1. AGEC 640 – Agricultural Policy Market equilibrium and Social Welfare Sept. 20, 2018
Today:
Policy incidence and social welfare
Next two weeks:
Policies, distortions, protection and impacts
Reminder: Assignment #2 due on 9/27

2. Recall from last lecture that 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

3. …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

4. What do we see? In “free” markets…
producers
1. tend to oppose trade that opens up competition for them
2. will be better off when trade provides them with more consumers
consumers
1. tend to prefer open trade that increases the number of sellers
2. prefer fewer buyers for the goods they want
This leads to a basic tension in policymaking: it is difficult to find policies that are in the best interests of everyone in the country!

5. What 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”:
Based on areas on a supply-demand diagram
Measured in terms of money (= price x quantity)
The basic assumption is that money=value

6. How could we evaluate a change? Criterion: marginal surplus
S=MC
as qty. rises, the gap between the curves falls…
until this marginal economic surplus reaches zero at the equilibrium P
D=MB Q

7. “Economic surplus” is simply the area between S & D curves
You should try to understand why.
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. P Q

8. 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%, P 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. Q Q′

9. Equilibrium = Optimum ? P Q 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! P Q

10. 640 is not about “public” or “welfare” econ
The question for welfare economics is, what can one infer about “aggregate welfare” from individual choices? (Assuming individuals are 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…

11. But to use econ surplus in a thoughtful way, we should remember…
The Pareto Principle
A “Pareto improvement” is preferred by at least one person, and “dis-preferred” 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!)

12. …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.

13. 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.
Actual politics often involves “King John redistribution” (from poorer to richer people) and “vested interests” (that block pro-poor changes).

14. 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”

15. We can divide “economic surplus” into two parts
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

16. Trade creates a distinction between production and consumption – e. g
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”

17. 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”

18. …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”

19. So what do we see, and why do we see it
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
Let’s take, for example, the US market for avocados.
Origin:
1/3 of avocados eaten in the US are grown in the US
2/3 are imported
Of imports, approximately:
90% come from Mexico
10% from Chile, Peru and the Dominican Republic.

20. U.S. Avocado policy
Many countries restrict imports when the product in question might transmit diseases or carry pests. The stated goal of these phytosanitary regulations is to keep the pest or disease from entering the importing country.
Protectionist? Yes, but generally justified.
Sometimes, these regulations can be considered unfair trade barriers if they are not based on science.
The US used phytosanitary regulations to block avocado imports from Mexico. These were challenged in the WTO and the barrier was relaxed slightly in 1993, 1997 and 2002.

21. The “stylized” U.S. market for avocados
Policy is an import quota (=M)
P($/lb) Qp Qc
M=imports Pw
Pus A B C D
Supply
Demand
Quantity (lbs)
Domestic production rises from Qp to Qp and domestic consumption falls from Qc to Qc
Consumers lose ABCD
Producers gain A
Who gains C?

22. The “stylized” U.S. market for avocados
Policy is an import quota (=M)
P($/lb) Qp Qc
M=imports Pw
Pus A B C D
Supply
Demand
Quantity (lbs)
Who gains C?
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.

23. Areas B and D are Harberger triangles, permanent losses to the U. S
Areas B and D are Harberger triangles, permanent losses to the U.S. economy.
The United States
P($/lb)
Pus A B C D Pw
Production efficiency losses,
where MC is above Pw
Consumption efficiency losses,
where WTP is above Pw

24. Comparing instruments across markets
An import quota instrument (M′)
An import tariff instrument (t) S
S+quota
Pus
Pw+t
Pus A Pw A B C D Pw B C D 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.

25. 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)

26. Some conclusions on market equilibrium and social welfare
Different market structures will lead to different equilibrium outcomes
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”
These and other questions of market structure are the topic of AGEC 620 (for PhD students) and AGEC 621 (for PhD and advanced MS students)
Different definitions of “welfare” lead to different policy preferences
These are examined in AGEC 617 and other courses in public economics
For AGEC 640 (and in most everyday policy analysis) we assume:
that equilibria are perfectly competitive
that “social welfare” is proportional to economic surplus
These are simple but powerful techniques that give us many non-obvious and yet useful results.