Market Stabilisation
Questions
1. OUTLINE the three main situations in Prices and market failure.
2. Why do governments do market intervention?
3. Explain Buffer Stock Schemes.
4. OUTLINE The Common Agricultural Policy (CAP)
5.
What were the 5 objectives of the Agricultural Policy in 1958?
6.
Define Merit Goods.
7.
Explain Maximum pricing.
8.
Describe minimum prices.
9.
What is the term decoupling in economics?
10. OUTLINE the set-aside policy.
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Market Stabilisation
Answers
1.
2.
Market mechanism sets the equilibrium price for each company or service brought forward into the economy. This can result
in three different outcomes:

Large Fluctuations in Price

High pricing

Low pricing
The reason for government intervention is sometimes done to help correction amongst market failure. Governments may
increase or decrease the price of certain products or services which will benefit them or the countries citizens.
3. See box:
The prices of agricultural products such as wheat, tea and coffee tend to fluctuate more than the prices of manufactured
products and services. This is largely due to the volatility in the market supply of agricultural products coupled with the fact
that demand and supply are price inelastic. One way to smooth out the fluctuations in prices is for the government to operate
price support schemes through the use of buffer stocks. But many of them have had a chequered history.
Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when
harvests are plentiful and selling stocks of the product onto the market when supplies are low.
The diagram below illustrates the operation of a buffer stock scheme. The government offers a guaranteed minimum price (P
min) to farmers of wheat. The price floor is set above the normal free market equilibrium price. Notice that the price elasticity
of supply for wheat in the short term is very low because of the length of time it takes for producers to supply new quantities
of wheat to the market. (Indeed in the momentary period, we would draw the supply curve as vertical indicating a fixed
supply).
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Market Stabilisation
If the government is to maintain the guaranteed price at P min, then it must buy up the excess supply (Q3-Q1) and put these
purchases into intervention storage. Should there be a large rise in supply due to better than expected yields of wheat at
harvest time, the market supply of wheat will shift out (see the diagram on the next page) – putting downward pressure on
the free market equilibrium price. In this situation, the government will have to intervene once more in the market and buy
up the surplus stock of wheat to prevent the price from falling.
It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow.
The problems with buffer stock schemes
In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the price is low and
sell them onto the market when the price is high. However, they do not often work well in practice. Clearly, perishable items
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Market Stabilisation
cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes.
Setting up a buffer stock scheme also requires a significant amount of startup capital, since money is needed to buy up the
product when prices are low. There are also high administrative and storage costs to be considered.
The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly
estimate the average price of the product over a period of time. This estimate is the scheme’s target price and obviously
determines the maximum and minimum price boundaries.
But if the target price is significantly above the correct average price then the organization will find itself buying more
produce than it is selling and it will eventually run out of money. The price of the product will then crash as the excess stocks
built up by the organization are dumped onto the market.
Conversely if the target price is too low then the organization will often find the price rising above the boundary, it will end
up selling more than it is buying and will eventually run out of stocks
The European Union Common Agricultural Policy has come under sustained attack for many years and there have been
several attempts to reform the system.
Source: http://www.tutor2u.net/economics/revision-notes/as-marketfailure-buffer-stocks.html
4.
See box:
The aim of the common agricultural policy (CAP) is to provide farmers with a reasonable standard of living, consumers with
quality food at fair prices and to preserve our rural heritage. The policy has evolved to meet society’s changing needs, so that
food safety, preservation of the environment, value for money and agriculture as a source of crops to convert to fuel have
acquired steadily growing importance.
As the most fully integrated of EU policies, the CAP takes a large share of the EU budget. Nevertheless, this has dropped
from a peak of nearly 70% of the EU budget in the 1970s to 34% of the budget during the 2007-2013 period, reflecting cost
savings from reforms, a shift of some agricultural spending into rural development, which will take 11% of the budget over
the same period, and expansion of the EU’s other responsibilities. The CAP ensures that farmers have an adequate income,
but they are not feather-bedded: their incomes are generally lower than those of people in other economic sectors.
Moving with the times
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Market Stabilisation
Born 50 years ago when the founder members of the EU had not long emerged from a decade of food shortages, the CAP
began by subsidising production of basic foodstuffs in the interests of self-sufficiency, increasing productivity, and food
security. Supporting production eventually created beef and butter ‘mountains’ and milk ‘lakes’, but these have been a thing
of the past for two decades as a result of a first wave of reforms.
Now the focus is on quality foodstuffs, and the role of agriculture in the preservation and management of our natural
resources. Farmers are expected to be market-oriented and competitive – to produce for markets and consumers without
being influenced in their choices by the possibility of a subsidy on a particular product. Support for products is being
progressively replaced by direct payments to farms.
The CAP supplements farm income in order to ensure that farmers make a decent living, but the support is linked to
compliance with broader objectives, such as standards on farm hygiene and food safety, animal and plant health, and animal
welfare, preservation of traditional rural landscapes, and bird and wild life conservation. The CAP also acts as a financial
safety net for farmers hit by natural disasters or animal diseases.
The role of rural development
Rural development policy ensures the survival of the countryside as we know it. As agriculture has modernised and the EU
economy become more service-oriented, agriculture has become much less important as a source of jobs. This means that
survival of rural economies can no longer be taken for granted. Consequently, more and more emphasis is being placed on
the role farmers can play in rural development, including forestry, biodiversity, diversification of the rural economy to create
alternative jobs and environmental protection in rural areas.
Continuing on the same reform path
The most fundamental change of approach – moving from payments which sometimes encouraged over-production to
payments which are more likely to encourage farmers to produce what consumers want and need - came at the beginning of
this decade. Since then products not included in the initial reform process have been added. These include wine, fruit and
vegetables, bananas, maize and sugar. Reforms in the sugar sector mean the EU is moving from being the world’s second
largest exporter to being a net importer.
The next steps are:

