Illustrations of Distorting Price Policies

Figure 3.1 contains representations of the four types of positive subsidy policies. The four types of negative subsidy policies are simply the converse of the positive ones and thus are not illustrated. Figure 3.2 illustrates the two kinds of trade policies. Any price policy for tradable commodities can be identified as one of these ten basic types, allowing prediction of the kinds and directions of policy effects. Three effects of price changes are of principal interest in agricultural policy analysis: the quantities of the commodity that are produced, consumed, and traded (imported or exported); the income transfers to or from producers, consumers, and the government budget; and the efficiency losses in production or consumption. The likely magnitudes of change depend on the size of the price change and on the elasticities of demand and supply, which compare percentage changes in quantities with percentage changes in prices. Because of data limitations, reliable estimates of elasticities are often difficult to obtain. But the direction of change is predictable so long as the demand curve is downward sloping and the supply curve is upward sloping.

Policies for Importables

A positive producer subsidy on importables, S₊PI, is illustrated in Figure 3.1 a. A government might desire to expand domestic output of an agricultural crop and choose to subsidize its production from budgetary revenues. The policy raises the domestic payment to producers, P_P, to a level above the world price, P_w thereby increasing the quantity of local output from Q₁ to Q₂. Local consumption (Q₃) is not affected. Under an S₊PI policy, the domestic market price, P_D, remains equal to the world price, P_w. The per unit revenue received by producers, P, is higher than P_D by the amount of subsidy from the government. The subsidy scheme is feasible only if producers and consumers are separated by enough economic distance, product transformation, or administrative control that the commodity cannot be repurchased at the lower market price and resold at the higher producer price. The quantity of imports is reduced from Q₃ - Q₁, the level without policy, Q₃ -Q₂

The level of subsidy per unit, P_p - P_w, is applied to Q₂ of production, so the total transfer to producers from the government budget is Q₂ x (P_p - P_w), shown by the area P_pABP_w. This budget transfer creates an efficiency loss in the economy, because the government chooses not to permit scarce resources to be allocated by a price formed at P_w, the competitive equilibrium. The government has the option of obtaining Q₂ - Q₁ by importing; the opportunity cost of this amount of output is given by its import cost, Q₁CBQ₂. The subsidy policy causes additional local production to replace imports; the value of the local resources used to produce the Q₂ - Q₁ of output is represented by the area under the supply curve, Q₁CAQ₂. The efficiency loss from policy S₊PI is the difference between the resource cost of increased domestic production, Q₁CAQ₂, and the opportunity cost, Q₁CBQ₂, or the triangle CAB.

A positive consumer subsidy on importables, S₊CI, is portrayed in Figure 3.1c. It differs significantly from S₊PI in that it results in a single domestic price for both producers and consumers, PD, at a level lower than the world price, P_w. The policy provides a per unit subsidy of P_te, - P_D on imports. Production is reduced from Q₁ to Q₂, consumption increases from Q₃ to Q₄, and imports are raised from Q₃ - Q₁ to Q₄ - Q₂. The transfers from S₊CI consist of two parts. The subsidy, (P_W - P_D)(Q₄ - Q₂), or AGHB, is transferred from the government budget. Because the subsidized imports reduce the price for producers as well as consumers, producers transfer P_wABP_D to consumers.

Efficiency-related losses are now present in both production and consumption. In production, the reduction of output from Q₁ to Q₂ implies a loss of income of Pw(Q_l - Q₂), or Q₂AFQ₁. By reducing output, the economy saves inputs; the value of these resources is again represented by the area under the supply curve, Q₂BFQ₁. The net income loss to the economy is represented by AFB.

Like its counterpart in production, the efficiency loss in consumption results from the government's decision to set the consumer price below the world price. The justification for this consumption loss is different from that for production. By subsidizing imports and lowering the consumer price, the government causes consumption to increase from Q₃ to Q₄. The opportunity cost (or value) of this increment in consumption is measured at world prices, PW(Q₄ - Q₃), or area Q₃EGQ₄. Total willingness to pay for this increment in consumption is approximated by the area under the demand curve, just as total costs of production are represented by the area under the supply curve. The consumer efficiency loss in consumption of policy S₊CI is therefore the difference between the opportunity cost of the increased consumption, Q₃EGQ₄, and the willingness to pay for the increased consumption, Q₃EHQ₄, or the triangular area EGH. Because the consumer efficiency loss is defined in terms of willingness to pay, it does not represent forgone income.

A restriction on imports, TPI, is shown diagrammatically in Figure 3.2a. This policy benefits producers by raising the domestic price facing both producers and consumers, P_D, above the world price, Pvv, thereby allowing domestic output to expand from Q₁ to Q₂. The trade effect is a reduction in imports from Q₃ - Q₁ to Q₄ - Q₂, reflecting the increase in local supply and the decrease in local demand. The policy is implemented by imposition of a per unit tariff of P_D - Pvv or an equivalent quantitative restriction permitting imports at a level of Q₄ - Q₂, which would have the same restrictive effect on trade as a tariff of P_D -P_W. Unlike S₊PI, which does not affect consumers, TPI causes a reduction in consumer demand from Q₃ to Q₄. Because of higher prices

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consumers to transfer income of (P_D - PW)Q₄, or P_DABP_w, to producers (P_D - PW)Q₂, or P_DEFP_w, and to the government budget (P_D - PW)(Q₄ - Q₂), or FEAB. Consumer efficiency losses are again measured as the difference between the opportunity cost of the change in consumption, PW(Q₃ - Q₄), or Q₄BCQ₃, and the willingness to pay for the same increment, Q₄ACQ₃. The consumer efficiency loss is thus the triangular area ACB. Efficiency losses in production (EFG) are measured in the same way as in the S₊PI case.

