NATIONAL LAW INSTITUTE UNIVERSITY BHOPAL

ECONOMICS PROJECT

On

PRICE FLOOR:

MINIMUM SUPPORT PRICE and

INDIAN AGRICULTURE

Submitted to

Prof Rajesh Gautam

Submitted by

Kunal Sharma

2013 BALLB 63

ContentsPRICE FLOOR: A Brief Introduction..............................................................................................................3

Understanding The Principle:......................................................................................................................4

MARKET EQUILIBRIUM................................................................................................................................4

GOVERNMENTS ROLE AND FUNCTION........................................................................................................9

Minimum Support Price............................................................................................................................10

and The Indian Agriculture........................................................................................................................10

Effects of Price Floor..................................................................................................................................12

Short Term Effects:................................................................................................................................12

Long term Effects:..................................................................................................................................13

Review of Literature..................................................................................................................................15

1. Pulse of the nation.....................................................................................................................15

2. Price Floors for Emissions Trading.............................................................................................15

3. An economic analysis of Price dynamics in the presence of a Price floor:.................................16

The case of American Cheese............................................................................................................16

4. Some variance effects of a floor price scheme for wool:...........................................................17

A two period analysis.........................................................................................................................17

5. Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post Marketing Permits or Ex Ante Production Contracts?......................................................................................................18

Conclusion.................................................................................................................................................19

Bibliography...............................................................................................................................................20

3

PRICE FLOOR : A Brief Introduction

What is Price Floor? Price Floor or floor below which prices are not allowed to fall is nothing but the lowest legal price that a commodity can be sold at. It is an economic mechanism of price control used by the government of countries to prevent prices from being too low so that fair prices for goods are available to the sellers of such goods.

The underlying principle of Price Floor is the concept of Market Equilibrium. For a price floor to be effective, it must be set above the equilibrium price. If it's not above equilibrium, then the market won't sell below equilibrium and the price floor will be irrelevant.. 

In a mixed socialist economy such as ours where the government steps in to protect the interest of the people such Price flooring is very vital to facilitate the welfare function of the government.

The most common price floor is the minimum wage--the minimum price that can be paid for labour. Price floors are also used often in agriculture to try to protect the farmers and Minimum Support Price (MSP) found throughout our countrys Public Distribution Shops or ‘Fair Price Shops’.

Thus, through this study we will be able to understand Price Floor as a tool of welfare economics in India, its uses and the principles on which it works on, in a comprehensive and systematic manner.

Understanding The Principle:

MARKET EQUILIBRIUM

Broadly speaking, Equilibrium is a state of rest or balance due to the equal action of opposing forces. In terms of Economics, Equilibrium Price is the price toward which the invisible hand drives the market. At this point, the upward and downward pressure on price is equal and the quantity

4

demanded equals the quantity supplied. The market mechanism naturally present in most markets consists of these counterbalancing pressures. Equilibrium can occur in all types of markets, but the commonly assumed model for its occurrence is the perfectly competitive market. When a market is in equilibrium, there is no excess supply or excess demand.  Equilibrium quantity is the amount bought and sold at the equilibrium price. It may be understood by a simple table, known as a schedule (table 1), and a graph (Fig 1):

Table 1

Price of Commodity Quantity Supplied Quantity Demanded10 25,000 50,00016.25 37,500 37,50020 45,000 30,000

(Fig 1)

Explanation of the Schedule (table 1) and Graph (Fig 1):

 In economics, we typically use a two-dimensional graph that has the price of the good or service on the Y-axis (vertical axis) and the quantity that people are willing and able to buy (or willing and able to sell) on the X-axis (horizontal axis). 

Each point on the graph represents the corresponding price and quantity demanded. At Rs. 10, the producer produces 25,000 units of the commodity as opposed to a demanded quantity of 50,000 thus showing a shortage of

5

supply. At Equilibrium price (which is Rs. 16.25 here), the quantity of goods demanded is exactly equal to the quantity of goods supplied. While at Rs. 20 the quantity supplied is 45,000 units as opposed to a lesser quantity demanded f 30,000 units which leads to an excess in supply.

To understand the Price Floor model, we must understand these two main concepts regarding Market Equilibrium i.e. the creation of excess supply and excess demand as explained by Fig 2:

(Fig 2)

Here (Fig 2) it can be seen that any price (P1) above the Equilibrium Price (EP) leads to the creation of excess supply (the blue shaded region) whereas at price (P2) below the Equilibrium Price (EP) excess demand is created or there is a shortage in supply(as seen in the red shaded region).

