Table of Content
Understanding the Market
Price support consists of two things you have a price floor and you have a promise from the government to purchase any excess supply. Let’s take the market for wheat for example and let’s say that before any price support we just let the market forces work. We’ve got an equilibrium price of wheat of $133 and then we have an equilibrium quantity of 58 million tons of wheat. We’ve got our consumer surplus in the blue triangle and then we’ve got our producer surplus in the yellow triangle. If we were to add this up the two triangles here would be our total surplus, our consumer surplus plus producer surplus.
Now let’s say that the government comes in and says look we’re going to institute a price floor of $200. So the price of wheat has to be at least $200 so it can’t go below that. So it’s illegal, it’s against the law to sell wheat for less than $200. Now in addition to that, the government does the second thing where it makes a promise and says “Look if we have any excess supply, that farmers make too much wheat or people aren’t wanting to consume all the wheat that is produced then the government agrees to purchase that excess supply.” So now in fact when we look at what is going to happen here at a price of $200 we see that the amount supplied by the wheat farmers is going to be at 100 million tons that’s the amount supplied and that’s going to exceed the amount demanded at 25 million tons by consumers.
So we see that we have excess supply, sometimes you’ll see your economics textbook call that a surplus of wheat which is perfectly correct and everything but I don’t want to use the term surplus here I’m going to use the term excess supply because I don’t want to confuse you with consumer surplus and producer Plus. Excess supply means that the wheat farmers produce a lot more wheat which is 100 million tons than what consumers were willing to buy which is 25 million tonnes.
So normally if we just had the price floor and we didn’t have the government promise to purchase the extra wheat then we would end up at 25 million because consumers are only demanding 25 million. So we would have basically this amount right side of the total surplus would all be a deadweight loss and so forth.
That’s what happens with just a price floor but now because we have this government promise to purchase that excess supply, we’re actually going to see that the producers are going to get all the excess supply area. Actually, the producers are going to get a lot, the producers are going to get that excess supply area so that’s all going to become part of producer surplus but in addition to getting this new area, the producers are going to get some of what the consumers used to have. So the consumer surplus is going to shrink and the producer surplus is going to grow a lot. You see why wheat farmers would be really happy to get all of this area.
The Effects of Price Support
Now let’s think about this, it looks like the total surplus has gone up because even though consumers lose out they just have this tiny triangle you might be thinking the total surplus used to be the triangle left to the equilibrium point but now we’ve added this triangle of excess supply here so you might be thinking that this price support is actually a great thing, we’ve increased the total surplus but don’t forget something, don’t forget the government has promised to purchase all the extra wheat so what we’re going to have? We’re going to have a situation where we’re going to have a cost of the government and who’s paying for this are taxpayers. So we can think of this big rectangle which is going to be the cost to the taxpayers, that’s going to be the cost to the government.
We can also calculate the area here of the excess supply. So just in case, you are wondering what is the gain here, let’s see that amount. So that gain is 2.5125 billion, the way I got that was 1/2 times the base times the height. So we’ve got 1/2 times 75 million times (200 – 133). It’s in case you’re interested in the math that’s the area of that triangle.
The producers have gained also some of the consumer’s surplus but that that doesn’t affect society. If we just think about the increase in the total surplus we’ve got that amount but again remember that not only are we gaining this amount, if there was no cost to the government then this would be an increase in total surplus but now we’re going to have this whole area this whole green rectangular area is the cost to the government. This is the cost to the government or cost to taxpayers of buying all the extra wheat and we can calculate the area of this rectangle.
So what we’re going to do to calculate the area of that is we will take 75 million, and how did I get that? You might be wondering how I got this 75 million. It is the amount of the excess supply that’s 100 million that is actually supplied minus the 25 million that consumers actually want. So the extra is 75 million that’s the excess supply of wheat that’s all the wheat that will supply the consumers didn’t want. So then we multiply it by the price floor just $200 because the government guaranteed that price. So that’s going to come up with the ultimate cost to the government of 15 billion.
So if we think about the gain and the loss here what happened is the producers, before we factor in the cost of government they ware at 2.5125 billion they gain that but then that excess area plus all of this rectangular area was lost as they cost the government to taxpayers of this 15 billion dollars. So actually you could look and say we gained 2.5125 billion but we had to pay 15 billion in taxes to be able to fund this, we can actually take the net difference so the net (15 billion – 2.5125 billion) so we’d say that, the amount is 12.4875 billion. So that is the cost that is the lost value in terms of doing this price support and that’s why price supports can be a very very bad idea.