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United Nations Development Programme (UNDP)

Measuring the impact of price changes on poverty1

Working Paper number 33

Hyun H. Son2, Nanak Kakwani

International Poverty Centre (IPC), United Nations Development Programme (UNDP)

November 2006

SARPN acknowledges UNDP as a source of this document: www.undp-povertycentre.org
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Abstract

This paper develops a methodology to measure the impact of price changes on poverty measured by an entire class of additive separable poverty measures. This impact is captured by means of price elasticity of poverty. The total effect of changes in price on poverty is explained in terms of two components. The first component is the income effect of the change in price and the second is the distribution effect captured by the price changes. It is the distribution effect which determines whether the price changes benefit the poor proportionally more (or less) than the non-poor. This paper also derives a new price index for the poor (PIP). While this index can be computed for any poverty measures, our empirical analysis applied to Brazil is based on three poverty measures, the head-count ratio, the poverty gap ratio and the severity of poverty. The empirical results show that price changes in Brazil during the 1999-2006 period have occurred in a way that favors the non-poor proportionally more than the poor. Nevertheless, during the last 2-3 years the price changes have favored the poor relative to the non-poor.

Introduction

Changes in relative prices can have a large impact on poverty yet most studies do not address the issue of relative prices.3 In the measurement of trends in poverty, a common method is to update the poverty line over time using the Laspeyres price index, which uses the average budget shares as the weights. This index is completely insensitive to the distributional impact of prices.

Kenneth Arrow in 1958 noted that people with lower incomes are likely to have consumption patterns that differ from those with higher incomes. For instance, people with lower incomes spend more of their budget, on average, on necessities than they spend on luxuries. This means that if the prices of necessities increase faster than those of luxuries, the poor will be more adversely affected than the non-poor.

The main objective of this paper is to systematically capture the impact of prices on poverty. Poverty can be measured by several indices; the most common among them are the class of Foster, Greer and Thorbecke (1984) poverty measures. Every poverty measure gives different weights to the poor depending on how far below the poverty line they are. Therefore, the impact of prices on poverty will differ depending on which poverty measure is used. In this paper, we develop a methodology to measure the impact of prices on poverty measured by an entire class of additive separable poverty measures. This impact is captured by means of the price elasticity of poverty, which is decomposed as the sum of two components. The first component is the income effect of price change and second component is the distribution effect. It is the distribution effect, which determines whether price changes are pro-poor or anti-poor.

In this paper, we also derive a new price index for the poor (PIP). The weights used in the new indices are derived from the price elasticity of poverty. Thus, there will be a monotonic relationship between the PIP and the changes in poverty; the higher the index, the greater the increase in poverty.4 Price changes are judged as pro-poor (or anti-poor) if the PIP is less (or greater) than the Laspeyres price index.

We introduce our actual analysis as follows: Sections 2-6 are devoted to the methodology to define and derive the new price index for the poor. Following that, the seventh section sets out the analysis of our empirical results, whereby the methodology developed in the paper is applied to Brazil. The final section offers some concluding remarks.


Footnotes:
  1. The authors are grateful to Rafael Osorio for his invaluable assistance and excellent work in matching price data with a household survey for a large number of commodities. We also would like to acknowledge Sergei Soares, Marcelo Neri and Marcelo Medeiros for their helpful comments.
  2. E-mail address for correspondence: ; Tel: 55-61-2105 5025; Fax: 55-61-2105 5001/5002.
  3. Many studies have focused on price indices for specific demographic groups including the poor. Related studies have examined the impact of inflation on low-income consumers, and a few have applied different price indices to adjust poverty thresholds and analyzed the impact of those adjustments on poverty rates. (see Michael and Hagemann (1982), Kokoski (1987), Amble and Stewart (1994), Boskin and Hurd 1985, Jorgenson and Slesnick 1983). Yet, none of these studies provide a theoretical framework to capture the impact of prices on poverty.
  4. Note that this relationship will be the first-order approximation because in this study we ignore the substitution effect of price changes.


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