Price formation at the domestic market takes place at the wholesale market level. During model solution, the level of the domestic wholesale price can be determined in three ways:
1. In a net importing situation, the domestic wholesale price is at the import-based level.
2. In a net exporting situation, the domestic wholesale price is at the export-based level.
3. In a no net trade situation, the domestic price is between the export-based and the import-based level. In such a situation the domestic wholesale price is determined by the equilibrium of domestic supply and demand.
Graph 5.1 below depicts these three options modelled in TURKSIM.
Graph 5.1: Domestic Price Formation in Different Net Trade Situations
At the vertical axis various prices and margins are shown. Due to international transportation cost the cif price exceeds the fob price. In the absence of any border policies at the export side the export based price (Peb) is determined by the fob price plus any margin due to domestic transportation and quality, which
Price
D2 D3 D1 S
Pib
t qual Pcif
Peb
qual Pfob
Quantity
is assumed to be positive in this example (qual). The import based price (Pib) is determined by the cif price plus a quality/transportation margin (qual) and any border policies at the import side, in this example a tariff (t).
If the demand curve is at D1, demand exceeds national supply S at Pib, and the country is in an importing situation. If the demand curve shifts left to D2, supply exceeds demand at Peb and the country is in an exporting situation. If the demand curve is at D3 a domestic market equilibrium exists with the price being below Pib but above Peb.
The adjustment of the internal price resulting from a changing net trade situation, whether it results from trade policy, world market price changes, or a shift of the supply or demand curve, takes place smoothly. This is shown in Graph 5.2 for a situation in which increasing domestic demand, ceteris paribus, induces price changes.
Graph 5.2: Domestic Price Formation in Different Net Trade Situations
In an exporting situation, in which net exports (NX) are positive, the internal price is at Peb. If net imports reach zero due to the demand curve shifting to the right, the domestic price increases along the price line, determined by the equilibrium of internal supply and demand. This price change does not necessarily assume a linear course as sketched in Graph 5.2, but rather depends on the selected functional forms of domestic demand and supply as well as on exogenous factors like population or productivity growth which determine their
Price
Pib
Peb
Domestic demand NX > 0 NX = 0 NX <0
position. If the price line reaches the import based level, net exports become negative and the domestic price remains constant with increasing net imports.40 5.3.2 The Generation of Border Prices and the Link to the Domestic Price
Level in the Base Situation
For the base situation, domestic wholesale prices and import or export prices are observed prices.41 If import-export prices are multiplied by the exchange rate and the relevant border policies (export subsidies, tariffs) are added one would expect these "border prices" to be close to the observed domestic prices. But this is not always the case; considerable margins, positive or negative, can be observed in many cases between domestic and border prices. Various factors can contribute to these margins. They are discussed here in the context of an importing situation, but would be similar in an exporting situation, as well:
• Transportation cost: the location of the domestic price observation can be closer or further from the main consumption regions than is the place of importation. The domestic price can therefore be higher or lower than the import price. In addition, a marketing margin of the importing company could result in the domestic price being above the import price.
• Quality differences: the imported product could be of higher or of lower quality than the average domestic product. The domestic price can therefore be higher or lower than the import price.
• Differences in packaging: the imported product can be packaged more or less ready for consumption than the product for which a domestic price is reported. For example, vegetable oil may be imported in tanks, while domestic wholesale oil is in 1 or 5 liter containers. The domestic price can therefore be higher or lower than the import price.
40 In order to solve TURKSIM such that the resulting net export position is in accordance with the wholesale price level chosen (Pib, Peb, or domestic), an iterative procedure is applied. First, all domestic wholesale prices are set at Peb level and the model is solved. In a loop over all products the domestic price is then set at Pib level if results of the first run indicate net exports below zero, and the model is solved again. If the resulting net exports are positive, net exports are fixed to zero and the model is solved again such that domestic demand equals domestic supply. The change of the net trade position of any product can, due to various cross-price relations at the demand as well as at the supply side, cause a change in the net trade position for any other product. Therefore this procedure is repeated several times until the net trade position remains stable.
41 In some cases the farmgate prices are the observed prices and wholesale prices are calculated by adding a processing margin. See Subchapter 7.2.
• Indirect import restrictions, e.g. restrictive import licensing can raise the domestic price above the border price.
How are these price margins to be handled in a model? For TURKSIM, product specific assumptions are made about the size of the transportation margin and, in some cases, about indirect border measures like implicit export subsidies financed by budgetary losses of state trading enterprises. The residual is considered a quality margin. Before explaining the procedure in detail, Table 5.4 presents the parameters and sets used for establishing the link between domestic and border prices.