Here we concern ourselves with the excess supply that is created as a result of raising the price above the equilibrium price.

It may be noted that if the price is set below the Equilibrium Price it would be ineffective as the price would be lower than the Equilibrium Price and thus non-binding on the producers.

6

(Fig 3)

Here (Fig 3) the Price F is lower than the desired Equilibrium Price which is the price at which maximum satisfaction to both consumers and producers in a market is achieved. Therefore to be effective, the price must be set above the Equilibrium Price. As mentioned earlier, at Equilibrium Price the quantity of goods supplied and demand are exactly equal. When the price is set above the Equilibrium Price, then there is a possibility that there will be an excess supply or a surplus. If this happens, producers who can't foresee trouble ahead will produce the larger quantity where the new price intersects their supply curve. Unbeknownst to them, consumers will not buy that many goods at the higher price and so those goods will go unsold. This is the underlying principle of Price Floor. In this scenario the invisible hand of market forces here will naturally drive the prices downwards in case of excess supply to bring it back to the equilibrium price.

An example below showing both the Schedule (table 2) and Graph (Fig 4) of the Price floor is given below.

Table 2

Price of Commodity Quantity Supplied Quantity Demanded10 25,000 50,00016.25 37,500 37,50020 45,000 30,000

7

(Fig 4)

Here the price F (20) is above the equilibrium price (16.25) E because it is supposed that the price E does not provide incentives to the farmers to produce. Therefore to promote such production by farmers government keeps the price at Price F. As a result of such pricing above the Equilibrium Price E there as can be seen from the diagram (fig 4) is created, a surplus in the market (as shown in the shaded region) as farmers expand their output and supply.

8

GOVERNMENTS ROLE AND FUNCTION

The Indian economy is a Mixed Socialist economy i.e. while retaining the free market feature, the government steps in to regulate and deregulate the prices as and when it is required for the welfare of the people. The government uses the economic tool of Price Control to carry out such functions. Price Floors and Price Ceilings are such Price Controls, examples of government intervention in the free market which changes the market equilibrium. They each have reasons for using them. Price Ceilings are maximum prices set by the government for particular goods and services that they believe are being sold at too high of a price and thus consumers need some help purchasing them. Price ceilings only become a problem when they are set below the market equilibrium price. On the other hand, Price Floors are minimum prices set by the government for certain commodities and services that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance. Price floors are only an issue when they are set above the equilibrium price, since they have no effect if they are set below market equilibrium price.

Here we discuss how the government in India plays a role in setting such Price floors which play an important welfare function.

9

Minimum Support Price

and The Indian Agriculture

 The Minimum Support Price (MSP) Scheme is a scheme of the Government of India (GOI) to safeguard the interests of the farmers. Under this Scheme the GOI declares the minimum support Prices of various agricultural produces and assures the farmers that their agricultural produce will be purchased at the MSP, thereby preventing its distress sale. The Food Corporation of India (FCI) acts as the Nodal Agency of the GOI. The Minimum Support Prices were announced by the government of India for the first time in 1966-67 for Wheat in the wake of the Green Revolution and extended harvest, to save the farmers from depleting profits. Since then, the MSP regime has been expanded to many crops.

Currently, the MSP is announced by the Government of India for 25 crops at the beginning of each season viz. Rabi and Kharif. The following are few of the crops covered in the two seasons as shown in the following table.

Kharif Crops Rabi CropsPaddy WheatJowar BarleyBajra GramMaize Masur (lentil)Cotton Mustard

The market price can sometimes be so low that farmers cannot make enough money to support themselves. In such cases, the government steps in and sets a price floor. The rationale is that if there is a fall in the prices of the crops, after a bumper harvest, the government purchases at the MSP and this is the reason that the price cannot go below MSP. So this directly helps the farmers.

The government decides the support prices for various agricultural commodities after taking into account various recommendations of Commission for Agricultural Costs and Prices, views of ministries and state governments and other relevant factors.

10

(Notice that when the price is artificially raised above p*, the quantity supplied exceeds the quantity demanded. Such a situation is called a surplus: farmers produce many more crops than buyers want to buy at the new, higher price.)

Effects of Price Floor

The argument for price floors is usually that the government has to protect suppliers from having to sell their goods at an unfairly low price. They are often meant to protect suppliers that are considered to be important because they provide a necessity. However there are various short term and

11

long term effects of such Price floor which are considered by many as negative effects on the economy.

