The Price Scissors in Open Economies

The analysis of the preceding chapter assumed that the government in less developed countries (LDCs) has the ability to maintain separate sets of prices in the urban and rural sectors, but if transportation costs between the sectors are low, then the presence of large price differences between the two sectors would provide strong incentives for tax arbitrage and tax evasion. Rationing of food in the urban sector (if the price of food in that sector is lower than in the rural sector) may serve to alleviate this problem, but not without incurring significant administrative costs, and some tax evasion is inevitable. If it is very extensive, government revenues will be significantly less than what was intended, and the legitimacy of the government (or at least of its tax-pricing policies) may be called into question. In any event, it is clear that the problems associated with maintaining different sets of prices in rural and urban sectors imply that some LDC governments may be constrained to having the same set of prices in both sectors. In this chapter, the consequences of changes in the price scissors (the price of industrial goods relative to that of agricultural goods) are analysed by a simple modification to the open-economy model described in the previous chapter, and a simple formula is derived for characterizing the optimal price scissors.