Do Government Policies Distort Relative Factor Prices : Evidence from Colombia

NOTE: The following is a description of the paper and not the actual abstract. Developing countries have a variety of governmental and trade policies which are intended to affect the return to capital and also distort factor prices. These distortions are significant and exist even before the government enters the capital market to borrow or inject capital. in our paper we estimate directly the return to capital and by accounting for trade distortions our estimates are closer to the true social opportunity cost of capital. We find that the return to capital in the manufacturing sector in Colombia from 1974-1990 ranged from 24 to 57 per cent per annum. This suggests that capital has been under allocated to certain sectors of the Colombian economy through the use of forced reserve requirements, directed credit, and macroeconomic policies such as intervention in the exchange rate and interest rate markets. Using the return to capital and the average annual effective rate of protection to the manufacturing sector estimates we calculated, we test for the relationship between the trade regime and the return to capital. Our results reveal that there is a significant relationship between trade protection and the rate of return to capital in Colombia. Our calculations differ those of others in that we account for trade distortions in the economy by including export subsidies and import taxes in the estimation of the return to capital. Our results indicate that in addition to direct protection mechanisms, the government is able to affect the rate of return to capital through interest rate and exchange rate management. The results reveal that an increase in the price of coffee will negatively affect the rate of return to capital as implied by the Stopler-Samuelson theorem. The use of government policies to distort relative factor prices can lead to an overall decrease in welfare as market signals are clouded and resources are moved inefficiently throughout the system