# **B – Price shock model**

# Step 4 – Identify the price shock

There are two main forms of subsidies reforms simulations that have slightly different implications for modeling. These two forms can be regarded as looking at the same problem from two different angles.

The first form is an increase in prices of the subsidized product. The government has an idea of the price increase it wants to apply to the subsidized product and wants to know what this implies for household welfare and government revenues. From a modeling perspective, this is a simple increase in the price of the subsidized product that can be modeled by changing the product price in the household expenditure data.

The second form of subsidies reform simulation is a budget cut that affects agents that manage the subsidized products. For example, the subsidized product may be produced by a public or private company that receives subsidies directly from the government so as to sell the product at regulated prices. In this case, we know the intended budget cut but not the corresponding increase in prices.

To model such change, we can follow one of at least two options. The first option is to spread the budget cut on households proportionally to the share of subsidized product consumed. In this case, households will bear the budget cut in a proportion that is equivalent to the share of subsidized product consumed over total household consumption of that product. This is what we described for the incidence analysis but it is unsatisfactory because amounts to an incidence evaluation where we cannot model elasticities. The second option is to simulate increases in prices that would result in an increase in revenues for the government equivalent to the budget cut. This is a more accurate approach because the final change in government revenues will result from simulations that can take into account price-quantity and crossprice elasticities and other factors that may affect demand. This is the approach followed in this manual.

# Step 5 – Define the assumptions

Before modeling changes in subsidies, the analyst needs to make a number of critical decisions on assumptions regarding sequencing of events, deflators, budget constraints and elasticities. To simplify these choices we can think of choosing between modeling short-term, medium-term and long-term effects. As a rule of thumb, we can think of these three time-horizons as described in terms of days, months and years respectively.

**Short-term effects (days)** include the change in price determined by the government but no inflation adjustments, no behavioral effects and no life-cycle effects. The assumption here is that when the price of a subsidized product increases, in the very short-term, households will simply respond by keeping quantities consumed unaltered and, as a consequence, by increasing expenditure. That is because most households can afford to buy at least once the subsidized product at increased prices and because it is unlikely that households would re-assess their income and budget priorities in a matter of days. Economically speaking, this amounts to assume that households can draw temporarily on savings to increase current expenditure and, by doing so, they lift the budget constraint. The odd effect of this assumption is that, with an increase in price and no inflation adjustments, households will increase

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