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Besides imposing a minimum price, the government of a country can increase the price of commodity by imposing control on quantity. The government often controls quantity in order to operate a system of price supports.
Under the price supports programme the government sets the market price of a commodity above the free-market level and purchases from the open market whatever output is needed to maintain that price. Another way of raising price is by restricting production, either directly or through incentives to producers.
These two schemes of quantity control may now be discussed one by one:
(a) Price Supports:
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The main objective of introducing price supports is to increase the prices of primary (agricultural) products so as to raise the revenues of the producers. Under a price support programme, the government first a support price and then buys up as much of the output supplied as necessary to keep the market price at this level.
The effect of a price support programme is illustrated in Fig. 2.26. The effects of price controls (in terms of gains and losses) to consumers, producers and the government are illustrated in the diagram.
Consumers:
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If a support price is fixed above the free market price as at Ps, the quantity demanded by consumers falls to Q1, but the quantity supplied increases to Q2. In order to maintain the price the government has to buy Q1Q2 units.
As a result the demand curve shifts to the right from Dc to Dt where Dt is total demand, Dc is consumers demand and Dg is government demand. Otherwise producers will left be with unsold stocks. At price Ps producers are able to sell their entire output Q2, simply because the government adds its demand Qg to the consumers’ Qc demand of.
Since consumers’ now buy less (Q1 instead of Q0) at a higher price (Ps > P0), there is loss of consumers’ surplus shown by the rectangle A. Due to price rise, existing consumers either buy less or some of them can no longer afford to buy the good. So there is an additional loss of surplus shown by the triangle B. Therefore the loss of consumers’ surplus is
∆CS = – A – B.
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Consumers suffer the same type of loss as in case of fixation of minimum price.
Producers:
Since producers are able to sell a larger quantity (Q2 instead of Q1) at a higher price they gain. So producers’ surplus (= profit + economic rent) goes up by the amount;
∆PS = A + B + D
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The government:
The cost to the government of purchasing the required amount of the commodity is Ps(Q1 – Q2). This is indicated by the area Q1FGQ2. The cost of government purchase is covered by taxes. So it is ultimately a cost to consumers. Thus consumers suffer a double loss — one explicit (higher price) and one implicit (more tax).
A related point may also be noted here. The government can reduce its cost by ‘dumping’ some of its purchases — i.e., sell them in foreign countries at a lower price. However, this reduces the ability of domestic producers to export the product. And the neglect of indirect effects is the common source of all fallacies. The reason is that it is the domestic producers that the government is trying to help in the first place.
Welfare Cost of the Policy:
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In order to find out the welfare cost of the policy we add the change in consumers surplus to the change in producers’ surplus and then subtract the cost to the government change in social welfare is:
∆CS + ∆PS – cost to government = D – (Q2 – Q1)Ps.
or, in terms of Fig. 2.26 Q1FGQ2 – EFG = Q1FE to Q2.
Defects of the Policy:
In some situations this welfare loss can be quite substantial. The main drawback of the policy is the fact that here is a preferable alternative — a much more efficient way to help farmers. If the objective of the government is to give farmers an additional income equal to A + B + D, it is better to give cash subsidy to producers directly rather than in help them indirectly through price supports.
The reason is that cash subsidy is less costly than the price support programme. Under the price support programme consumers are losing A + B. So by paying farmers directly, society saves the area Q1FGQ2 – EFG. But for political reasons the government implements the price support programme instead of simply giving money to farmers.
(b) Production Quotas:
Instead of entering the market and purchasing a portion of current supply – thereby increasing total demand — the government can raise the price of a good by reducing supply. This can be done by allocating production quotas, i.e., by simply setting quotas on how much each firm can produce. By fixing quotas at appropriate levels, it is possible to raise price to any desired level.
Fig. 2.27 shows the welfare effects of such production controls. The government restricts the quantity supplied to Q1, below the market clearing (equilibrium) level Q0. This means that the supply curve becomes completely inelastic such as S at Q1. In this case consumers’ surplus is reduced in two ways.
Those who buy the commodity at a higher price lose the rectangle A. In addition those who are not able to purchase the good at the higher price lose the triangle B. Producers gain rectangle A due to price rise, but lose triangle C due to fall in sales volume from Q0 to Q1. So triangles B and C measure deadweight loss.
Now consider the following programme:
Incentive Programme:
In some countries such as the USA agricultural output is reduced by incentives rather than by outright quotas. Such acreage restriction programmes give farmers necessary financial incentives to leave a portion of their land idle. Since farmers receive cash from the government as an incentive to reduce production, the total change in producers’ surplus is now –
∆PS = A – C + payments for not producing.
The incentive has to be as large as B + C + D because that is the additional profit that can be made by planting, given the higher price Ps. So the government must pay farmers at least this much, and the total change in producers’ surplus is;
∆PS = A – C + B + C + D = A + B + D
Thus the change in producers’ surplus is the same as it is under the price support programme maintained by government purchases of output. So farmers have hardly anything to choose from. Since they end up gaining the same profit (in terms of money) under each programme they are indifferent between the two. In a like manner consumers lose the same amount of money under each policy.
However, which policy is most costly for the government administration depends on whether the sum of triangle B + C + D in Fig. 2.27 is larger or smaller than (Q2 – Q1)PS or the rectangle Q1FG Q2 in Fig. 2.26. In the normal case, it will be smaller. So an acreage restriction programme costs the government (and society) less than price support maintained through government purchases.
In spite of this, an-acreage restriction programme is more costly from society’s point of view than the programme of direct subsidy to farmers. The change in social welfare under the crop restriction programme is
∆ welfare = ∆CS + ∆PS – cost of government;
= -A – B + A + B + D – B – C = -B – C.
If instead the government simply handed over A + B + D to farmers, without affecting price and output, society would gain in terms of efficiency. If price and output are allowed to be determined by the market forces, then farmers would gain A + B + D.
At the same time the government would lose A + B + D. So there will no change in social welfare. However, the government policy is not always based on the objective of efficiency. Non- economic considerations also determine the design of such policy.
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