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Unformatted text preview: 246 Pricing Institutions hand, at the individual transaction level, the farmer may know more about the possible defects of his produce than does the buyer. The production contracts, discussed earlier, help eliminate the asymmetries at the indi- vidual transaction level. In summary, the issues related to the effects of pricing institutions on price behavior are complex. It is clear that alternative pricing mechanisms influence individual transaction prices and perhaps overall price levels as well. Logical hypotheses are that pricing institutions evolve, as the economy changes, to minimize transaction costs between the individual buyers and sellers, but that these changes can have the side effect of reduc— ing the amount of publically available information about prices. The role of futures markets in price discovery and the potential rela- tionship to spot prices are discussed in the next two chapters. Before turning to that topic, however, we discuss some of the ways in which gov— 'ernment policy can influence agricultural product prices. Government Intervention in Pricing Agricultural Products Governments in nearly every country have attempted to influence the prices of at least some agricultural products. Sometimes the objective is to reduce the prices of food paid by urban consumers. Often the objective is to support the prices and incomes of farmers or to reduce price and income instability. Associated objectives may be to preserve small farms and to achieve self-sufficiency in food and fiber production (or to decrease dependence on imports). In this section, we review selected types of government intervention that are intended to raise farm prices and perhaps reduce the variability of prices. Such programs require some type of administrative actions and can be viewed broadly as falling in the category of administered prices. I Not all government programs, however, directly set prices.There is a large literature on agricultural policy and the effects of these policies (e.g., Knutson et al. 1995), and our discussion is limited to the consequences for price behavior of some such programs. _ The economic effects of government programs designed to support or raise farm prices depend on inter alter the level of support and on the methods employed to raise prices. It'is also possible to enhance farm incomes via direct payments or subsidies; such payments may influence prices indirectly via their effects on farmers’ incentives to produce. If, however, the program operates by attempting to influence market prices, then it is necessary to restrict supply (e.g., import quotas, acreage restric- _Mechanisms for Discovering Prices 247 D Price per unit Domestic production Figure 11-2. Effect of a tariff on domestic production, consumption, and imports tions) or increase demand (e.g., export or domestic food subsidies). We turn to a discussion of selected programs. Tariffs and Import Quotas From the viewpoint of a country that is trying to support its domestic farm prices, tariffs, variable levies (which have been used in the European Union), and import quotas have similar effects on internal prices and the volume of imports. They make it possible to maintain domestic prices above import or world prices. (This assumes, of course, that imports are a source of supply to meet domestic demand.) The effect on the volume of imports depends on the slopes or elasticities of the demand and supply functions of the importing nation: the more elastic these relationships, the greater the impact on residual exporters of a given tariff or import duty. This assumes that import supply is perfectly elastic at the import price. If it is not, the imposition of a tariff will affect the import price as well as the external market price (see appendix). The potential effect of an import duty on domestic production, con- sumption, and imports is illustrated in Figure 11-2. The supply of an imported commodity is assumed to be perfectly elastic at .the price P1. In the absence of any tariff or other protectionist measures, domestic production will equal to Q1 and consumption will be equal to Q4, with imports making up the difference between total consumption and domes- 248 Pricing Institutions tic production (Q4 — Q). If a tariff is impdsed on imports such that the domestic price rises to P2, producers will eventually increase output to Q2 and consumers will reduce purchases to Q3. These changes are the pro— duction and consumption effects of a tariff policy. If the import price remains the same, the costs to consumers will rise by the full amount of the tariff, and imports will decline from Q; — Q to Q3 —~ Q2. The flatter the slopes of the supply and demand curves, the more pro- duction will rise and consumption will fall if a tariff is imposed; Even a modest increase in the degree of protection can lead to a substantial per- centage decline in the volume of imports. The percentage effect will depend on the elasticities of the demand and supply schedules in the importing country and the proportion of total consumption that is imported}; The foregoing analysis can be reversed to ask, what are the conse- quences of reducing tariffs? Clearly, one of the effects is to reduce prices for producers and ceteris paribus reduce the quantity supplied by domes- tic producers. Not surprisingly, whentariffs or quotas have been used to protect producers for many years, their removal is controversial. When facing a fixed charge per unit or ad valorem (percentage) tariffs, exporting countries can maintain the existing volume of sales by reducing their own export prices. If this occurs, the internal price may not increase or will rise less than the amount of the tariff. But if the importing country makes use of variable levies that are adjusted up and down to compen- sate for any change in import prices, there is no way (short of negotiating for a guaranteed share of the market) that exporters can maintain or increase sales. . Restricting imports by means of a quota, say, in the amount Q3 — Q2, has the same effect as the tariff described in Figure 11—2. In this case, however, the government does not receive revenue from a tariff. The benefit of higher prices accrues to those exporting countries that are able to obtain quotas. By restricting imports in this way, benefits can be dis- tributed selectively to preferred suppliers. The allocation of such rights, not surprisingly, can become a sensitive political issue. Domestic con- 6. The import demand elasticity is a weighted sum of the elasticities of demand and supply. The weights used to derive the import elasticity of demand are equal to the ratio of total consumption to imports for the domestic demand elasticity and the ratio of domestic production to imports for the internal supply elasticity. For example, if imports make up one- fifth of the total supply and domestic production fourth-fifths, the elasticity of domestic demand (Ed) is equal to —0.3, and the elasticity of domestic supply (E,) is equal to 0.2, then the elasticity of import demand (E,) is equal to —2.3. The algebraic relation is as follows: _ consumption E _ production E- . .1 . imports imports r 5 4 E =— —0.3 —— 0.2. =—2..3. 