Short Term Effects:

In the short run, a price floor will have no effect on the supply curve. Due to the Price floor effect, consumers pay a higher price and decide to reduce their purchases, while producers find they are guaranteed a higher price than before and they raise production. This will increase the quantity supplied if the price floor is binding, that is, the price is higher than the market price. This causes surplus of the product and a deadweight loss.

Example: Lets say that the price of wheat is falling so the government imposes a price floor on wheat at Rs 10/kg. If the market were left to itself, wheat would eventually fall to Rs.8/kg. Once again it is clear that less wheat is going to be bought at Rs.10 than at Rs.8 which means there will be a chronic surplus of wheat. The excess would either spoil, be discarded, or be purchased by the government. Producers who would go bankrupt if the price were allowed to reach equilibrium would be able to remain in business because of the artificially high price. Those producers would consider this to be a benefit. 

The benefit to producers of the price support is equal to the gain in producer surplus (represented in blue).

The cost to consumers of the price support is equal to the loss in consumer surplus (represented in red).

The cost to the government of the price support is equal to the cost of the surplus in the market (represented in gray).

12

However, since the consumers ultimately pay taxes for the government to purchase the surplus, the total cost to consumers (in the short run) of the price support is the sum of the loss in consumer surplus and the cost of the government purchasing the surplus off the market.

Long term Effects:

In the long run, a binding price floor will induce market entrance in perfectly competitive markets, which will cause supply to increase -- this is represented as an outward shift of the supply curve -- because firms will be able to sell their product at above their average total cost, which creates an economic profit. Since prices cannot fall, this means that economic profits may not fall to normal, inducing continued firm entrance and ever-larger surpluses, and this may make the price floor impossible to maintain in the long run.

In the above mentioned example of the government setting a price floor for wheat, the consumers who are paying more for wheat or buying less wheat than they want would consider it a penalty. Producers would benefit by not losing their jobs. The overall economy is penalized because people who would otherwise have to produce something thats more in demand are able to stay in an inefficient business. Similarly, when the government imposes a minimum wage to provide a fair wage to workers the effects include higher wages for some people along with unemployment (chronic surplus of workers as businesses will hire fewer people due to the higher cost of labor), bankruptcy of marginal producers, rise in prices. These are included as some of the negative effects of such Price flooring in the long run.

13

Review of Literature

1. Pulse of the nation

Editor, The Hindu

The Editor, Business Line in his editorial article dated July 26, 2013 has revealed the need for MSPs for pulses like gram, chana, etc. in the country. He starts by emphasizing the fact that India being a chronic importer of pulses has done well in the recent years in terms of domestic production but highlights the grim fact that the prices are much lower than required there being no adequate floor price set by the government for the same. Quoting the recent price crash in Chana prices, he stresses that the government must incentivise the farmers to grow more pulses as they have various nutritional values (considering the nutrition deficiency in the country) and also functions as a nitrogen fixer.

He is of the opinion that if this continues it will discourage farmers from producing pulses. He urges the government to ensure that farmers get the officially declared MSPs for the crop to be harvested a couple of months from now. In the absence of physical procurement support, these MSPs have meaning only on paper and the new National Food Security legislation may aggravate this, given its sole focus on guaranteeing a minimum quantity of cereals as a legal entitlement to two-thirds of the population. This will, in turn, further skew our public resources and procurement efforts.

2. Price Floors for Emissions Trading

Peter John Wood and Frank Jotzo

Wood Peter and Jotzo Frank (2009) in their article “Price Floors for Emissions Trading” have revealed the advantages of Price flooring for emission trading and have given suggestions for the same on how the government can tackle the issue at hand. They have discussed the advantages of price flooring for emissions trading and implied that Price floors need to be carefully designed to avoid budgetary liabilities, and to avoid barriers to international trade in permits. They further argue that the most direct approach of a government commitment to buy back permits at a threshold price is unlikely to be viable, especially in the context of international permit trading, because it implies large contingent budgetary liabilities but that an alternative approach of a

14

minimum reserve price for auctioned permit, could yield the desired effect, but could be ineffective if the share of auctioning is small. They have used various economic tools of research such as graphs, schedule and other relevant data to support the same.

Concluding, price floors could fulfill an important supporting role in ensuring effective and efficient climate change mitigation, they can be implemented without compromising vital aspects of emissions trading, and their budgetary properties may turn out to be highly attractive to governments.

