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AGEC 640 – Agricultural Policy Week 6_ Market Equilibrium and

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									     AGEC 640 – Agricultural Policy
   Market Equilibrium and Social Welfare
            Sept. 25 – 27, 2012


Today:
   Market equilibrium with trade & policy
Thursday:
    Policy incidence and social welfare

Next week:
   Tues. – policy distortions
   Thurs. – measuring protection
                                            1
   Market equilibrium with trade & policy
                         The story so far…
 Up to now we’ve taken prices as given, asking how
  households respond with substitution in production:
Qty. of corn                 Qty. of corn
(bu/acre)                    (bu/acre)
                                     Pb/Pc′
               Pl/Pc Pl/Pc′                      Pb/Pc
                                                            Each price change
                                                                    affects the
                                                                  household’s
               more corn,        more corn,                production choices,
                more input use    less other outputs                 input use
                                                                   and income

         Qty. of labor                    Qty. of beans
         (hours/acre)                     (bushels/acre)                          2
      …and on the consumption side:
     Households respond to price changes with
      both income and substitution effects:

Qty. of                                                    Each price change
  corn                                                affects the household’s
                               substitution
                                     effect               production choices,
                                                        input use and income
                    income
                      effect                  The household’s
                                              total income and
                                              expenditure at Po/Pc′
          The household’s
          total income and
          expenditure at Po/Pc
                           Qty. of all other goods                              3
Adding up production decisions across households
      gives us an aggregate supply curve:
     Price
     ($/lb)   each producer’s production is added horizontally

                                      each price is every
                               participating household’s
                             marginal cost of production,
                                 in terms of other goods
                               …but remember at each price
                               some households are not trading!

                                       Quantity Produced
                                       (thousands of tons/yr)

                                                                  4
…and adding up households’ consumption decisions
      gives us an aggregate demand curve:
     Price
     ($/lb)   each consumer’s demand is added horizontally

                       each price is every participating
                               household’s willingness
                                      and ability to pay
                               …but again at each price
                               some households are not trading!

                                    Quantity Consumed
                                    (thousands of tons/yr)

                                                              5
   …so the aggregate of all households’
production costs and willingness-to-pay is:

       P($/lb)
                                  MC



                                WTP

                                Q(tons)

 So, what price are we likely to observe in the market?
       …almost all interesting cases have
       something else we’d need to draw!                  6
What price would we observe if these people
   can trade with the rest of the world?
           P($/lb)
                            MC



                           WTP

                           Q(tons)
          We need to draw a similar diagram for them,
            and for the trade between us and them
                                   Trade between      The Rest of the
          “Us” (e.g. the U.S.)       us & them        World (RoW)
P($/lb)                                       P($/lb)




                         Q(tons)
           Starting with foreign supply and demand:
                                  Trade between
          The United States       US and world The Rest of the World
P($/lb)                                     P($/lb)




                        Q(tons)
               Note we’ve drawn the same price axis for
              the US and RoW (ignoring exchange rates)
                  Then we can draw the U.S.’s
               willingness to trade with the RoW:
                              Trade between
          The United States    US and RoW        The Rest of the World
P($/lb)                                   P($/lb)




                                             ED
                        Q(tons)        Q(tons)


   The U.S. “excess demand curve” in trade, i.e. the amount demanded
   at any price that cannot be met by domestic supply.
                and RoW’s willingness to trade…
                                  Trade between
          The United States       US and ROW        The Rest of the World
P($/lb)                                      P($/lb)




                                               ES
                                               ED
                        Q(tons)          Q(tons)             Q(thou. tons)


   The “excess supply curve” in trade shows the amount supplied by
   the world at any price that exceeds the world price.
                      World Price Clearing…
                                  Trade between
          The United States       US and ROW        The Rest of the World
P($/lb)                                      P($/lb)




                                               ES
                                               ED
                        Q(tons)          Q(tons)             Q(1000 tons)
Because total quantity in the RoW is large, the “excess supply” curve is
    almost flat when graphed on the same axis as the U.S. curves.

