Week 7

1. Week 7 Presentation is from: Class notes of Prof. Gerald Shively Purdue University (AGEC 640: Agricultural Development and Policy)

2. Market Equilibrium and Social Welfare

3. Market equilibrium with trade & policyThe 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) Pb/Pc’ Pb/Pc Pl/Pc’ Pl/Pc Each price change affects the household’s production choices, input use and income more corn, more input use more corn, less other outputs Qty. of labor (hours/acre) Qty. of beans (bushels/acre)

4. …and on the consumption side: Households respond to price changes with both income and substitution effects: Each price change affects the household’s production choices, input use and income Qty. of corn substitution effect 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

5. 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)

6. …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)

7. …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!

8. What price would we observe if these people can trade with the rest of the world? P($/lb) MC WTP Q(tons)

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

10. Starting with foreign supply and demand: Trade between Turkey and the world Turkey The Rest of the World P($/ton) P($/ton) Q(tons) Note we’ve drawn the same price axis for Turkey and RoW (ignoring exchange rates)

11. Then we can draw Turkey’swillingness to trade with the RoW: Trade between Turkey and RoW Turkey The Rest of the World P($/ton) P($/ton) ED Q(tons) Q(tons) The Turkey’s “excess demand curve” in trade, i.e. the amount demanded at any price that cannot be met by domestic supply.

12. and RoW’s willingness to trade… Trade between Turkey and ROW Turkey The Rest of the World P($/ton) P($/ton) 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.

13. World Price Clearing… Trade between Turkey and ROW Turkey 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 Turkey’s curves. International markets clear when ED=ED

14. The large size of the rest of the world allows us to simplify the diagram Trade between us and them Turkey The Rest of the World P($/ton) P($/ton) ES ED Q(tons) Q(tons) Q(thou. tons) the simplifying assumption that this line is horizontal is called the “small country” assumption.

15. The small-country assumption allows a single diagram to both Turkey & the RoW Trade between Turkey Turkey The Rest of the World P($/ton) P($/lb) ES Pw ED Q(tons) Q(tons) Q(thou. tons) As the “world” price would not be affected by changes in Turkey.

16. For many important traded products, prices are determined by the world’s supply-demand balance,not local production and consumption. Turkey P($/ton) Pw Q(tons) Local supply and demand determine production, consumption and trade, at a price given by the big (bad?) world market

17. But then there’s policy! Policies on imports Policies on exports Policies that help producers raise Pd above Pt export subsidies import tariffs or quotas Policies that help consumers lower Pd below Pt import subsidies (rarely seen) export taxes or quotas Policies that work through trade affect both producers and consumers.

18. 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…

19. 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.

20. Combining these concepts, we have six possiblepolicies 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

21. …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

22. 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

23. Criteria:How could we evaluate a change? as qty. rises, the gap between the curves falls… Pobs. until this marginal economic surplus reaches zero at the equilibrium Qobs.

24. “Economic surplus” is simply the area between S & D curves 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. Pobs. Qobs.

25. 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%, Pobs. 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. Qobs. Q’

26. Equilibrium = Optimum ?! If the equilibrium is the social optimum, do we live in the best of all possible worlds? If you have no other information, you cannot say something else would be better! Pobs. Qobs.

27. Econ 101 vs. Econ 102 To continue the analysis, we need to know something about some other costs and benefits incurred in this market. Pobs. Qobs.

28. 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…

29. … 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!)

30. …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.

31. 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…

32. 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 Qa Pb slope of income line =-Pb/Pa Qb Qb Qty of “b”

33. 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 is society’s total economic surplus Qb

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

35. 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”

36. …but note that if a good is traded at a fixed price… 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”

37. 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 Producers gain A Who gains C? Pus A B C D Pw M Qc Qp Qp Qc 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.

38. Areas Band D are Harberger triangles, permanent losses to domestic economy. Turkey P($/lb) Pus A B C D Pw Production efficiency losses, where MC is above Pw Consumption efficiency losses, where WTP is above Pw

39. Comparing instruments across markets An import quota instrument (M’) An import tariff instrument (t) S S+quota Pus Pw+t Pus A A B C D B C D Pw Pw Qp Qp’ Qc’ Qc Qp Qp’ Qc’ 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!

40. 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’ Qd Qs 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)

41. 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” • Different definitions of “welfare” lead to different policy preferences • For policy analysis in this class 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.