Right way of comparing poverty across countries

The Asian Development Bank has just recently released this years Key Indicators Publication. It contains a special chapter, which I co-wrote with Rana Hasan and Rhoda Magsombol, focuses on the subject of purchasing power parities (PPPs). Entitled "Comparing poverty across countries: The role of purchasing power parities," this special chapter explores how alternative approaches to compiling PPPs influence internationally comparable estimates of poverty. Well, I wouldn't be surprised if in the next few days, a debate would show up comparing the "Asian" poverty line that we came up and the latest $1.25-a-day poverty line recently published by the World Bank (the media always like conflicts). But what our chapter places more emphasis on, and what I will focus on my piece below, is the importance of the methodology used in generating the PPPs, with the particular goal of using these PPPs for poverty analysis.

By the way, most of my discussion below is drawn heavily from the Highlights paper of the Special Chapter.

Why the PPPs?

The demand for internationally comparable estimates of poverty is considerable. Policy analysts, researchers, and international donor agencies often want to compare the incidence of poverty across countries. These international comparisons can be carried out globally, regionally, or even across two countries.

Now, three things are needed to make such international comparisons: (1) nationally representative data on household expenditures for each country; (2) an international poverty line is needed that represents some predetermined threshold standard of living that is constant across the countries where poverty is to be compared; and, (3) a conversion factor needed to express the international poverty lines into local currency values in order to finally compute for the estimates of poverty using the aforementioned data on household expenditures.

Getting the first one is easy (depending on the availability). As I mentioned, I won't dwell on the second one. So for the third one, what is the conversion factor to be used?

Crucially, it will not be market exchange rates, but instead it will be the purchasing power parities (PPPs). PPPs are conversion factors that ensure a common purchasing power over a given set of goods and services. The chapter goes into detail on the differences between the market exchange rate and the PPP, but suffice to say the PPPs capture the prices of all products while market exchange only captures prices of tradeable goods. Obviously, the value of the international poverty line will depend on the value taken by PPPs, which means that the precise value taken by PPPs can make a considerable difference to the estimates of poverty for any given international poverty line. Moreover, . For these reasons, it is crucial to get the value of PPPs right.

Which PPP?

At heart, PPPs are based on comparisons of prices of a selected set of products across countries. There are many types of PPPs, which depend on where the international comparison will be used for: GDP PPP, household consumption PPP, etc. Using household consumption PPP as and example, PPPs are computed in the following way. First, a basket of goods and services relevant for household consumption was identified. Second, the products in the basket were priced through a survey of retail outlets. Third, PPPs were generated at the “basic heading” level – i.e., a grouping of closely related products, for example, different varieties of rice or types of garments. Finally, basic heading PPPs were “aggregated” to generate a final set of PPPs.

Crucially, the process of aggregation involves weighting basic heading PPPs by an appropriate set of expenditure weights, or shares. In my example, the expenditure shares should accurately reflect the relative importance of basic heading groups of products consumed by households.

The general point is that the choice of the basket of goods and services is crucial for purposes of interpretation and use of a given PPP. In practice, PPPs at the GDP level are commonly used for comparing real incomes across countries. If instead the comparison involves standards of living across households, PPPs for household consumption expenditure would be more appropriate than PPPs for GDP.

As noted, PPPs are available for comparisons of GDP and its various subcomponents. Among these, the PPP most naturally suited for poverty comparisons is that pertaining to household final consumption expenditures.

However, as the special chapter clearly emphasizes, consumption PPPs are not ideal for generating comparable estimates of poverty. They may be inappropriate for poverty comparisons if poor households’ consumption patterns are significantly different from those of the general population. Such a difference may be explained by two broad reasons.

First, poor households may consume different types of products from the general population, i.e., the basket of goods and services priced for compiling consumption PPPs may not match up well with the basket of goods and services consumed by the poor. Some of the differences in the products consumed by the poor and by the general population may be quality related. For example, while both the poor and nonpoor may consume rice, the former may consume a lower-quality variety than the latter. Alternatively, some products are consumed by only one group or the other – automobiles, for example.

