AGEC 640 – Agricultural Policy Market equilibrium with trade and policy Sept. 18, 2018 Today: Market equilibrium with trade & policy Thursday: Policy incidence and social welfare

Market equilibrium with trade & policy The 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)

…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

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)

…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)

…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!

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

We need to draw a similar diagram for them, and for the trade between us and them Trade between X & them The Rest of the World (RoW) “Country X” P($/lb) P($/lb) S D Q(tons)

Starting with foreign supply and demand: Trade between X and ROW Country X The Rest of the World P($/lb) P($/lb) S D Q(tons) Note we’ve drawn the same price axis for X and RoW (ignoring exchange rates)

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

and ROW’s willingness to trade… Trade between X and ROW Country X The Rest of the World P($/lb) P($/lb) 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.

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

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

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

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

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.

Policies that tax production affect a market like this: 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…

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.

Combining these concepts, we have six possible policies in markets for importables on trade on production on consumption taxes or restrictions subsidies or encouragements affect both prod. & cons. affect only production affect only consumption

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

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)

Some initial perspectives on “free trade” In a “free” market… producers oppose trade that opens up competition for them will be better off when trade provides them with more consumers consumers prefer open trade that increases the number of sellers prefer fewer buyers for the goods they want A basic tension in policymaking is that it is difficult to find policies that are in the best interests of everyone in the country!

“social welfare” To see strengths and limitations of econ surplus approach to measuring social welfare under trade restrictions, we will need to start with fundamentals… next lecture