Understanding price elasticity of supply, which measures the responsiveness of producers to changes in the price of different goods, allows firm managers and government policymakers to better evaluate the effects of their output decisions and economic policies.
Price controls and PES:
A common policy in rich countries aimed at assisting farmers is the use of minimum prices for agricultural commodities. The European Union’s Common Agricultural Policy (CAP) involves a complex system of subsidies, import and export controls and price controls, the objective of which is to ensure a fair standard of living for Europe’s agricultural community.
The use of minimum prices in agricultural markets can have the unintended consequence of creating substantial surpluses of unsold output. Take the example of butter in the EU. The following excerpt was taken from the January 22, 2009 issue of the New York Times:
“Two years after it was supposed to have gone away for good, Europe’s ‘butter mountain’ is back… Faced with a drastic drop in the [demand for] dairy goods, the European Union will buy 30,000 tons of unsold butter. Surpluses… have returned because of the sharp drop in the [demand for]… butter and milk resulting partly from the global slowdown.
In response, the union’s executive body, the European Commission, said it would buy 30,000 tons of butter at a price of 2,299 euros a ton… Michael Mann, spokesman for the European Commission, said that the move was temporary but that if necessary, the European Union would buy more than those quantities of butter — though not at the same price.”
The situation in the European Union butter market can be attributed to an underestimate by policy makers of the responsiveness of butter producers to the price controls established under the CAP. A minimum price scheme of any sort, if effective, will result in surplus output of the good in question, but the 30,000 tons of unsold butter in Europe appears to exceed the expected surplus considerably.
The graph below illustrates why:
A price floor (Pf) is set above the equilibrium price of butter established by the free market. Butter producers in Europe are guaranteed a price of Pf, and any surplus not sold at this price will be bought by the European Commission (EC).
Assuming a relatively inelastic supply, which corresponds with the short-run period (Ssr), the increase in butter production is relatively small (Qsr), resulting in a relatively small surplus (Qsr – Qd). In the short-run, the amount of surplus butter the EU governments needed to purchase was minimal. But as we learned earlier in this chapter, as producers of goods have time to adjust to the higher price, which in the case of the CAP is a price guaranteed by the EC, they become more responsive to the higher price and are able to increase their output by much more than in the short-run. Slr represents the supply of butter in Europe after years of the minimum price scheme. As demand has fallen due to the global economic slowdown, butter producers have continued to produce at a level corresponding with the price floor (Pf), leading to ever growing butter stocks and the need for the EC to spend, in this case, 69 million euros on surplus butter.
Understanding the behavior of producers in response to changes in prices, whether due to excise taxes or price controls, better allows both firm managers and government policy makers to respond appropriately to the conditions experienced by producers and consumer in the market place and avoid inefficiencies resulting from various economic policies.
Discussion questions:
Explain why the price elasticities of both demand and supply of primary commodities tend to be relatively low in the short run and higher in the long-run.
Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.
Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries.
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