Table 5.4: Parameters and Sets Used for Establishing a Link between Domestic and Border Price
Price parameters Margins
p_ws Domestic wholesale price cfsp Cif-fob spread
p_eb Export-based price tr_im Transportation cost in an importing situation
p_ib Import-based price tr_ex Transportation cost in an exporting situation
p_ex Export price qual Quality margin p_im Import price Policy parameters
p_wm World market price t_av Ad valorem tariff chg_wm World market price change t_sp Specific tariff
pr_tr Price transmission es Export subsidy er Exchange rate
Sets
Abbrev. Description External parameter Calculated parameter ib Products for which the domestic price in the
base situation is linked to the import price
p_ws, p_im, cfsp, tr_im, tr_ex, er
p_ex, qual, p_eb eb Products for which the domestic price in the
base situation is linked to the export price
p_ws, p_ex, cfsp, tr_im, tr_ex, er
p_im, qual, p_ib dom_ib Products for which the domestic price is not
linked to a border price in the base situation, import price observed
p_ws, p_im, cfsp,
tr_im, tr_ex, er, qual p_ex, p_ib, p_eb dom_eb Products for which the domestic price is not
linked to a border price in the base situation, export price observed
p_ws, p_ex, cfsp,
tr_im, tr_ex, er, qual p_im, p_ib, p_eb sc Scenarios (base and simulations)
Source: Own compilation.
The top of Table 5.4 presents price, margin and policy parameters which are used in establishing the link between domestic and border prices. The lower part shows the four categories into which tradable products are classified, and indicates which parameters are external parameters and which are calculated internally for each of these categories. For each of the categories, the establishment of border prices is described in detail below.
The category ib includes products for which significant net imports are observed in the base period, and therefore the domestic wholesale price (p_ws) is assumed to be linked to the import price (p_im). In such a situation, p_ib is set equal to p_ws. The quality margin, the export price, and the border price, which would occur in an exporting situation (p_eb) under the base situation, are then calculated as follows.
The quality margin is determined as the residual of the wholesale price minus the import price multiplied by the exchange rate (er) plus tariffs (ad valorem and specific) and a transport margin in an importing situation (tr_im):
(5.24) qual = p_ws – p_im • er • (1+t_av) + t_sp + tr_im.
The export price equals the import price minus the cif-fob spread (cfsp):
(5.25) p_ex = p_im – cfsp.
The border price which would occur in an exporting situation (p_eb) equals the export price multiplied by the exchange rate plus any export subsidy (es), a transport margin (tr_ex), and the quality margin as determined in (5.24):
(5.26) p_eb = p_ex • er +es + tr_ex +qual.
The set eb includes products for which significant net exports are observed in the base period, and therefore the domestic price is assumed to be linked to the export price. In such a situation p_eb is set equal to p_ws. The quality margin, the import price (p_im), and the border price, which would occur in an importing situation (p_ib), are then calculated as follows:
(5.27) qual = p_ws – (p_ex • er + es + tr_ex), (5.28) p_im = p_ex + cfsp, and
(5.29) p_ib = p_im • er • (1+t_av) + t_sp + tr_im + qual.
For some products, no significant trade exists in the base situation and the domestic wholesale price is therefore assumed to be determined by domestic supply and demand. These products are included in sets dom_ib and dom_eb.
Border prices must be established for these products as well to allow for a shift
towards a net exporting or a net importing situation in the course of the simulation process. To this end an export price (in case of dom_eb) or an import price (in case of dom_ib) for the product concerned is chosen such that it is as
"representative" as possible for the domestic quality. This allows for the omission of the specification of any quality margins in those cases. In the case of dom_ib, border prices are established as follows:
(5.30) p_ib = p_im • er • (1+t_av) + t_sp + tr_im, p_ex is obtained according to (5.25), and
(5.31) p_eb = p_ex • er +es + tr_ex.
For dom_eb, prices are determined in analogy, the only difference is that the export price is external and the import price is determined according to (5.28).
5.3.3 The Generation of Border Prices and the Link to the Domestic Price Level in Simulations
Changes in border prices between the base situation and the simulations can be caused by two factors: changes in world market prices, and changes in border policies. These changes are introduced in TURKSIM as follows. World market price changes for each scenario and product are specified externally and applied to the respective import and export prices in the base period. The relative changes of world market prices under the simulations are also applied to the quality margins. The underlying assumption is that different qualities are very close substitutes and relative prices therefore remain constant.
All border policy parameters (es, t_av, t_sp) are defined for each scenario, and border prices are calculated according to (5.26) and (5.29), based on the respective import/export prices, policy parameters, and quality margins.
Based on these mechanisms the extent of price transmission from changing border prices to domestic prices differs according to the net trade poition:
1. The relative change of the border price is almost fully transmitted to the domestic price if the net trade position does not change (only specific tariffs, export subsidies and transport margins do not vary with the border price). In this case, the price transmission elasticity is close to one.
2. The change of the border price is only partially transmitted to the domestic price if the net trade status changes.
3. The change of the border price is not transmitted to the domestic price if price formation is domestic in the base situation and in the respective simulation.
For some products for which transportation costs are high, the mechanism described above seems questionable. This is especially the case for meat and dairy products. Most of these products require chilled transportation and storage from the point of entry to the retail level. These requirements are costly and, in some local markets may be unavailable. As a result, even in a clear net importing situation, price transmission from border price to domestic price may, on national average, be significantly below unity as some local markets are separated from the border price. In order to model this effect, a price transmission parameter (pr_tr) is introduced, which is usually fixed at unity but, in some cases, may be set below one and influences the change in border price:
(5.32) p_ebsc, i = p_ebsc = base, i + pr_tri • (p_ebsc, i - p_ebbase,i), with the import based price determined accordingly.42