Economics Project Price Floor
Economics Project Price Floor
Economics Project Price Floor
BHOPAL
ECONOMICS PROJECT
On
PRICE FLOOR:
MINIMUM SUPPORT PRICE and
INDIAN AGRICULTURE
Submitted to
Prof Rajesh Gautam
Submitted by
Kunal Sharma
2013 BALLB 63
Contents
PRICE FLOOR: A Brief Introduction..............................................................................3
Understanding The Principle:...................................................................................... 4
MARKET EQUILIBRIUM................................................................................................ 4
GOVERNMENTS ROLE AND FUNCTION........................................................................9
Minimum Support Price............................................................................................ 10
and The Indian Agriculture....................................................................................... 10
Effects of Price Floor................................................................................................. 12
Short Term Effects:................................................................................................ 12
Long term Effects:................................................................................................. 13
Review of Literature................................................................................................. 15
1.
2.
3.
Quantity Supplied
25,000
37,500
45,000
Quantity Demanded
50,000
37,500
30,000
(Fig 1)
supply. At Equilibrium price (which is Rs. 16.25 here), the quantity of goods
demanded is exactly equal to the quantity of goods supplied. While at Rs. 20
the quantity supplied is 45,000 units as opposed to a lesser quantity
demanded f 30,000 units which leads to an excess in supply.
To understand the Price Floor model, we must understand these two main
concepts regarding Market Equilibrium i.e. the creation of excess supply and
excess demand as explained by Fig 2:
(Fig 2)
Here (Fig 2) it can be seen that any price (P1) above the Equilibrium Price
(EP) leads to the creation of excess supply (the blue shaded region) whereas
at price (P2) below the Equilibrium Price (EP) excess demand is created or
there is a shortage in supply(as seen in the red shaded region).
Here we concern ourselves with the excess supply that is created as a result
of raising the price above the equilibrium price.
It may be noted that if the price is set below the Equilibrium Price it would be
ineffective as the price would be lower than the Equilibrium Price and thus
non-binding on the producers.
(Fig 3)
Here (Fig 3) the Price F is lower than the desired Equilibrium Price which is
the price at which maximum satisfaction to both consumers and producers in
a market is achieved. Therefore to be effective, the price must be set above
the Equilibrium Price. As mentioned earlier, at Equilibrium Price the quantity
of goods supplied and demand are exactly equal. When the price is set
above the Equilibrium Price, then there is a possibility that there will be an
excess supply or a surplus. If this happens, producers who can't foresee
trouble ahead will produce the larger quantity where the new price intersects
their supply curve. Unbeknownst to them, consumers will not buy that many
goods at the higher price and so those goods will go unsold. This is the
underlying principle of Price Floor. In this scenario the invisible hand of
market forces here will naturally drive the prices downwards in case of
excess supply to bring it back to the equilibrium price.
An example below showing both the Schedule (table 2) and Graph (Fig 4) of
the Price floor is given below.
Table 2
Price of Commodity
10
16.25
20
Quantity Supplied
25,000
37,500
45,000
Quantity Demanded
50,000
37,500
30,000
(Fig 4)
Here the price F (20) is above the equilibrium price (16.25) E because it is
supposed that the price E does not provide incentives to the farmers to
produce. Therefore to promote such production by farmers government
keeps the price at Price F. As a result of such pricing above the Equilibrium
Price E there as can be seen from the diagram (fig 4) is created, a surplus in
the market (as shown in the shaded region) as farmers expand their output
and supply.
Rabi Crops
Wheat
Barley
Gram
Masur (lentil)
Mustard
The market price can sometimes be so low that farmers cannot make enough
money to support themselves. In such cases, the government steps in and
sets a price floor. The rationale is that if there is a fall in the prices of the
crops, after a bumper harvest, the government purchases at the MSP and this is
the reason that the price cannot go below MSP. So this directly helps the
farmers.
The government decides the support prices for various agricultural
commodities after taking into account various recommendations of
Commission for Agricultural Costs and Prices, views of ministries and state
governments and other relevant factors.
10
(Notice that when the price is artificially raised above p*, the quantity
supplied exceeds the quantity demanded. Such a situation is called a
surplus: farmers produce many more crops than buyers want to buy at the
new, higher price.)
11
term effects of such Price floor which are considered by many as negative
effects on the economy.
12
However, since the consumers ultimately pay taxes for the government to
purchase the surplus, the total cost to consumers (in the short run) of the
price support is the sum of the loss in consumer surplus and the cost of
the government purchasing the surplus off the market.
13
Review of Literature
1. Pulse of the nation
Editor, The Hindu
The Editor, Business Line in his editorial article dated July 26, 2013 has
revealed the need for MSPs for pulses like gram, chana, etc. in the country.
He starts by emphasizing the fact that India being a chronic importer of
pulses has done well in the recent years in terms of domestic production but
highlights the grim fact that the prices are much lower than required there
being no adequate floor price set by the government for the same. Quoting
the recent price crash in Chana prices, he stresses that the government must
incentivise the farmers to grow more pulses as they have various nutritional
values (considering the nutrition deficiency in the country) and also functions
as a nitrogen fixer.
