Agricultural Surplus, Price Floors, and Policies to Address Surpluses

Question

When production exceeds consumption in a free market, a drop in price will normally restore equilibrium. However, in the case of an agricultural product like corn, high price floors are set by governments to protect the income of farmers.

(a) Explain why a surplus of agricultural product like corn might exist and why a fall in price cannot eradicate the surplus. [10]

(b) Discuss the alternative policies that could be adopted by a government to address future surpluses. [15]

Answer

Part (a) [10]

A surplus occurs when quantity supplied exceeds quantity demanded at the prevailing price. A price floor is a legally established minimum price. This part explains why a surplus of an agricultural product such as corn exists and why a fall in price cannot, by itself, eradicate it.

Why the surplus exists. A price floor in the corn market is set above the free-market equilibrium price, typically to protect farmers’ incomes. By raising the price from the equilibrium P₀ to the floor P_f, the floor causes quantity supplied to rise and quantity demanded to fall. At P_f, quantity supplied Q₂ exceeds quantity demanded Q₁, and the difference Q₂ − Q₁ is the surplus.

Why a fall in price cannot eradicate the surplus. Two reasons. First, the elasticities. Agricultural products like corn have price-inelastic demand, because food is a necessity with a high degree of necessity, and price-inelastic supply, because of long production lags. With both demand and supply price-inelastic, a given fall in price produces only a small rise in quantity demanded and a small fall in quantity supplied, so a very large fall in price is needed to close the gap. If a government with imperfect information does not lower the floor enough, a surplus persists.

Second, supply shocks. Corn supply is subject to positive supply shocks — for instance, favourable weather raising the harvest. If the floor is lowered to reduce the surplus but supply increases simultaneously, the rightward shift of supply re-creates an excess. Even at the original equilibrium price, quantity supplied at the higher supply exceeds quantity demanded, so a surplus remains.

Part (b) [15]

Beyond simply lowering the price, a government can address future surpluses by reducing supply (removing a subsidy or imposing a tax) or by raising demand (developing downstream industries that use the crop as an input). The stand of this essay is that raising demand is the more effective strategy, because the supply-reducing policies aggravate the very inequity that price support exists to relieve.

Reducing supply — removing a subsidy. Agricultural industries often receive subsidies to protect farmers’ incomes. A subsidy lowers producers’ cost of production and raises supply, contributing to the surplus. Removing the subsidy shifts supply back to the left, raising the equilibrium price towards the market-clearing level and shrinking the surplus.

In-body evaluation. Because agricultural producers are typically low-income, removing the subsidy lowers their earnings and worsens income inequity.

Reducing supply — imposing a tax. Alternatively, a tax raises producers’ cost of production, shifting supply left and reducing the quantity supplied until the surplus created by the floor is eliminated.

In-body evaluation. As with subsidy removal, taxing low-income farmers reduces their profits and worsens inequity.

Raising demand — developing downstream industries. The government can instead raise demand for corn by investing in industries that use it as an input — for example, providing grants to develop a biofuel industry that uses corn as feedstock. As demand for biofuel grows, the derived demand for corn rises, shifting the demand curve right. At the higher demand, quantity demanded rises to meet quantity supplied, eradicating the surplus left by the price floor — while raising, not lowering, farmers’ revenue.

In-body evaluation. Developing a new industry requires large up-front fixed costs, which a government facing a budget constraint may be unable to bear.

Judgement. Raising demand is the better strategy on two counts. First, on equity: removing subsidies or imposing taxes both reduce the output and incomes of low-income farmers, worsening the inequity that price support was designed to address; raising demand instead increases their revenue, relieving the surplus and improving equity simultaneously. Second, on the time horizon of the budget objection: the fixed costs of seeding a downstream industry are a short-run constraint. Industries like biofuel require specialised capital and have high barriers to entry, so once established they tend to earn supernormal profits and can self-fund their own research and development; the government’s outlay is therefore largely a one-off. On balance, raising demand addresses the surplus without sacrificing the income-protection objective, and is the more appropriate policy.