Agricultural Policy: Market Equilibrium, Social Welfare, and Policy Incidence

AGEC 640 Agricultural Policy Market equilibrium and Social Welfare Sept. 20, 2018 Today: Policy incidence and social welfare Next two weeks: Policies, distortions, protection and impacts Reminder: Assignment #2 due on 9/27 1

Recall from last lecture that we have six possible policies in markets for importables on trade on production on consumption taxes or restrictions subsidies or encouragements affect only consumption affect both prod. & cons. affect only production 2

and six possible policies in markets for exportables: on trade on production on consumption taxes or restrictions subsidies or encouragements affect only consumption affect both prod. & cons. affect only production 3

What do we see? In free markets producers 1. tend to oppose trade that opens up competition for them 2. will be better off when trade provides them with more consumers consumers 1. tend to prefer open trade that increases the number of sellers 2. prefer fewer buyers for the goods they want This leads to a basic tension in policymaking: it is difficult to find policies that are in the best interests of everyone in the country! 4

What 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 : Based on areas on a supply-demand diagram Measured in terms of money (= price x quantity) The basic assumption is that money=value 5

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 6

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 7

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 8

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 9

640 is not about public or welfare econ The question for welfare economics is, what can one infer about aggregate welfare from individual choices? (Assuming individuals are 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 10

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!) 11

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. 12

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). 13

Economic surplus treats the market as a household highest indifference level in a household model highest economic surplus in a market model Qty. of a goods Price of b goods equilibrium among optimizing people in a perfectly competitive market slope of indiff. curve Qa MRS = = Qa Qb Pb slope of income line =-Pb/Pa Qb Qb Qty of b 14

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 Qb The sum of everyone s gains/losses is society s total economic surplus 15

Trade creates a distinction between production and consumption e.g. when we start selling A A Producer surplus in b declines by: Qty. of a goods but consumer surplus in b rises by: B Price of b goods ==> net social gain from trade in b is: B Net gain from trade Increase in consumption of b AB Decline in production of b Qty of b Qty of b 16

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 17

note that if a good is traded at a fixedprice innovation does not affect consumers; all gains go to producers! With no trade With free trade Price of b goods Price of b goods No innovation No innovation With innovation With innovation Qty of b Qty of b 18

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 Let s take, for example, the US market for avocados. Origin: 1/3 of avocados eaten in the US are grown in the US 2/3 are imported Of imports, approximately: 90% come from Mexico 10% from Chile, Peru and the Dominican Republic. 19

U.S. Avocado policy Many countries restrict imports when the product in question might transmit diseases or carry pests. The stated goal of these phytosanitary regulations is to keep the pest or disease from entering the importing country. Protectionist? Yes, but generally justified. Sometimes, these regulations can be considered unfair trade barriers if they are not based on science. The US used phytosanitary regulations to block avocado imports from Mexico. These were challenged in the WTO and the barrier was relaxed slightly in 1993, 1997 and 2002. 20

The stylized U.S. market for avocados Policy is an import quota (=M) P($/lb) Supply Pus A B C D Pw Demand Qp Qp Qc Qc Quantity (lbs) M=imports Domestic production rises from Qp to Qp and domestic consumption falls from Qc to Qc Consumers lose ABCD Producers gain A Who gains C? 21

The stylized U.S. market for avocados Policy is an import quota (=M) P($/lb) Supply Pus A B C D Pw Demand Qp Qp Qc Qc Quantity (lbs) M=imports 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. 22

Areas Band D are Harberger triangles, permanent losses to the U.S. economy. The United States P($/lb) Pus A C D B Pw Consumption efficiency losses, where WTP is above Pw Production efficiency losses, where MC is above Pw 23

Comparing instruments across markets An import quota instrument (M ) An import tariff instrument (t) S+quota S Pw+t Pus Pus A A B C D B C D Pw Pw Qp Qp Qc Qp Qc Qc Qp Qc C.S. change: -ABCD P.S. change: +A quota rent: +C net change: -B D 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. 24

What about policy on exports: If trade is good, surely more trade is better? Pdom C E A D an export subsidy: B F Ptrade Qd Qs Qd Qs CS loss: area AB PS gain: area ABCDE Subsidy cost: area BCDEF Net loss: area BF Remember it s not trade as such, but free trade that s desirable (at least in this model) 25

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 simple but powerful techniques that give us many non- obvious and yet useful results. 26