He is of the opinion that if this continues it will discourage farmers from
producing pulses. He urges the government to ensure that farmers get the
officially declared MSPs for the crop to be harvested a couple of months from
now. In the absence of physical procurement support, these MSPs have
meaning only on paper and the new National Food Security legislation may
aggravate this, given its sole focus on guaranteeing a minimum quantity of
cereals as a legal entitlement to two-thirds of the population. This will, in
turn, further skew our public resources and procurement efforts.
Wood Peter and Jotzo Frank (2009) in their article Price Floors for Emissions
Trading have revealed the advantages of Price flooring for emission trading
and have given suggestions for the same on how the government can tackle
the issue at hand. They have discussed the advantages of price flooring for
emissions trading and implied that Price floors need to be carefully designed
to avoid budgetary liabilities, and to avoid barriers to international trade in
permits. They further argue that the most direct approach of a government
commitment to buy back permits at a threshold price is unlikely to be viable,
especially in the context of international permit trading, because it implies
large contingent budgetary liabilities but that an alternative approach of a
minimum reserve price for auctioned permit, could yield the desired effect,
14
but could be ineffective if the share of auctioning is small. They have used
various economic tools of research such as graphs, schedule and other
relevant data to support the same.
Concluding, price floors could fulfill an important supporting role in ensuring
effective and efficient climate change mitigation, they can be implemented
without compromising vital aspects of emissions trading, and their budgetary
properties may turn out to be highly attractive to governments.
3. An economic analysis of Price dynamics in the presence of a Price floor:
The case of American Cheese
Jean-Paul Chavas and Kwansoo Kim
15
Duloy J.H. (1964) in his article Some variance effects of a floor price
scheme for wool: A two period analysis has revealed that for complete
cycles, a floor price scheme cannot be expected to have any significant
effect upon the mean level of either growers income or of receipts from
commercial sales of, in this study, wool. He gives the reason that because
of the absolute magnitude of changes in both buying and selling periods,
a scheme may be expected to have a more substantial impact upon the
variance of both growers income and of receipts from commercial sales.
Hence concluding, because the variance of the income of the individual
wool grower is likely to be greatly influenced by changes in local
conditions leading to changes in output and by cost changes, any
reduction in the variance of the aggregate is likely to be far less important
at individual farm level. Any increase in the variance of receipts from
commercial sales, and hence of export received of wool sold is likely to
lead to an intensification of the severity of periodic balance of payment
crisis. For the income stream of individual woolgrower the impact of the
external effect may predominate, and a fortiori for the rest of the
economy.
5. Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post
Marketing Permits or Ex Ante Production Contracts?
Sandhyarani Patlolla
In this paper titled Managing Quantity, Quality and Timing in Cane Sugar
Production: Ex Post Marketing Permits or Ex Ante Production Contracts?
Patlolla Sandhyarani (2010) highlights the issue that Sugar processors must
comply with a floor price for cane, but gur and khandsari producers are
exempt from the floor price. Thus, any effect of the sugar processors choice
of procurement method on the incentives facing farmers will depend on the
expected cane price in these competing unregulated markets. She has
developed a theoretical model of the Andhra Pradesh cane procurement
market that incorporates the government-mandated floor price policy that
applies only to the cane used for sugar processing, and compared the
processors profits under the probabilistic ex post permit system and ex ante
production contracts.
The main conclusion is that ex post permits creates competition among the
farmers to increase cane quality that brings higher profits to the processor at
the expense of higher costs to the farmers. This hypothesis is tested and not
rejected using data
16
Conclusion
It is apparent that instituting a price floor is economically unsound but
refraining from instituting one doesnt mean that everything would work out
optimally for everyone. Price floors have negative long-term economic
consequences. The effects arent always noticeable because the price floor
could be set at a level that is commensurate with the market minimum. In
those cases it is as if the floor doesnt exist. They are still sometimes enacted
because of their short-term effect. A price floor has the immediate effect of
increasing the profit of producers. Without a price floor, some people would
lose their jobs and they might not have the skills to quickly find a new one or
they may not get a fair price for their hard earned produce in the market due
to the various exploitations they face in the market by middlemen etc. The
object of setting a Price Floor by the government is driven by its welfare
motive to protect the interest of the class of people who are most
substantially affected by rising and lowering prices of commodities upon
which the very livelihood and life of such people exists. Thus ours being a
welfare state, we take along everyone in our stride to achieve greater
economic growth keeping every individuals own economic goals in mind.
17
Bibliography
Internet:
Wikipedia.com
Investopedia.com
economics.fundamentalfinance.com
Indiabudget.nic.in
Articles from:
o www.jstor.com
o Econpaper.repec.org
Books:
Modern Economic Theory: KK Dewett
Principles of Micro economics( vol 1): N. Gregory Mankiw