Download Agricultural, Food and Environmental Policy

Chap 4 – Theory
Welfare economics - incentives
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Economic efficiency
• Judging alternative policies
• criteria
• Economic efficiency:
– maximum social economic benefit
– minimum social cost
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• Markets: perfectly competitive
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Perfect Information
Many buyers/sellers
Homogeneous product
Divisibility
No transaction costs, externalities
Optimal allocation, max welfare
• Optimal income distribution
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social welfare function
income redistribution
gains/losses due to intervention
need a criterion to judge alternatives
Methods to evaluate welfare
– Pareto Principle - Compensation principle
– Economic Surplus
– Efficiency of Income Transfers
– Contestable market theory
– Economics and Information
– Transaction cost theory
– The economics of regulation
• Pareto (1848-1923)
– Economist - training in science, mathematics and
engineering,
– taught at the University of Lausanne
Pareto Principle
• Criterion to rank alternatives - new policy
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• Does the policy lead to a better situation than
before?
– Is society better off or indifferent?
• Pareto Improvement:
– at least one person better off
– no one worse off
• Pareto Optimum:
– No one better off without making one worse off
– Marginal rate of substitution in production is equal
to the marginal rate of substitution in consumption
– Competitive equilibrium
– Market prices link production to consumption
• Problem:
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many potential Pareto optima
distribution of benefits of new policy
transfers: achieve alternative optima
how to decide?
no Pareto answer
The Pareto Principle
Grain
MRS - Consumption
MPL\MPG=PL\PG
G*
MRS - Production
MPG \MPL =PL\PG
PL\PG
L*
Livestock
Kaldor-Hicks Compensation Principle
Kaldor, and Hicks - 1939 Economic Journal
Comparison of a new policy to the status quo
• Policy option is preferred to the status quo if there
are efficiency gains
– Policy change => gainers and losers
– gainers could compensate losers
– all better off = welfare improvement
• Does not require the actual payment of
compensation - compensation is hypothetical
• Examples:
– Removal of the Crow benefit
– Compensation for the elimination of supply
management
Harberger's Postulates (JEL-1971)
1 - Empirically tractable (measurable)
2 - Economic Surplus
- measure of gain/losses - costs/benefits
- Dupuit (1844) - concept of economic suplus
Three Postulates:
At a competitive equilibrium:
1) demand price=value to consumer (WTP)
2) supply price= willingness to supply (MC)
Given a policy intervention:
3) evaluate costs and benefits without prejudice to
any individual or group
> income transfer
> Equality: Marginal value of a dollar
• any deviation from competitive equilibrium
•
– Government intervention or externality
economic welfare loss: Harberger triangle
Consumer-Producer Surplus
• measure the impact of policy changes
• Consumer & producer welfare
– Consumer –> value of consuming Q* - cost
– Producer –> revenue – cost of production
• No externalities
• Competitive equilibrium = max surplus
Income Transfer Programs
– Deficiency payments (Secretary Brannan – 1949)
– Production Quota (W. Cochrane, JPE 1959)
Price
Competitive Equilibrium
Supply - MC
CS
P*
PS
Demand - WTP
Q*
Quantity
Consumer Surplus (CS) - Marshallian Demand
Producer Surplus (PS)
Price
Market Distortion
Supply
CS
P*
PS
Demand
Q*
Quantity
Harberger Triangle - Deadweight loss (surplus)
Deficiency Payment
Government support price Ps
above the competitive price P*
Consumer pays Pc < P*
Government pays the price difference
Result:
Output increases
Consumers benefit (lower price)
Producers benefit (higher price)
Government expenditure
Deadweight loss to society
> consumers
> producers
> government/taxpayers
Price
Deficiency Payment
Supply
Ps
P*
Pc
Demand
Q*
Quantity
Harberger Triangle - Deadweight loss (society)
Production Quota
Supply restricted by quota (enforced)
milk, poultry, eggs
Result:
Lower output
Higher supply price
Higher consumer price
No government payments
Transfer from consumer to producer
Deadweight loss to society
Which is Better?
Neither satisfy Pareto or compensation criteria
Efficiency of income transfer
Deadweight loss per dollar transferred
Size of the deadweight loss
Price
Production Quota
Supply
PQ
P*
Demand
QQ
Q*
Quantity
Harberger Triangle - Deadweight loss (society)
Quota vs Deficiency Payment
• Assume:
– Same price change
– No cost to acquire quota
• Which is more efficient ?
• Quantities are different
– higher for deficiency payments
– agri-business happy
• Deadweight Loss
DWLQ
DWLDP
 (1   /  ) 

 
 
(1   /  ) 