A further twist can appear if the prices paid by the poor versus the nonpoor differ in some systematic manner. In particular, to the extent that the poor and nonpoor purchase items in different quantities and/or at different types of retail outlets, one can expect the prices paid by the two groups to differ.

For many products, the unit price may well decline as purchase quantities increase. Since the poor are less likely to be able to afford large purchase quantities, they may end up paying more per unit of the product. Conversely, if the poor frequent fresh-produce markets as opposed to modern supermarkets-–where the retail prices may well incorporate the costs of air conditioning, parking space for cars, and other amenities for shoppers – more often than the nonpoor, they may pay less.

Second, even if both groups consume identical products and purchase them in similar quantities and from similar retail outlets, they are likely to spend very different proportions of their total expenditures on these products.

Thus for example, even if the poor and the nonpoor purchase and consume the same variety of rice and buy it in similar quantities and from similar retail outlets, the poor can be expected to spend a larger proportion of their total expenditures on rice than the nonpoor. Since PPPs are ultimately based on aggregating relative prices by expenditure shares, using the expenditure shares of the general population rather than those of the poor may well yield PPPs that are less than ideal for comparisons of poverty across countries.

Expenditure weights are provided for two different population groups in each country. The first is based on national accounts weights, i.e., weights are drawn from the national accounts and refer to the whole population in the country. The second is drawn from household expenditure survey data and is based on the expenditure patterns of individuals in the bottom 30% of the distribution of per capita expenditures.

While the overlap between these individuals and those who are “poor” in terms of a given absolute poverty line is unlikely to be perfect, the bottom 30% should capture the expenditure patterns of the poor better than the expenditure patterns of the entire population for any reasonable poverty line. As expected, the poor – defined here to be the bottom 30% – tend to spend a significantly larger share of their outgoings on food and nonalcoholic beverages. For example, the shares of food and nonalcoholic beverages are 65.6% and 51.1%, respectively, for the poor and for the general population in Bangladesh. More generally, the expenditure weights presented in the figure show systematic and significant differences in the purchase patterns of the general population and of the bottom 30%.

In a nutshell, the practice of using consumption PPPs for international comparisons of poverty implies that the PPPs are derived via a list of products and associated prices that may not be representative of products consumed by the poor and the prices paid by them. Additionally, the consumption PPPs are derived using expenditure weights, or shares from the national accounts, i.e., they reflect the expenditure patterns of the general population and not necessarily the poor.

To what extent do these two factors affect the generation of international poverty lines and associated poverty rates? Well, you'll just have to check the special chapter yourself. I won't go into those details. Suffice it to say, we generated alternative PPPs that make use of a price dataset that is relevant to the poor, as well as expenditure shares that are reflective of the poor. What turns out is that there are differences between the alternative PPPs, and given that our main purpose is to compare international poverty, we recommend the use of PPPs that are calculated using prices paid specifically by the poor, and using expenditure weights that are exactly represented by the poor.

Why poor countries are... well, poor

by Polar Bear (guest-blogger)

In one of the chapters of his 2006 book, Undercover Economics, Tim Harford presented an engaging analysis that tries to explain why countries such as Cameroon and Nepal are poor.

The author asks the question: Why is it that in spite of (1) potentially higher rate of returns on investment in poorer countries (i.e., aggregate production function exhibits diminishing returns) and (2) the increasing availability and affordability of technology that will allow poorer countries to catch-up with richer ones, some countries like Cameroon fall farther behind?

“Banditry” at the top level which spills over to all aspects of governance is the root of persistent poverty in poor countries. It is in the nature of this problem to resist solution but according to the author, there are some simple reforms which could move poor countries in the right direction. These include (1) cutting red tape, (2) allowing business to be legally established, (3) enlisting the global economy’s help for access to cheaper raw materials, loans and manufacturing equipment, and (4) bringing down trade barriers.