3. An economic analysis of Price dynamics in the presence of a Price floor:

The case of American Cheese

Jean-Paul Chavas and Kwansoo Kim

Chavas Jean-Paul and Kim Kwansoo (2005) in their article” An economic analysis of Price dynamics in the presence of a Price floor: The case of American Cheese” have provided useful insights on price dynamics in the presence of a government determined price floor. In the paper they have provided an econometric analysis of the effects of Price floor on price dynamics and price volatility. Focussing on the Price floor providing a censoring mechanism to price determination, they have specified and estimated two competing models with dynamic Tobit specification under time varying volatility. In their economic analysis they have revealed three important findings. First, they documented how the price support programme contributed to reducing price volatility and secondly they uncovered evidence that such volatility-reducing effects are much stronger in the short run than the long run. Thirdly they have also found that even under the market regime scenario the support price can have significant positive side effects on long run expected prices. They have supported the study with empirical evidence on the dynamics of American cheese prices and their changing volatility.

Conclusively they have evaluated the welfare effects of changing the price support level indicating that although lower support prices reduce taxpayer cost and aggregate welfare loss, they might not improve the relative economic efficiency of transferring income from consumers and taxpayers to producers.

4. Some variance effects of a floor price scheme for wool:

15

A two period analysis

J.H. Duloy Duloy J.H. (1964) in his article “Some variance effects of a floor price scheme for wool: A two period analysis” has revealed that for complete cycles, a floor price scheme cannot be expected to have any significant effect upon the mean level of either growers’ income or of receipts from commercial sales of, in this study, wool. He gives the reason that because of the absolute magnitude of changes in both buying and selling periods, a scheme may be expected to have a more substantial impact upon the variance of both growers income and of receipts from commercial sales.Hence concluding, because the variance of the income of the individual wool grower is likely to be greatly influenced by changes in local conditions leading to changes in output and by cost changes, any reduction in the variance of the aggregate is likely to be far less important at individual farm level. Any increase in the variance of receipts from commercial sales, and hence of export received of wool sold is likely to lead to an intensification of the severity of periodic balance of payment crisis. For the income stream of individual woolgrower the impact of the external effect may predominate, and a fortiori for the rest of the economy.

5. Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post Marketing Permits or Ex Ante Production Contracts?

Sandhyarani Patlolla

In this paper titled “Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post Marketing Permits or Ex Ante Production Contracts?” Patlolla Sandhyarani (2010) highlights the issue that Sugar processors must comply with a floor price for cane, but gur and khandsari producers are exempt from the floor price. Thus, any effect of the sugar processor’s choice of procurement method on the incentives facing farmers will depend on the expected cane price in these competing unregulated markets. She has developed a theoretical model of the Andhra Pradesh cane procurement market that incorporates the government-mandated floor price policy that applies only to the cane used for sugar processing, and compared the processors profits under the probabilistic ex post permit system and ex ante production contracts.

The main conclusion is that ex post permits creates competition among the farmers to increase cane quality that brings higher profits to the processor at

16

the expense of higher costs to the farmers. This hypothesis is tested and not rejected using data

from a survey of 205 cane farmers.

Conclusion

It is apparent that instituting a price floor is economically unsound but refraining from instituting one doesnt mean that everything would work out optimally for everyone. Price floors have negative long-term economic consequences. The effects arent always noticeable because the price floor could be set at a level that is commensurate with the market minimum. In those cases it is as if the floor doesnt exist. They are still sometimes enacted because of their short-term effect. A price floor has the immediate effect of increasing the profit of producers. Without a price floor, some people would lose their jobs and they might not have the skills to quickly find a new one or they may not get a fair price for their hard earned produce in the market due to the various exploitations they face in the market by middlemen etc. The object of setting a Price Floor by the government is driven by its welfare motive to protect the interest of the class of people who are most substantially affected by rising and lowering prices of commodities upon which the very livelihood and life of such people exists. Thus ours being a welfare state, we take along everyone in our stride to achieve greater economic growth keeping every individuals own economic goals in mind.

17

Bibliography

Internet: Wikipedia.com Investopedia.com economics.fundamentalfinance.com Indiabudget.nic.in Articles from:

o www.jstor.como Econpaper.repec.org

Books: Modern Economic Theory: KK Dewett Principles of Micro economics( vol 1): N. Gregory Mankiw