Policies for Exportables

The three types of policies just discussed influence importables. Similar detailed discussion for exportables is not necessary, because the three types of policies that affect exportables are obverses of the policies for importables. In Figure 3.1, S₊PI is the opposite of S₊CE, and S₊CI is matched with S₊PE; in Figure 3.2, TPI and TCE are opposites. All that needs to be done to apply the discussion on policies for importables to policies for exportables is to exchange exportables for importables, decrease for increase, more for less, and so forth. Indeed, one can see the diagram for either member of the pair by taking a thin piece of paper on which is drawn the diagram for its partner policy, turning the paper over so that the original bottom is at the top, and looking into the light through the back side of the paper. The measures of efficiency losses from exportable policies are labeled accordingly. This exercise demonstrates the totally symmetric relationship between each pair of policies.

Policies for Tradable Inputs

Tradable-input policies are identified in the classification system with the addition of I (inputs) to the second criterion. Tradable-input policies have direct relevance only for producers of outputs; therefore, a superscript + on the first criterion describes input policies that encourage input use and benefit producers; a superscript - describes input policies that discourage input use and are costly to producers. For example, a fertilizer subsidy for rice producers would be classified as S₊II or S₊IE because the input policy has reduced the cost of producing a given quantity of rice. A negative fertilizer subsidy (tax) raises production costs and is designated S_-II or S_-IE. Trade policies bear the designation T₊I_- and T _-L_-.

The efficiency effects of input policies on a particular output market are illustrated in Figure 3.3. Figure 3.3a shows the effect of a tax on an input used to produce an importable output. For each level of output, the costs of production are increased_. The magnitude of increase depends on the share of the input in production costs and the ability of the producer to substitute other inputs for the taxed input. A tax on ammonium phosphate, for example, will have little impact on the costs of producing rice if rice producers are able to substitute alternative fertilizers, such as urea and superphosphate. A tax on all fertilizers will have a larger impact, because the rice producer cannot avoid the tax. The only possible response is to reduce fertilizer use and decrease output.

In Figure 3.3a, output declines from QQ₁, to Q₂, the intercept of the new output supply curve, S', with the world price. The efficiency loss to the economy is measured by the triangular area ABC; this area represents the difference between the value of lost output, Q₂CAQ₁, and the cost of producing that output, Q₂BAQ₁. If the input is used in more than one output market, similar efficiency losses result in those markets. By summing across all the output markets, one can estimate the total efficiency effects of the input tax.

Figure 3.3b shows the impact of an input subsidy on the production of an importable output. Costs of producing any given amount of output are reduced, and the lower input price encourages intensified use. The supply curve in the output market shifts downward; production increases from Q₁ to Q₂. The efficiency cost of this policy is ACB, the difference between the cost of producing the increased output, Q₁ACQ₂, and the value of the increased output, Q₁BQ₂. As before, total efficiency effects can be estimated by consideration of all outputs that use the subsidized input.

Policies for Nontradables

Nontradable-commodity policies (N) are the final class of commodity price policies. By definition, trade policies cannot affect nontradables; therefore, all nontradable policies are designated subsidy (S) policies. But unlike tradable-commodity policies, nontradable subsidies affect both producers and consumers. All nontradable production is consumed domestically (assuming no permanent storage or destruction of the commodity). Therefore, any policy that encourages production (such as a positive subsidy to producers) also results in lower consumer prices; these lower prices are necessary to clear the market. Similarly, policies that discourage production cause higher consumer prices. Because both groups either benefit or incur efficiency losses, the second criterion is unnecessary. Instead, the superscript + or - on the first criterion is sufficient to indicate whether the subsidy policy is encouraging production and consumption (S₊) or discouraging them (S_-).

Figure 3.4 illustrates the effects of nontradable-commodity policies on consumer and producer efficiency. In Figure 3.4a, a tax (equal to P_C - P_P) on the commodity is introduced. Whether the tax is initially imposed on consumers or producers makes no difference. In the new equilibrium, the two groups share the burden of the tax because only one level of output, _Q2, is consistent with a per unit tax of P_C- P_p. Attempts to force the entire amount of the tax on producers (P_D - P_P’), for example, would cause output to decline below Q₂ to a point such as Q_3. At this point, consumer prices would be well above P_C and the producer price after taxes would be above P_P’. Subsequently, output would increase and consumer prices would fall until the amount of the tax accounted for the full difference between consumer and producer prices.

Relative to the pretax situation, consumer prices have increased (to P_C) and producer prices have fallen (to P_D). Efficiency losses are measured by a comparison of consumers' willingness to pay and of production resource costs to the value of forgone output, Q₂BAQ₁. Consumer efficiency losses are measured as BCA and production efficiency losses as DBA.

Analysis of positive subsidies for the nontradable commodity, S+_ N, is presented in Figure 3.4b. Both groups necessarily benefit from the subsidy. Output expands from Q₁ to Q₂. Relative to initial price P_D, the consumer price is lower and the producer price is higher. Efficiency losses are measured by comparison of the value of increased output at initial prices, Q₁ABQ₂, to the incremental production cost and the increment in consumer willingness to pay. The total efficiency loss is ACD.

Analysis of the effects of input subsidy policies on nontradable outputs proceeds in a fashion similar to that described in Figure 3.3. Positive input subsidies, S₊IN, cause the nontradable-output supply curve to shift downward; input taxes, S_-IN, cause the curve to shift upward. But, unlike the case of tradable outputs (where only producers are affected by input policies), both consumer and producer prices of nontradable outputs change. Hence, the measures of efficiency losses assume shapes similar to those shown in Figure 3.4.