Harford’s analysis is very much in line with theories on New Institutional Economics as popularized by eminent economists such as Ronald Coase, Kenneth Arrow, Friedrich Hayek, Gunnar Myrdal, Herbert Simon, Douglas North and John Commons. In his 1998 article “New Institutional Economics”, Ronald Coase succinctly explained the foundation of NIE as follows:

The welfare of human society depends on the flow of goods and services. The flow of goods and services depends on the productivity of economic system. The productivity of the economic system depends on specialization (or the division of labor). Specialization is only possible if there is exchange. The lower the cost of exchange, the more specialization there will be and so the greater the productivity of the system. The cost of exchange ultimately depends on the institution of a country.

Institution matters. But what does “institution” mean? Oliver Williamson in his 2000 article “The New Institutional Economics, Taking Stock, Looking Ahead” describes the four levels of institutional analysis as follows:

Level 1—the top level is often referred to as the social embeddedness level. This is where the norms, customs, traditions and religion are formed. Institutions at this level change very slowly – on the order of centuries and millennia. The concept of level 1 institutions has been advanced to answer questions such as “What is it about informal constraints that gives them such a pervasive influence upon the long-run character of economies?” Why for instance can the Filipino people ignore character flaws and lack of credential of political personalities the moment they become “anointed” candidates? Religion, no matter how irrational it sometimes is has been imbedded in the Filipino psyche by hundred of years of indoctrination just as the “kanya-kanya” mentality can be rooted to the archipelagic nature of our lands.

Second Level – going beyond informal traditions and codes formal rules such as the constitution, laws and property rights are introduced in this level. While constrained by the informal factors in level 1, the reform instruments in level 2 include the executive, legislative, judicial and bureaucratic functions as well as the distribution of powers across different levels of government. Although these are arguably important, introducing reforms at this level is very hard to orchestrate. Failed attempts to introduce charter change in the Philippines can be categorized in this level. Changing the rules of the game at such level has overwhelming impact that initiatives to institute such wide-ranging reforms are often clouded by distrusts. Nations sometimes need to be pushed on the brink of chaos to introduce change at this level. The massive discontent at the dictatorship of Ferdinand Marcos for instance paved the way for the introduction of the 1987 constitution.

Third level – this is where the institutions of governance are located. Going beyond established rules, the analysis is now centered on enforcing contractual relations. Since it is often costly to settle disputes in court, much of the contract management is dealt with directly through private ordering. For instance, one only has to follow the procedure in getting a business permit from pertinent government agencies in order to obtain one. The rules of the game need not be changed for each person who has to get a business permit. The term “weak governance” is thus explained by deviation from the rules of the game. “Oiling” the process of getting a business permit by giving “lagay” is a governance issue because parties to the transaction deviates from established procedures as defined by established rules and regulations. Similarly, application of the “rules” as defined by the whims and moods of a dictator to suit his personal interest is a categorical breakdown in governance.

Fourth Level – this is the level at which optimality apparatus works. Economic agents now take norms, traditions, rules of the game and enforcement of contracts as given, aligning their actions to the risks and incentives as set by these institutions.

NIE as an analytic tool implies that needed reforms, which will allow poor countries to get out of poverty have to be instituted on a case to case basis. There is no universal remedy.

For instance, while Harford’s article suggests that poor countries can be helped via cheap provision of raw materials such as fuel, loans from international banks and manufacturing equipment, there is no guarantee that this will work. There is one universal principle that guides people’s actions as economic agents – self-interest.