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to simplify the rules governing agriculture by overhauling the laws which have grown up piecemeal over the last five
decades;
Market Stabilisation

to replace different market organisations and rules for different products with a single common market organisation
and a uniform set of rules;

To work with national governments to cut the red tape farmers face in qualifying for EU support.
At the same time, the CAP is adapting to new opportunities for farmers to grow crops biofuel for vehicles and biomass for
power generation. Growing crops for fuel is not yet generally economically viable, but the CAP provides financial support
because these crops serve the interest of society in reducing dependence on fossil fuels and combating climate change.
The reforms have also been in the interests of fairer world trade and the EU is prepared to do more in that direction as part
of a balanced package of trade reforms worldwide. The reforms the EU has made to the CAP reduce the risk that trade will
be distorted by EU subsidies for export of surplus production. These changes thus prepared the EU for the currently
suspended ‘Doha’ round of international trade liberalisation talks, where the EU offered to eliminate export subsidies
altogether by 2013 and halve the average tariff on agricultural imports from 23% to 12%. However, even without these
measures, the EU is already the world’s largest importer of food and the biggest market for Third World foodstuffs.
The challenge of enlargement: When the EU enlarged in May 2004 and January 2007, the number of farmers in the EU
increased first by 55%, and then by a further 53%. Farmers and food processors in the new member countries face particular
challenges when competing with agriculture in the rest of the EU and received funding to modernise even prior to
enlargement. A special funding package tailored specifically to the needs of these farmers has provided help for early
retirement, less favoured areas, environmental protection, afforestation, semi-subsistence farms, producer groups and
compliance with EU food, hygiene and animal welfare standards. Some CAP rules are being phased in gradually to allow time
for adjustment.
Addressing consumer concerns: Quality products are a cornerstone of EU agricultural policy .
The EU promotes the production of quality – and internationally competitive — foodstuffs through financial assistance to
innovation in farming and food processing, and the use of voluntary quality labels. These include labels to designate
foodstuffs coming entirely from one area of the EU using recognised know-how, for well-known foods with a clear geographic
tie to a certain part of the EU, foods made of traditional ingredients or using traditional methods, and a label for organic
foods. The ‘EU Organic’ label can only be used on foods in which 95% of the ingredients have been produced according to
EU definitions of what constitutes organic farming.
Source: http://europa.eu/pol/agr/overview_en.htm
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Market Stabilisation
5.
The 5 objectives were:

