Tuesday, April 21, 2009

A short essay from a past exam (May 1994.....)

Here are some points on an older short essay, one on buffer stocks:

Using supply and demand curves, explain how buffer stocks might be used to try to stabilize agricultural prices.

Prices of agricultural products (corn, wheat, coffee, corn etc) are characterized by significant short run fluctuations: they vary a lot from one period to the next. This is the result of their low price elasticity of demand (few substitutes for buyers) for farm products and the fact that short run supply is perfectly price inelastic (vertical) as a result of the long time lags of their production process and also greatly affected by random factors like weather. {this paragraph explains why agricultural prices fluctuate from period to period - in the short run}

In the diagram the price varies between P’ and P’’ as supply in the short run is unstable and varies between S’ and S’’.

(insert diagram here; a file these points and the diagram can be found at our wiki here)

As these price fluctuations create uncertainty and instability in farmers' incomes (and often these farmers are developing countries with a significant concentration of exports in only one or two primary products), buffer stocks have been used in attempt to stabilize these prices.

The idea is simple: an authority will buy and stock the good (coffee, for example) when there is oversupply (effectively increasing demand) or will sell from stocks when supply is below normal (artificially increasing market supply).

In the diagram it is assumed that the target price is at P*.

Given demand conditions, if output is at Q (supply at S) there is no reason to intervene as the market will lead to the desired target price P*.

If good weather leads to Q’ units (of cocoa, coffee, corn: some non-perishable product) produced (supply is at S’) then authorities must buy and stock QQ’ units (effectively increasing demand to D’).

If bad weather leads to only Q’’ units produced (supply at S’’) then for the price not to rise the authority would have to sell Q’’Q units from stocks (effectively shifting supply back to S).

In this way the price is, in principle, stabilized. Farmers’ incomes though are not. Incomes vary directly with output. Higher output means higher income for farmers. No matter how much they produce, someone will buy their output. If output is at Q’ then their revenues are at area (0Q’AP*) whereas if output is at Q’’ then they earn area(0Q’’BP*) i.e. less.

An incentive to overproduce is thus created and thus misallocation of scarce resources. The authority will have to continuously buy the commodity so it will run into financing problems. This explains why buffer stock schemes have all collapsed.

Keep on walking....

1 comment:

Shreddie said...

This is EXTREMELY useful
Thank you!