Appendix 3 Examining the Short-Term Impact of Reducing Price Subsidies on Real Household Incomes: An Illustration
- Juan Cordoba, Robert Gillingham, Sanjeev Gupta, Ali Mansoor, Christian Schiller, and Marijn Verhoeven
- Published Date:
- December 2000
42. This appendix provides two competing pragmatic approaches to estimating the impact of price-subsidy reform on households in the short term.
- Estimate the loss of real household income as the arithmetic mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This amounts to the following:where RL denotes the impact on real household income in percent, wi is the share of item in household expenditures, Pi(1) is the new (in most cases, higher) price of item i, and Pi(0) the price before the reform of price subsidies. This estimate of the loss of real household income can be illustrated with an example. Suppose the price of subsidized rice rises by 50 percent, and that the weight of rice in the expenditures of poor households averages 30 percent, and that of non-poor households, 10 percent.18 Using the above equation, the average impact on the real income of poor households can then be estimated at 15 percent. For nonpoor households, the corresponding loss in real income is smaller—5 percent, on average.This estimate provides an upper boundary on the increase in living costs. If households respond to changes in relative prices by shifting away from the item for which the price has increased, the actual loss will be smaller. The loss will be close to the above estimate if the subsidized item is a basic commodity for which no ready substitutes are available. If there is a perfect substitute, households will react to even a small change in the price of the subsidized item by shifting completely out of that item and into the substitute, suffering no loss in real income. The procedure below recognizes the likelihood of a consumer response.
- Alternatively, estimate the real loss of household income as the geometric mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This can be calculated as follows:Using the same example as before, the estimated loss of poor house-holds from a rise in the price of rice by 50 percent can be calculated at 13 percent, and for nonpoor households, 4 percent. These estimates reflect the case when households are responsive—but not infinitely so—to changes in relative prices.19
43. Which estimate of real-income loss is more appropriate? The above approaches provide a reasonable range within which the correct answer is likely to fall. Which point in this range is most relevant for estimating the desirable level of compensation for price-subsidy reform depends on many factors, including whether the subsidized item is a basic commodity and some substitution possibilities exist. To be more precise, which estimate is more accurate depends on the size of the income effect of the price change versus the substitution effect. What is reassuring, however, is that the difference between the two estimates is typically small for poor households. In the above example, the estimates differ by only two percentage points.
Index Guide to Concepts and Issues20
- Administrative capacity, 7, 14, 16, 23, 25, Box 1, and Table 1.
- Available financing, 7 and 26.
- Benefit incidence and equity, 19–20, 28, 31–32, 35, and 40.
- Cash transfers, 8–11, 15–16, 29, and Boxes 3–4.
- Delivery mechanism, 15, and Box 3.
- Exogenous factors, 29, 33, and Box 1.
- Efficiency of compensation mechanisms, 12–13 and 34.
- Fiscal savings, 1–2, 5–7, 26, 33, and Boxes 1–3.
- Mass information campaigns, 32, and 35.
- Middle class and other nonpoor groups, 7, 28–29, and 32.
- Political disruption, 28–32, and Box 4.
- Political support for price-subsidy reform, 6–7, 28–32, and Boxes 1 and 4.
- Price-subsidy reform in the longer term, 9, 32, and 34.
- Rationale for price-subsidy reform, 1, 4, 18, 20, and 41.
- Reversal of price-subsidy reform, 6–7, 33, and Box 1.
- Social impact and disruption, 2, 4–5, 20–21, and Boxes 1 and 3.
- Social safety nets and social compensation instruments, 5, 7–10, 15–16, 23, 25–26, 32, 34, Boxes 1–4, and Table 1.
- Speed of price-subsidy reform, 5–7, 33, and Box 1.
- Stakeholder approach, 32, 35, and Box 4.
- Subsidies by type,
- Subsidies and environment, 27 and 41.
- Targeting, 8, 10–16, 25, 28, 34, Boxes 2–3, and Table 1.
- Targeting by type,
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