                 International markets clear when ED=ED
      The large size of the rest of the world allows
               us to simplify the diagram
                                  Trade between
          The United States        us and them       The Rest of the World
P($/lb)                                       P($/lb)




                                                ES
                                                ED
                        Q(tons)           Q(tons)             Q(thou. tons)
                          the simplifying assumption that
                          this line is horizontal is called
                          the “small country” assumption.
                                                                        13
      The small-country assumption allows a single
           diagram to both the US & the RoW
                                   Trade
          The United States       between        The Rest of the World
P($/lb)                              us   P($/lb)




                                              ES
   Pw
                                              ED
                        Q(tons)          Q(tons)          Q(thou. tons)
               As the “world” price would not
               be affected by changes in the U.S.

                                                                    14
  For many important traded products, prices are
determined by the world’s supply-demand balance,
      not local production and consumption.

                       The United States
             P($/lb)




                Pw

                                     Q(tons)

Local supply and demand determine production, consumption
and trade, at a price given by the big (bad?) world market   15
                 But then there’s policy!
                       Policies on imports         Policies on exports
Policies that
help producers   import                      export
                 tariffs                     subsidies
raise Pd         or
above Pt         quotas

Policies that
               import                        export
help consumers subsidies                     taxes or
lower Pd       (rarely                       quotas
below Pt       seen)

                     Policies that work through trade
                     affect both producers and consumers.                16
     But what about “domestic” policies?
    Policies that tax production affect a market like this:
                                       S′ (market supply, after taxes)
                                        tax
                                       S (producers’ marginal cost)




       and policies that tax consumption look like this:


                                      D (consumers’ demand)
                                         tax
                                       D′ (market demand, after taxes)

Taxes restrict the market supply or demand, shifting them to the left…
                                                                         17
        Policies that subsidize production work like this:
                        S (producers’ marginal cost)
                           subsidy
                        S′ (market supply, after taxes)




    and policies that subsidize consumption work like this:



                          D′ (market demand, after subsidies)
                           subsidy
                          D (consumers’ demand)

Subsidies expand market supply or demand -- shift curves to the right.
                                                                         18
         Combining these concepts, we have six possible
              policies in markets for importables
               on trade    on production   on consumption



taxes
or
restrictions



subsidies
or
encouragements
          affect both     affect only       affect only
          prod. & cons.   production        consumption
                                                            19
      …and six possible policies in markets for exportables:
               on trade    on production     on consumption



taxes
or
restrictions



subsidies
or
encouragements
          affect both      affect only        affect only
          prod. & cons.    production         consumption
                                                               20
Can we say anything about “social welfare”?
• What can we infer from the diagrams about how price changes
  affect consumer or producer welfare?
• What can we infer about net effects on “social” welfare?
• The simplest and most widely used approach is to compute
  changes in aggregate “economic surplus”:
   – areas on a supply-demand diagram
   – measured in terms of money (=price X quantity)
   – but equally relevant in a non-monetized setting…
• To see strengths and limitations of econ surplus approach we
  should start with fundamentals

We will pick up here next lecture…
                                                                 21
           Criteria:
How could we evaluate a change?


                      as qty. rises, the gap
                      between the curves falls…
P                     until this marginal
                      economic surplus
                      reaches zero at the
                      equilibrium




               Q
 “Economic surplus” is simply
the area between S & D curves


                  The Hines article
                  explains how this area
P
                  came to be the workhorse
                  definition of “social welfare”
                  in applied policy work, despite
                  its limitations relative to other
                  definitions of social welfare.


              Q
     There is a very close link between
   “positive” economics (for prediction)
and “normative” economics (for evaluation)


                              For example, if new
                              technology reduces
      P                       marginal cost by 10%,
      P′                      we can predict that
                              the new P′ will be lower and
                              the new Q′ will be higher.
                            A lower price means
                            producers may lose…
                            but the logic of economic
                            surplus means there must be a
                            net gain to society as a whole.
                     Q Q′
    Equilibrium = Optimum ?