Stabilisation of the markets

Make sure fair prices were being used towards consumers

Increase the agricultural production

Allow a standard form of living for farmers

Guarantee the citizens with availability of supplies.
6.
Merit goods are simple products or services which are considered to be good towards the buyer.
7.
See box:
The Government can set a legally imposed maximum price in a market that suppliers cannot exceed – in an attempt to prevent the
market price from rising above a certain level. To be effective a maximum price has to be set below the free market price.
One example of a maximum price might when shortage of essential foodstuffs threatens large rises in the free market price. Other
examples include rent controls on properties – for example the system of rent controls still in place in Manhattan in the United
States.
A maximum price seeks to control the price – but also involves a normative judgment on behalf of the government about what that
price should be. An example of a maximum price is shown in the next diagram. The normal free market equilibrium price is shown at
Pe – but the government decides to introduce a maximum price of Pmax. This price ceiling creates excess demand for the product
equal to quantity Q2-Q2 because the price has been held below the normal equilibrium.
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Market Stabilisation
It is worth noting that a price ceiling set above the free market equilibrium price would have no effect whatsoever on the market –
because for a price floor to be effective, it must be set below the normal market-clearing price.
Maximum prices and consumer and producer welfare
How does the introduction of a price ceiling affect consumer and producer surplus. This is shown in the next diagram. At the original
equilibrium price consumer surplus = triangle ABPe and producer surplus equals the triangle PeBC.
Because of the maximum price ceiling, the quantity supplied contracts to output Q2. Consumers gain from the price being set
artificially lower than the equilibrium, but there is a loss of consumer welfare because of the reduction in the quantity traded. At P
max the new level of consumer surplus = the trapezium ADEPmax. Producer surplus is reduced to a lower level Pmax EC. There has
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Market Stabilisation
been a net reduction in economic welfare shown by the triangle DBE.
Source: http://www.tutor2u.net/economics/revision-notes/as-marketfailure-maximum-prices.html
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Market Stabilisation
8.
See box:
A minimum price is a price floor set by the government where the price is not allowed to fall below this set level (although it is
allowed to rise above it). Reasons for setting a price floor:
·
·
·
To protect the earnings of producers – in certain industries prices are subject to great fluctuations. Minimum prices will
guarantee producers income in periods when prices would otherwise have been very low. Examples include certain
agricultural products.
To create a surplus – in periods of glut surpluses can be stored in preparation for possible future shortages.
To guarantee a certain level of earnings – workers can be given a minimum wage so that their earnings don’t fall below a
certain (unacceptable) level.
The diagram below shows the effects of a minimum price:
The minimum price has created a surplus (excess supply) of Qs – Qd.
There are three ways in which the government can deal with this
surplus:
The government purchases the entire surplus to store it, destroy it or
sell it in other markets. If the government seeks to do this then it has
to buy up the excess (Qs – Qd) at the current minimum price. This
means the cost to the government and therefore taxpayer is the
shaded area QdabQs.
The government could artificially lower supply to Qd by issuing quotas
which limit production.
Source: http://www.revisionguru.co.uk/economics/minimum.htm
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Market Stabilisation
9.
The term decoupling in economics means the non-correlation between variables. This can be within an economy market or
production. An example of this is a social worker being given a grant in which has nothing to do with the workers market
area.
10. See box:
An agricultural policy designed to reduce surplus production, by requiring the withdrawal of land from production in exchange for
specific payments or guarantees. It has been used extensively in the USA and Europe. Under the 1992 MacSharry reforms of its
Common Agriculture Policy (CAP), the European Union introduced a series of direct payments to farmers as a means of moving away
from market support to secure farm incomes. To qualify for these payments, farmers have to conform to a range of controls
intended to restrain production. Arable production is restrained by set-aside. It has encouraged farmers to remove from production a
fixed amount of their land. While set-aside is a logical response to overproduction, it has the negative effect of a further
intensification on the productive land.
Source: http://encyclopedia.jrank.org/Cambridge/entries/015/set-aside-policy.html
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