AGEC 640 – Agricultural Policy
Market Equilibrium and Social Welfare
Sept. 23 – 25, 2014
Today:
Market equilibrium with trade & policy (slides 1-22)
Thursday:
Policy incidence and social welfare (slides 23-41)
Assignment #2 due
Next week:
Policy
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
(bu/acre)
Qty. of corn
(bu/acre)
Pl/Pc Pl/Pc′
more corn,
more input use
Qty. of labor
(hours/acre)
Pb/Pc′
Pb/Pc
more corn,
less other outputs
Qty. of beans
(bushels/acre)
Each price change
affects the
household’s
production choices,
input use
and income
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…and on the consumption side:
Households respond to price changes with
both income and substitution effects:
Qty. of
corn
substitution
effect
income
effect
Each price change
affects the household’s
production choices,
input use and income
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)
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…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)
7
We need to draw a similar diagram for them,
and for the trade between us and them
Trade between
The Rest of the
X & them
World (RoW)
P($/lb)
“Country X”
P($/lb)
S
D
Q(tons)
8
Starting with foreign supply and demand:
Trade between
X and ROW
The Rest of the World
P($/lb)
Country X
P($/lb)
S
D
Q(tons)
Note we’ve drawn the same price axis for
X and RoW (ignoring exchange rates)
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Then we can draw the U.S.’s
willingness to trade with the RoW:
Country X
P($/lb)
Trade between
X and ROW
The Rest of the World
P($/lb)
ED
Q(tons)
Q(tons)
X’s “excess demand curve” in trade, i.e. the amount demanded at
any price that cannot be met by domestic supply.
10
and ROW’s willingness to trade…
Trade between
X and ROW
The Rest of the World
P($/lb)
Country X
P($/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.
11
World Price Clearing…
Trade between
X and ROW
The Rest of the World
P($/lb)
Country X
P($/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 X’s curves.
International markets clear when ED=ED
12
The large size of the rest of the world allows
us to simplify the diagram
Trade between
X and ROW
The Rest of the World
P($/lb)
Country X
P($/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 represent both X & the ROW
Trade between
The Rest of the World
X and ROW
P($/lb)
Country X
P($/lb)
ES
ED
Pw
Q(tons)
Q(tons)
Q(thou. tons)
As the “world” price would not
be affected by changes in X.
14
For many important traded products, prices are
determined by the world’s supply-demand balance,
not local production and consumption.
Country X
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 that
help producers
raise Pd
above Pt
import
tariffs
or
quotas
Policies that
import
help consumers subsidies
lower Pd
(rarely
seen)
below Pt
Policies on exports
export
subsidies
export
taxes or
quotas
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
prod. & cons.
affect only
production
affect only
consumption
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…and six possible policies in markets for exportables:
on trade
on production
on consumption
taxes
or
restrictions
subsidies
or
encouragements
affect both
prod. & cons.
affect only
production
affect only
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
21
Some perspectives on “free trade”
• in a free market…
“producers”
oppose trade that opens up competition for them
will be better off when trade provides them with more consumers
“consumers”
prefer open trade that increases the number of sellers
prefer fewer buyers for the goods they want
• A basic tension in policymaking is that it is difficult to find
policies that are in the best interests of everyone in the country!
We will pick up here next lecture…
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How could we evaluate a change?
Criterion: marginal surplus
S=MC
as qty. rises, the gap
between the curves falls…
until this marginal
economic surplus
reaches zero at the
equilibrium
P
D=MB
Q
23
“Economic surplus” is simply
the area between S & D curves
You should try to understand why.
The Hines article explains how this
area came to be the workhorse
definition of “social welfare”
in applied policy work, despite
its limitations relative to other
definitions of social welfare.
P
Q
24
There is a very close link between
“positive” economics (for prediction)
and “normative” economics (for evaluation)
For example, if new
technology reduces
marginal cost by 10%,
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.
P
P′
Q Q′
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Equilibrium = Optimum ?
If the equilibrium is the social
optimum, do we live in the
best of all possible worlds?
P
If you have no other information,
you cannot say something else
would be better!
Q
26
640 is not about “public” or “welfare” econ
• 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…
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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 “dis-preferred” 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!)
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…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.
• Actual politics often involves “King John
redistribution” (from poorer to richer people) and
“vested interests” (that block pro-poor changes).
30
Economic surplus treats the market as a household
highest indifference level
in a household model
Qty. of
“a” goods
Qa
highest economic surplus
in a market model
Price of
“b” goods
slope of indiff. curve
 Qa
 MRS 
Qb
equilibrium
among
optimizing
people in a
perfectly
competitive
market
Pb
slope of income
line =-Pb/Pa
Qb
Qty of “b”
Qb
31
We can divide “economic surplus” into two parts
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
is society’s total economic surplus
Qb
32
Trade creates a distinction between production and
consumption – e.g. when we start selling
Producer surplus in “b” declines by:
Qty. of “a”
goods
…but consumer surplus
in “b” rises by:
Price of “b”
goods
Net gain from trade
A
A B
==> net social gain
from trade in “b” is:
B
Increase in
consumption of
“b”
A B
Decline in
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
supply is very elastic, then
innovation causes producer
surplus to fall.
This is “Cochran’s Treadmill”,
pushing ag. producers to become
ag. consumers.
C
Qty of “b”
34
…note that if a good is traded at a fixed price…
innovation does not affect consumers;
all gains go to producers!
Price of
“b” goods
With no trade
Price of
“b” goods
No innovation
With innovation
Qty of “b”
With free trade
No innovation
With innovation
Qty of “b”
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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 avocados
P($/lb)
Policy is an import quota (M)
Pus
Pw
A
B C
Qp
Qp M Qc Qc
D
Consumers lose ABCD
Producers gain A
Who gains C?
In this case, avocado growers’ associations were given import quotas, and so captured the
“quota rent” C from buying at Pw and selling at Pus, as well as the increased producer
surplus A.
36
Areas B and D are Harberger triangles,
permanent losses to the U.S. economy.
The United States
P($/lb)
Pus
Pw
A
Production efficiency losses,
where MC is above Pw
B C
D
Consumption efficiency losses,
where WTP is above Pw
37
Comparing instruments across markets
An import quota instrument (M′)
S
Pus
Pw
An import tariff instrument (t)
S+quota
Pw+t
A
B
Qp Qp’
C
D
Qc’ Qc
C.S. change: -ABCD
P.S. change: +A
quota rent:
+C
net change: -B D
Pus
Pw
A
Qp
B C
Qp’
D
Qc’ Qc
C.S. change: -ABCD
P.S. change: +A
tariff revenue: +C
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:
Ptrade
A BC D
Qd’ Qd
Remember it’s not trade
as such, but free trade
that’s desirable
(at least in this model)
E
F
Qs Qs’
CS loss:
area AB
PS gain:
area ABCDE
Subsidy cost: area BCDEF
Net loss:
area BF
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Some conclusions on market equilibrium
and social welfare
• Different market structures will lead to different equilibrium outcomes
– 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 nonobvious and yet useful results.
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