                    If the equilibrium is the social
                    optimum, do we live in the
P                   best of all possible worlds?

                    If you have no other information,
                    you cannot say something else
                    would be better!



                Q
    Econ 101 vs. Econ 102



                    To continue the analysis,
P                   we need to know
                    something about some
                    other costs and benefits
                    incurred in this market.




              Q
   640 is not about “public” or “welfare” econ
• Most econ departments have such a course, but our full-semester
  offering AGEC 617 has not attracted enough students, so we just
  have the 1-credit AGEC 604.

• The question for welfare economics is, what can one infer about
  “aggregate welfare” from individual choices, which are assumed to
  be optimizing an unknown utility function.

• The answer is…
    not much…
    unless we make additional, quite strong assumptions
      e.g. all consumers are similar in certain ways,
               or face prices that are similar in certain ways
      “Welfare economics” is about those assumptions and their effects.
      Most are not testable…                                          27
    But to use econ surplus in a thoughtful
         way, we should remember…
• The Pareto Principle
   – A “Pareto improvement” is preferred by at least one person, and
     dispreferred by no one.
   – Very many situations are already “Pareto optimal”, and
     designing Pareto-improving policies is very difficult!
• The “first theorem” of welfare economics
   – A perfectly competitive equilibrium would be Pareto optimal
      (because everyone faces identical prices)
• The “second theorem” of welfare economics
   – Any P. optimum can be reached by a p.c.e. with transfers
      (but only if everyone can use the transfers to adjust consumption!)
                                                                            28
              …and, more practically,
            the Compensation Principle
• Is “Pareto improvement” needed for a change to be good?
   – what if many gain, and only one person loses?
   – what if the gains are much larger than the losses?
   – would the gains have to be redistributed immediately for the
     change to be socially desirable?
• Usually, we invoke the “compensation principle”:
   – we use the term “Pareto improvement” loosely, to mean a
     potentially Pareto-improving change, whose gainers could (but
     don’t necessarily) compensate losers and still be better off.
   – Income and wealth is constantly being (re)distributed through
     various mechanisms; this way we separate the questions, and do
     not expect changes to generate gains and also redistribute them!
• In real life, “reform packages” often involve some
  compensation, to those who could block the change.                29
           Arnold Harberger and
     the Triumph of Economic Surplus
• Harberger’s three postulates (untestable!):
   – marginal willingness to pay is value in consumption
   – marginal supply price is cost of production
   – economists should be impartial, and count everyone’s
     money equally.
• Surprisingly, this turns out to lead towards political
  positions that are often quite “liberal”,
   – because actual politics often involves “King John
     redistribution” (from poorer to richer people) and “vested
     interests” (that block pro-poor changes).
• A major determinant of economic growth is the
  extent to which governments follow Harberger…
                                                                  30
 Economic surplus treats the market as a household
     highest indifference level         highest economic surplus
     in a household model               in a market model
Qty. of                    Price of
“a” goods                  “b” goods


                                                     equilibrium
                                                          among
                                                      optimizing
Qa                                Pb                  people in a
                                                        perfectly
                      slope of income                competitive
                        line =-Pb/Pa                      market


              Qb        Qty of “b”           Qb
                                                                31
We can divide “economic surplus” into:


                   Price of
                   “b” goods

 “Consumer surplus” :
    area between price paid
      and the demand curve
                         Pb
 “Producer surplus” :
 area between price received
        and the supply curve

 The sum of everyone’s gains/losses    Qb
 is society’s total economic surplus        32
Trade creates a distinction between production
and consumption – e.g. when we start selling:
                                Producer surplus in “b” declines by:    A
Qty. of “a”                                 …but consumer surplus
goods
                                    Price of
                                                   in “b” rises by:     A B
                                    “b” goods           ==> net social gain
              Net gain from trade                      from trade in “b” is:   B