3 1t ) 1( ) Mechanisms for Discovering Prices 249 5 P3 H & P2 8 a P1 ----.._..-__............-..--..\.......__ Q1 Q2 Q3 Q4 Quaiity Figure 11-3. Effects on prices in exportng nations of protectionist measures in importing countries sumers pay the full cost of supporting agriculture if tariffs .pr import restrictions are the vehicle for raising prices. One way in which a government, rather than suppliers, can capture the gains from higher internal prices is by auctioning import quotas. The price potential suppliers would be willing to offer the government for the right to sell in the higher-priced market would approximately equal the differ— ence between the protected price and the prices prevailing in alternative markets. The price effects on exporting nations of protectionist measures that succeed in reducing the volume of imports depend on whether or not prices are supported in exporting nations and on the elasticities of demand and supply for export commodities in such countries. If prices are not sup— ported in exporting countries, the general effect of protectionist measures by importers is to reduce the prices received by exporters. The relation— ships that determine the magnitude of such price effects are illustrated in Figure 11-3. ' 250 Pricing Institutions The curve D, in Figure 11-3 represents the domestic demand for an export commodity such as wheat; D,” is the total demand for wheat, including export demand. If the imposition of a tariff or quota (by an importing country) reduces export demand by the amount Q3 — Q2, the aggregate demand function will shift to the left. Such a decline in demand is indicated by the dashed demand curve (D’). The effect of the decline in demand will depend on the exporting country’s farm policy. If it has a price-support program that maintains price at P3, then by definition the farm price is not affected, but the “surplus” of domestic production rela- tive to total demand increases from Q4 — Q3 to Q4 — Q2. If the exporting country does not support farm prices, then the effect of the imposition of a tariff is to lower the price in the exporting country from P2 to P1. The magnitude of the effects on prices and quantities depends on the slopes of the supply and demand functions. The combined effects on exporting and importingpountries of the intro- duction of a tariff are further illustrated in the appendix to this chapter. Basically, the relevant model is adopted from the discussion of spatial prices in Chapter 8 (also from Houck 1992). Price Supports Commodity prices can be maintained above the equilibrium level if the government is willing to provide the demand for the surplus production generated by the support price. For storable commodities, the government can buy and hold inventories. The amount that must be acquired and the cost (to taxpayers) of doing so depends on the level of support relative to the equilibrium price and on the slopes of the relevant supply and demand schedules. The level of support is determined by political decisions, but perhaps giving the secretary or minister of agriculture some discretion in ' setting prices. The critical relationships are illustrated in Figure 11—4. If the support price is P2 and if the equilibrium price is P1, then absent any attempt to control supply, farmers will produce the quantity Q2, but buyers will demand only the quantity Q1. The government will have to acquire an amount represented by the shaded area, which is the quantity Q2 — Q. Total consumer expenditures are represented by the unshaded rectangle, that is, Pg x Q. Producers receive the sum of consumer and'government purchases. The cost to the government of a given level of support depends on the slopes of the demand and supply functions. If the equations shown in Figure 11-4 had been drawn with flatter slopes, it is clear that the govern- ment costs would be larger than those shown. The figure, however, is Mechanisms for Discovering Prices 251 Consumer expenditures n Quality Figure 11-4. Consumer expenditures and government costs of supporting prices above equilibrium through'a government purchase program drawn for static supply and demand schedules. The potential to recover government costs (to reduce government-held inventories) will depend on how supply and demand change with time. For example, if demand were to grow faster than supply, this would give the government an opportu-' nity to release stocks while maintaining the support level. But if supply grows relative to demand, stocks will accumulate, and at some point, no government, no matter how rich, will be able to maintain a status quo that involves continued stock accumulation. High support prices also have the potential to stimulate the develop- ment of lower-cost substitutes. A plausible hypothesis is that the price— support program for cotton in the United States provided an umbrella for the development of synthetic fibers. Likewise, the support of butter prices made butter relatively more expensive than its principal substitute, margarine. Thus, with the passage of time, inventories can increase because of the decline in demand associated with the introduction of substitutes (which in turn were encouraged by the price-support program). There is another practical problem in administering a price-support 252 Pricing Institutions and related government purchase program. Namely, support prices received by farmers should be adjusted to take account of the 'quality and location characteristics of individual lots of the commodity. When no price supports exist, markets determined the relevant price differences and appear to do so relatively efficiently (see Chapters 7 and 8). This is more difficult to do administratively, and with inappropriate administrative dif- ferentials, the government will acquire low-quality stocks in undesirable locations. 