One has to look at levels of a country’s institutional set-up to determine how such actions will flow through its incentive system. It is possible for instance for cheap raw materials to land at the hands of a select and powerful few who could take advantage of the wider margin that they can squeeze out of such a transaction. Positive impact to growth of allowing the economy to benefit from such a concession could eventually cut the flow of cheap goods and can therefore be perceived as a threat by those benefiting from it. Hence, the response would be to ignore the growth objective and pocket as much in order to keep the money flowing in.

Without the right incentive system, economic agents’ response to aid or concessions can be pretty perverse. An example is the outreach program to AIDS infected people in Africa – because families of AIDS infected household heads were given donations, getting well was not perceived as the appropriate response (i.e., without AIDS, there is no aid). According to reports, some even intentionally acquire the disease in order to get donations that will tie their families over at least in the short-run.

There are various reforms that strike at a country’s institutional set-up giving economic agents the right incentives to adopt the appropriate actions. We agree with examples of reforms cited in the case. Among which are:

1. Trade liberalization—In the Philippines, this successfully chipped away at cronyism which was pervasive in the determination of industry winners prior to the liberalized set-up.

2. Free Market—Encouragement of market competition under a transparent environment where the rules are explicit and easy to follow would attract investors, generate jobs, promote growth and alleviate poverty

3. Promotion of Good Governance and Accountabilities—this could include pending reforms such as the botched computerization of the Philippine election system

4. Improvement of the Nation’s soft and hard infrastructure – this should include priority spending on infrastructure projects and education backed up by transparent budgeting and disbursements

Indeed institutions, be it at the first or the fourth level is susceptible to reform. It sometimes takes visionary and reform-oriented leaders to get a country’s institutions right but absent such persons, citizens of a country in their own way can help in the process.

I believe that as ordinary citizens, while it is almost beyond our sphere of influence to reform the government and steer it to adopt and implement the needed reforms as suggested above, there are ways to help facilitate the process.

For instance, as aspiring leaders in our field, we can help advocate and steer our business organizations into practicing good corporate social responsibility which will help our own organizations, and eventually organizations we deal with, to benchmark transaction processes not in the norms and standards set-up by the domestic environment (which we know needs fixing) but by the global community. This in the context of new institutional economics can help countries get out of poverty by:

1. Helping define and implement the rules of the game: While it is expedient to succumb to bribery and ‘lagay’, exerting pressure for the government to define rules more clearly and encourage players to stick to these rules will help businesses in the long-run. Viewed as a repetitive process, transaction with the government under an environment of weak governance can only be damaging to business in the long run. An acknowledgement of the significance of this transaction cost to businesses’ survival, prompting needed reforms to address it, can strike at the heart of level 3 institutions.

2. Helping build the foundation for better norms and traditions through scholarship programs that recognize merit and excellence. This in the long-run can help re-define level 1 institution making our country a nation of achievers.

3. Supporting non-government organizations such as Transparency International and other deserving non-government organizations with credible background who are engaged in social marketing programs (e.g., anti-corruption campaigns, campaign for clean elections).

4. Being vigilant and critical about (a) reform policies being promulgated by the government and (b) actions by the government to help promote good governance and accountability.

5. Practicing responsible advertising (i.e., advertising that promotes good values)

And then again, institutions of whatever level can only be described by the aggregation of the characters of individuals who compose it. Good individuals make good institutions. Practicing good citizenship and observance of the rule of law in our daily lives and in relating to our individual spheres of influences could help in growth promotion and poverty alleviation. If each of us does these, even if we could only hope that the multiplier effect is more than one, one day we will be out of the rot our nation is currently in.

References
Harford, Tim. 2006. “Why Poor Countries Are Poor”. The Undercover Economics.
Coase, Ronald. 1998. "The New Institutional Economics." The American Economic Review. 88(2):72-74.
North, Douglass C. 1993. "The New Institutional Economics and Development." Mimeo. Washington University, St. Louis.
Williamson, Oliver E. 2000. "The New Institutional Economics: Taking Stock, Looking Ahead." Journal of Economic Literature." Vol.38 (September): 595-613.