                             Increase in
                             consumption
                             of “b”
        Decline in
                                                   A B
        production of “b”



                               Qty of “b”                               Qty of “b”
                                                                                     33
    New technologies also have very different
      impacts on producers and consumers
Price of
“b” goods
                               Consumer Surplus Gain = A+B
                               Producer Surplus Change = C-A
                               Net Econ. Surplus Gain = B+C
            A       B
                                  If demand is very inelastic, and
                C                    supply is very elastic, then
                                     innovation causes producer
                                     surplus to fall.
                                  This is “Cochran’s Treadmill”,
                                     pushing ag. producers to
                        Qty of “b” become ag. consumers.          34
  …but note that if a good is traded at a fixed price…
        innovation does not affect consumers;
              all gains go to producers!
Price of    With no trade             Price of    With free trade
“b” goods                             “b” goods

                            No innovation                   No innovation


                              With innovation                With innovation




                             Qty of “b”                    Qty of “b”
                                                                        35
      So what do we see, and why do we see it?
The incidence of each policy is price change X qty. affected,
 or economic surplus – a useful measure of welfare change
             For example, the U.S. market for avocadoes
               P($/lb)
                                  Policy is an import quota (M)

                                           Consumers lose ABCD
                   Pus    A                Producers gain A
                   Pw         B C   D
                                           Who gains C?

                          Qp Qp M Qc Qc

  In this case, avocado growers’ associations were given import
  quotas, and so captured the “quota rent” C from buying at Pw and
                                                                     36
  selling at Pus, as well as the increased producer surplus A.
       Areas B and D are Harberger triangles,
       permanent losses to the U.S. economy.

                      The United States
            P($/lb)




               Pus     A
               Pw           B C   D




Production efficiency losses,         Consumption efficiency losses,
where MC is above Pw                  where WTP is above Pw
                                                                   37
         Comparing instruments across markets
   An import quota instrument (M′)      An import tariff instrument (t)

                        S     S+quota



   Pus                          Pw+t    Pus    A
   Pw     A    B C D                     Pw         B C   D


           QpQp’     Qc’Qc                     Qp Qp’ Qc’Qc
         C.S. change: -ABCD                   C.S. change: -ABCD
         P.S. change: +A                      P.S. change: +A
         quota rent:    +C                    tariff revenue: +C
         net change: -B D                     net change: -B D
Note that this “tariff-quota equivalence” is limited; if there are
changes in S, D or Pw, the two policies lead to different responses?      38
              What about policy on exports:
       If trade is good, surely more trade is better?
                      Pdom
 an export subsidy:              A BC D      E
                                              F
                      Ptrade




                                  Qd’ Qd    Qs Qs’
                               CS loss:      area AB
Remember it’s not trade        PS gain:      area ABCDE
as such, but free trade        Subsidy cost: area BCDEF
that’s desirable               Net loss:     area BF      39
(at least in this model)
         Some conclusions on market equilibrium
                   and social welfare
• Different market structures will lead to different equilibrium outcomes
   – To the extent that buyers or sellers don’t trust each other, quantity sold would go
     to zero -- unless remedied by trust in a brand or third-party certification
   – To the extent that buyers or sellers are protected from competition by barriers to
     entry, they won’t act competitively -- won’t be “price takers”
   – These and other questions of market structure are the topic of AGEC 620 (for
     PhD students) and AGEC 621 (for PhD and advanced MS students)
• Different definitions of “welfare” lead to different policy preferences
   – These are examined in AGEC 617 and other courses in public economics
• For AGEC 640 (and in most everyday policy analysis) we assume:
   – that equilibria are perfectly competitive
   – that “social welfare” is proportional to economic surplus
  These are the simple but powerful techniques, that give us many non-
  obvious and yet useful results.
                                                                                      40

								
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