 = absolute demand elasticity
 = supply elasticity
 >   Quota more costly
Technological Change
Does technological change benefit
Consumers?
Producers?
Depends on the way technology affects supply (MC)
1)
Horizontal supply shift
> Pareto superior – both benefit
> Lower prices – more output
> Increased consumer and producer surplus
1)
Rotation of the supply function
> fails the Pareto criterion
> compensation is possible
> net gain in surplus – welfare improvement
Price
Horizontal Supply Shift
S1
S2
P*
a
b
c
Q*
Consumer Surplus – increases (a + b)
Producer Surplus - increases (c > a)
Quantity
Price
Rotation of Supply
S1
S2
P*
a
b
c
Quantity
Consumer Surplus – increases (a + b)
Producer Surplus - decreases (a > c)
Price
Harberger Tax
Supply
PT
a
P*
b
PS
Demand
QT
Q*
Deadweight loss = (a + b)
Quantity
4.3 Transfer Efficiency
government policy –> income transfers
result: distortions in market solutions
> criterion to compare interventions
> minimize the economic costs
Wallace (JFE, 1962) and Gardner (AJAE, 1983)
• What is the most efficient way of transferring
income to farmers?
• transfer with a lower DWL is preferred
• Compare quota with deficiency payment
• COST (DWL)
– Elasticity of supply and demand
– Extent of intervention
– Social cost of raising tax revenue
• Surplus Transformation curve (STC)
Surplus Transformation Curve
Quota vs Deficiency Payment
Slope = -1
m
e
n
CS
e – competitive equilibrium
n – maximum consumer surplus
m – maximum producer surplus
Contestable Markets
Policy analysis uses the basis of competitive markets
Intervention = F( market structure, market failure )
• Competitiveness  Contestable market
– Free entry and exit
– Technology – cost of production
– Economic Profits  Firms will enter or exit
– Price = Marginal Cost = Average Cost
• Barriers of entry
– Advertising costs – licence fees
– Regulations (Quota)
– Outcome: P >MC
• Imperfect Competition – loss of efficiency (DWL)
– Monopoly, Duopoly, Oligopoly
• Intervention (policy to improve effeciency)
– E.g. Monopoly changing to Duopoly
Price
Deadweight loss to Monopoly
Supply - MC
MR
Pm
P*
Demand
Qm
Q*
Quantity
Duopoly – MR rotates right
- smaller Deadweight loss (society)
Economics of Information
Incomplete information - asymmetry
– Some agents have more than others
• Affects market equilibrium
– Motive for policies and programs
• Cost of information
– search costs (transaction cost)
Moral Hazard – Adverse Selection
– Government involvement in insurance markets
– Principal-agent problem
– Insurance contracts => farmer incentives
• Moral Hazard: - e.g. crop insurance
– Farmer maximizes utility (farm profits)
– Insurance contract – changes objective function
• Now includes expected returns from contract
• Agent can affect risk - outcome
• Premiums increase
• Adverse selection:
– Principal can not distinguish between good/bad risks
– Premiums discourage good risks from insuring
– Market mail fail – government subsidy
Transaction Cost Economics
Transaction Cost
• cost of making exchange
– friction
– search, negotiation, transfer, closure
– any cost => inefficiency (competitive ideal)
• Examples:
– Search – locate buyers/sellers/product
– Standards, labels, testing, guarantees (GMO)
– Speculation – liquidity – thin markets
• Transaction costs and policy making
– design, implement, deliver, monitor
• define the target beneficiaries
• search for the target beneficiaries
• delivery - transfer cost
• monitor & enforcement costs
• evaluation – audit - prosecute
Transaction Costs & Institutions
Williamson (1985) and Coase (1937)
• transaction costs
– makes market inefficient
– can prevent markets from existing
 institutional arrangements for making exchanges
Institution: rules/norms  behaviour
– Organizations (government, church, market)
– formal (marriage) – informal (handshake)
– Institutional choice - minimize costs of exchange
Transaction costs and the firm (Coase)
- internalize exchange and reduce costs
- vs exchanges in markets
Vertical integration/coordination in agriculture
> produce brokers – large retailers
> IP contracts – farmers and seed suppliers
Factors affecting transaction costs
(Williamson,1983, 1985)
Human
Differences in Costs
Nature of transaction
(physical)
A) Human Factors
1) Bounded Rationality
– context of decisions
Limited information ex ante
 ex post costs
 Existence of contracts
Full & costless information: contracts not needed
Contract design <= Cost(Information, enforcement)
2) Opportunism
Costs when self-interested agents take
advantage of the situation
e.g. post contract – new information
B) Nature of transaction
• The nature of a transaction may affect the costs to
one of the parties
e.g. investment specific to the transaction
 Asset specificity
 limited alternative uses
 low salvage value (sunk cost)
 potential opportunistic behaviour
• Agriculture: asset specificity
– Potential for opportunism
– “hold up problem”
• underinvestment
• Potential welfare loss
• rationale: government intervention
– Marketing boards – negotiated prices
– Grades and standards
• Economic inefficiency – motive for intervention
– Externalities, market power
– Transaction costs (bounded rationality,
opportunism, asset specificity)
4.7 Theory of Regulation
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Stigler: regulation related to rent-seeking behaviour
– Limits market power / improve market failures
– Intervention is imperfect
– Regulators are subject to capture by the regulated
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Regulators need accurate information to establish the
appropriate policies
– e.g.
• what is the right price (P=MC) ?
• Information on industry cost structure
• State of scientific knowledge
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Difficult to obtain sufficient information
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Asymmetry between the regulator and the industry
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Government depends on industry for information, and is
subject to lobbying - regulatory capture
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Examples:
– Supply management - COP formula
– Labeling regulations