital Cost + Land Cost) in Social Prices (Revenues- Cost of Tradable Inputs) in Social Prices The stage has now been set to examine the sensitivity of these production systems to alternative assumptions about output, input, and domestic factor prices. Examine the impact of the effects among crops if: 1)The market price for all fertilizers is raised to Rp200/kg. 2)The market price for soybeans is lowered to Rp380/kg. 3)The market price for corn is doubled. 4)The yield for corn is doubled. 21

5)Social prices (reflected by changes in international markets) for paddy and soybeans double. 6)Determine the "break-even" world price for output that either gives or removes each crop's comparative advantage. 22

CHAPTER 6: ESTIMATING SOCIAL PRICES Chapter 3 provided a ready-made set of social prices that were used to illustrate PAM computations. In most cases, however, analysts will be required to compute the social prices for both tradables and nontradables. This chapter shows how to calculate the import and export parity prices that measure social prices for tradable inputs and outputs. Social prices are calculated on the basis of the opportunity cost, or most profitable alternative, of inputs and outputs. For tradable inputs and outputs, social prices are derived from prices in international markets. Estimation of social values for nontradable goods and domestic factors is more difficult and requires detailed knowledge of individual factor markets (see Chapter 8). 1 This chapter discusses import and export parity prices and details the computation of social prices for the tradables (linked back to the Social Prices table constructed in Chapter 3). Social Prices for Tradable Goods The social price of a tradable output or input at the wholesale market nearest to the farm gate equals the international or border price adjusted for exchange rates and domestic transportation, processing, and marketing costs. The resulting farm gate prices are called import and export parity prices or sometimes border price equivalents. They are computed in the following steps: Determining International Commodity Prices. Determining an international price for the commodity can be done in several ways. The simplest way, if the data are available, is to consult the country's trade statistics. For imports, the appropriate measures are the so-called c.i.f. prices. 2 They often can be obtained by dividing the value of the imported commodity by the quantity imported. For exports, the appropriate values are f.o.b. prices, computed in the same way. 3 Using local sources may be misleading, however, when only limited amounts have been traded or trade has taken place under special concessional circumstances. In this case, the alternative is to use quotes from a major international market in which a large volume of the good is traded, adjusted for international shipping. Data on insurance and freight can be obtained from shipping companies or freight forwarders. 1 Important references for the computations made in this chapter are contained in Chapter 11 of the M-P text. Pages 188-199 deal with the calculation of domestic import and export parity prices when starting with the prices in international markets. That section also contains a discussion of the implications of over- or undervalued exchange rates for establishing the prices of tradables in domestic currency. Pages 199-209 address the difficult question of how to estimate social prices of factors, i.e., of domestic resources. 2 C.i.f. prices include the cost of the commodity in the exporting country plus the insurance and freight required to move it from the point of export to the harbor of the importing country. Consequently, "border" prices have traditionally meant "at the border" and do not include the handling cost required to move goods from the boat to the dock of the importing country. The latter distinction is rendered meaningless in the case of truck, rail, and air transport. 3 F.o.b. (free on board) prices are measured on the boat in the harbor of the exporting country. 23

The computation of import parity prices using international market sources begins with the f.o.b. price at the border of the reference country, usually a major exporter. Insurance and freight are added to obtain the c.i.f. price in the importing country. Export parity prices can be obtained in a similar fashion. In this case, however, the reference is the border of major importers. Insurance and freight are subtracted to arrive at f.o.b. prices at the local border. Determining an Exchange Rate. Converting prices expressed in international currency to their domestic currency equivalent requires an appropriate foreign exchange rate. The official exchange rate can be used in the calculations only if it accurately reflects the true scarcity value of foreign exchange. In many developing countries, the official foreign exchange rate is overvalued and foreign exchange is rationed through a system of exchange controls. Hence, the exchange rate must be adjusted to reflect the true "willingness of the economy to pay" for tradable goods and services. When the equilibrium foreign exchange rate (EER) -- the social price that reflects the true value of foreign exchange -- differs from the official exchange rate, the difference can be expressed as a foreign exchange premium. For example, if the official exchange rate is overvalued by 10 percent, the shadow exchange rate equals the official rate times (1+.1). 1 Once an EER is selected, international prices can be converted to local currency by multiplying the international price times the equilibrium exchange rate. Converting Weights of Locally Traded Units. Often the units of international trade differ from those traded locally. In the current example, domestic prices have been quoted on a per kilo basis, while those for international trade are often quoted per metric ton. The appropriate ratio must be established to convert the international units into locally meaningful measures. Determining the Costs of Distribution. The fourth step in computing the value of a commodity at the farm gate requires costing the marketing (transportation, storage, and processing) activities that link the border to the nearest wholesale market and the farm. The computation can be broken into two parts. For imports, the first part consists of adding the costs of activities between the border and the wholesale market where the farmer sells or purchases the commodity; imports cost more as they move from the border inland. For exports, the reverse is true. Transportation and processing costs between the wholesale market and the border are subtracted; exports are worth less at the wholesale market than they are at the border. The second part of the computation involves the link between the wholesale market and the farm gate. In the case of imports, the calculation depends on whether the commodity is an output or an input. For imported outputs, the c.i.f. value of the commodity at the wholesale market is too high because it does not take into account the cost to the farmer of bringing his goods to market. Hence, the farm to wholesale distribution costs must be subtracted. For imported inputs, the opposite is true. Inputs must be transported to the farm, and, hence, distribution costs must be added to the wholesale price to obtain a farm gate price. 1 The discussion on the top of page 197 in M-P regarding exchange rate adjustments to factor prices represents a long-run view. A more complete discussion of equilibrium exchange rate computation when partial equilibrium methods are being used is contained in Isabelle Tsakok, Agricultural Price Policy, Cornell University Press, 1991. 24