(a) Using the concepts of demand and supply and elasticity, explain why the price of
agricultural products fluctuates wide...
In the above diagram, an increase in the supply of agricultural products (S) from S0 to S1
leads to a huge fall in the pri...
(b)
A maximum price, or a price ceiling, is the highest price that firms are legally
allowed to charge. The effects of a m...
profits of black marketeers. In reality, however, it is unlikely that all of the output will be
sold on the black market.
...
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Q.2 agriculture-products-and-maximum-price

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Q.2 agriculture-products-and-maximum-price

  1. 1. (a) Using the concepts of demand and supply and elasticity, explain why the price of agricultural products fluctuates widely in the short run and has been falling over time and why these have posed problems to farmers. [12] (b) Discuss the effects of a maximum price on agricultural products on the welfare of consumers and producers. [13] (a) In the absence of government intervention, the price and the quantity of a good are determined by the market forces of demand and supply. The demand for a good is the quantity of the good that consumers are able and willing to buy, known as the quantity demanded, at each price over a period of time, ceteris paribus. The supply of a good is the quantity of the good that firms are able and willing to sell, known as the quantity supplied, at each price over a period of time, ceteris paribus. The elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded to a change in a determinant of demand, ceteris paribus. The price of agricultural products fluctuates widely in the short run due to wide fluctuations in the supply and the price inelastic nature of both the demand and the supply. The supply of agricultural products depends to a large extent on weather conditions. When weather conditions become more favourable, the supply of agricultural products will rise and vice versa. Therefore, wide fluctuations in weather conditions lead to wide fluctuations in the supply of agricultural products. The demand for agricultural products is price inelastic due to the high degree of necessity and lack of close substitutes. This means that a change in the price will lead to a smaller percentage change in the quantity demanded. Further, since the growing time of agricultural products is long and farmers cannot keep stocks due to the perishable nature of the goods, the supply is price inelastic. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  2. 2. In the above diagram, an increase in the supply of agricultural products (S) from S0 to S1 leads to a huge fall in the price (P) from P0 to P1 and a decrease in the supply (S) from S0 to S2 leads to a sharp rise in the price (P) from P0 to P2. Since the demand for agricultural products is price inelastic, a fall in the price will lead to a smaller percentage increase in the quantity demanded resulting in a fall in farmers’ income. The converse is also true. Due to the positive relationship between the price of agricultural products and farmers’ income, wide fluctuations in the price of agricultural products leads to wide fluctuations in farmers’ income. The price of agricultural products has been falling over time due to the rapid increase in the supply relative to the demand. The continual increase in agricultural productivity due to improvements in farming methods and inputs has led to a continual increase in the supply of agricultural products over time. However, due to the low income elasticity of demand for agricultural products, the demand has not increased at the same rate. In the above diagram, a large increase in the supply of agricultural products (S) from S 0 to S1 and a small increase in the demand (D) from D0 to D1 lead to a fall in the price (P) from P0 to P1. Due to the positive relationship between the price of agricultural products and farmers’ income, the falling price of agricultural products leads to falling farmers’ income. In conclusion, in a country with a large agricultural sector, the government can use price regulation to reduce wide short-run fluctuations in the price of agricultural products. The problem of the falling price of agricultural products over time may be solved by developing alternative uses of agricultural products such as biofuels. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  3. 3. (b) A maximum price, or a price ceiling, is the highest price that firms are legally allowed to charge. The effects of a maximum price on agricultural products on the welfare of consumers and producers can be discussed in terms of the effects on the consumer surplus and the producer surplus. Due to the inelastic nature of the supply, a maximum price on agricultural products is likely to lead to an increase in the consumer surplus and hence the welfare of consumers. The consumer surplus is the difference between the maximum amount that consumers are able and willing to pay and the amount that they actually pay. A maximum price on agricultural products will lead to a fall in the price and the quantity. Although the fall in the price will lead to an increase in the consumer surplus for consumers who can buy the good, the decrease in the quantity will lead to a decrease in the consumer surplus for consumers who cannot buy the good. However, since the supply of agricultural products is price inelastic, the decrease in the quantity will be small. Therefore, the consumer surplus will rise. In the above diagram, before the maximum price regulation, the price is equal to the equilibrium price (P0) and the consumer surplus is represented by the sum of area A, area B and area C. A maximum price (PMAX) leads to a fall in the price from P0 to PMAX and the new consumer surplus is represented by the sum of area A, area B and area D. Since area D is greater than area C, the consumer surplus rises. A maximum price on agricultural products will lead to a shortage and if this results in a black market, the consumer surplus and hence the welfare of consumers will fall. In the above diagram, at the maximum price (PMAX), the quantity demanded (QD) is greater than the quantity supplied (QS). When a shortage occurs, a black market may emerge. In other words, agricultural products may be illegally sold at prices above the price ceiling. In the extreme case where black marketeers buy up the quantity supplied at PMAX, the black market price will be PBM and the consumer surplus will fall from the sum of area A, area B and area C to area A. The sum of area B and area D represents the © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  4. 4. profits of black marketeers. In reality, however, it is unlikely that all of the output will be sold on the black market. In the absence of government intervention, the shortage of agricultural products may force some consumers to go without the goods and this is undesirable because agricultural products are essential for survival. A maximum price on agricultural products will lead to a decrease in the producer surplus and hence the welfare of firms. The producer surplus is the difference between the minimum amount that firms are able and willing to receive and the amount that they actually receive. A maximum price on agricultural products will lead to a fall in the price and the quantity and both of these effects will lead to a decrease in the producer surplus. Therefore, the producer surplus will fall. In the above diagram, before the maximum price regulation, the producer surplus is represented by the sum of area D, area E and area F. After the maximum price regulation, the producer surplus falls to area F. In the final analysis, to achieve the objective of a maximum price regulation on agricultural products, the government should take measures to solve the shortage problem. Otherwise, it may worsen the problem the government intended to solve. One of the measures to solve the shortage problem is by increasing the supply of agricultural products. This can be done by direct government production or by giving a subsidy to farmers to induce them to increase output. The government should also weigh the benefit of the greater affordability of agricultural products against the cost of the inefficient allocation of factor inputs, both which will result from the use of a maximum price regulation. An inefficient allocation of factor inputs is undesirable as it will lead to welfare loss. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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