5 One approach to the problems associated with acquiring inventories is to try to limit production, and another is to try to subsidize exports. For example, if production can be held to the quantities consumers are willing to buy at the support price (Q, in Figure 11-4), then the government can avoid the costs of acquiring and storing inventories. Of course,'the total revenue received by producers is less under an effective supply-control program than under a government purchase program, since a smaller quantity is produced and sold at the higher price. But farmers may be better off because they do not have to incur the costs that would be required to produce the larger quantity. Also, some government programs have compensated farmers for not producing. Supply management programs require considerable administrative apparatus to ensure compliance with program rules. But export subsidies too require administrative oversight and with uncertain results. Export subsidies are equivalent to reducing the export price, but in practice, questions arise about the degree to which the reduced export price is transmitted to importing countries (the elasticity of price transmission), about the reactions of competitors (cross-price elasticities), and about the effect of the lower price on consumption and production in importing countries (their internal elasticities of supply and demand). A detailed dis- cussion of all of the possible consequences of such subsidies is beyond the scope of this book. It is sufficient to note that in a political climate that emphasizes relatively freer trade and given the uncertainties associated with the effects of subsidies, their impact on domestic farm prices is difficult to evaluate. Deficiency Payments Rather than attempting to influence supply or demand in order to raise farm prices, a program can be designed to make direct payments to farmers. This type of program is perhaps more acceptable because it allows market forces to determine prices. Buyers of agricultural products pay market clearing prices. Market prices allocate inventories, and the government does not have to manage surpluses. If the market prices are below those deemed equitable to farmers, then Mechanisms for Discovering Prices 253 Price Consumer expenditures Q1 Q2 Quality Figure 11-5. Consumer prices and expenditures and government costs of supporting farm prices above equilibrium by making deficiency payments direct payments are made to farmers. The magnitude of the payments is a political decision, and the funds come from taxpayers.7 The economic effects of an unlimited deficiency payment program (i.e., with no limits on production or the size of payments to individual farmers) are illustrated in Figure 11—5. In this figure, the price guaranteed to producers is P3, which is above the equilibrium price, P2. The quantity supplied, however, will be Q2 because farmers receive P3 not P2. Assum- ing the quantity Q; is realized (no yield risk), it is placed on the market, and the market clearing price is P1. Thus, the actual market price is below the equilibrium price that would have existed without the program. Government payments will be equal to the difference between the guar- anteed price (P3) and the market clearing price (P1) multiplied by the total volume of production. This is represented by the shaded area in Figure 11-5. Consumers benefit from below—equilibrium prices, while producers receive above-equilibrium prices. Both production and consumption are subsidized. Of course, the payments come from tax revenues. 7. The United States has had several deficiency payment programs for major crops. At one time, payments were based on a difference between a “target price” and an “average market price,” and the payment was based on historical production rather the actual current production. A more recent program based the payment on the difference between the support price (loan rate) and a current market price (on a date selected by the farmer). The payment is based on proven actual production. Because program rules change and vary from country to country, we describe a generic payment scheme. 254 Pricing Institutions Analogous to the previous discussion of other programs, the slopes of demand and supply schedules influence the cost of the program to the gov- ernment. Shifts in the functions also will influence the size of payments. In principle, demand could grow relative to supply, such that the market price rises above the guaranteed prices, and government payments would drop to zero. The reverse is also possible. At the beginning of the let century, the prices of major grains in the United States were low relative to support levels, and the federal government made large payments to farmers. Stabilization Schemes As discussed in previous chapters, agricultural product prices are highly variable, and this implies that the price risk faced by buyers and sellers of commodities is large. A price—support program can help stabilize prices. It provides a floor price, and if demand should increase so that market prices rise above the support level, stocks can be released to reduce the upper- ward movement in prices. In principle, a program could be designed to reduce the amplitude of fluctuations without affecting the average level of prices. For storable com— modities, this could be achieved by the management of inventories. Stocks would be acquired when production is large and prices would otherwise be low. These inventories would then be released when production is small, thereby preventing prices from rising as far as they otherwise would. Of course, it is not possible to maintain prices exactly at the long—run equilibrium level, but it might be possible to hold prices within a band. In practice, even this is difficult to do, partly because it is difficult to predict the long—run equilibrium price and hence to establish appropriate acquisi— tion and release prices. One can visualize the effects of a stabilization program on prices, as shifts in a supply function along a static demand function. When a random shock (say, good weather) results in a large crop, this is depicted as a shift in the supply function to the right relative to the normal supply. The gov- ernment agency would acquire stocks, helping to raise prices. The supply entering market channels is, therefore, that associated with normal condi- tions. Subsequently, when a random shock reduces supply, inventory would be released from government-held stocks, thereby reducing prices relative to the level they otherwise would have been. A reserve scheme that succeeds in reducing the amplitude of price fluc- tuations may help producers to survive a period of depressed prices, but will not necessarily lead to more stable returns for farmers. When prices are free to fluctuate in response to changes in production, high prices tend to offset low production, and vice versa....
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