7. PRICE MECHANISM AND RESOURCE ALLOCATION
PRICE MECHANISM (PROFIT – PRICE MECHANISM/ THE INVISIBLE HAND) AND RESOURCE ALLOCATION
Price mechanism is a system in free enterprise economy where prices in the market are determined by market forces of demand and supply with limited or no government intervention.
Price mechanism is a system where prices act as automatic signals in the allocation of resources.
To understand better the concept of price mechanism, we need to note the following.
1. Demand dictates what is to be supplied by the producers.
2. Consumers’ expenditure is equal to seller’ revenue. It means that one’s expenditure on a commodity is what a seller gets as his or her income.
3. Consumers are regarded as voters. It follows that whenever consumers buy a product, they are casting votes in favour of production and supply of the commodity.
4. Consumers take an upper hand in deciding what is to be producedi.e. there is consumer sovereignty where a consumer takes a leading role in determining allocation of resources.
ASSUMPTIONS OF PRICE MECHANISM
1. It assumes existence of a free enterprise economy where resource allocation is determined by the interaction of market forces of demand and supply.
2. There is no government intervention/ interference as far as pricing and output policies of the producers are concerned.
3. There are many buyers and sellers, hence no monopoly to influence market conditions.
4. Producers aim at profit maximization and they produce commodities whose price is high.
5. Consumers aim at utility maximization and thus they buy from the cheapest source.
6. There is free entry and exit in the market i.e. when super normal profits are earned, firms are free to join the industry and when profits are exhausted, inefficient (high cost) firms leave the industry.
7. There is consumer sovereignty in the market i.e. consumers have an upper hand in deciding what is to be produced by “casting votes” to commodities as they buy.
8. It assumes no wastage of resources because producers only supply what consumers want at a particular time.
9. There is perfect mobility of factors of production, so resources go where the price is high.
10. There is perfect knowledge about market conditions by both sellers and buyers for instance consumers know the price and qualities of the products on the market.
Price mechanism responds to the basic economic questions by providing appropriate answers to these questions. These questions are;
- What to produce?
- How to produce?
- When to produce?
- Where to produce?
- How much to produce?
- For whom to produce?
THE ROLE OF PRICE MECHANISM IN THE ALLOCATION OF RESOURCES
NB
We consider the functional role of price mechanism in the allocation of resources i.e. we focus on what price mechanism does in the process of allocating resources in an economy.
1. It guides on what to produce.
The producers are induced to produce and supply a commodity at a high price in order to make profits.
2. It determines where to produce/ it determines the location of the production unit.
Producers always locate their production units in areas where demand for the goods is high and consumers are ready to buy at a price that enables them to make a profit.
OR
Producers decide to locate their business firms in areas with the lowest costs of production. The aim is to maximise profits through minimising costs.
3. It determines when to produce.
Producers always produce more of a good at that time when demand for it is high so as to make profits.
4. It determines how much to produce.
Demand dictates the quantity of goods that producers supply on the market. This checks the danger of over production and wastage is avoided.
5. It determines for whom to produce/ it determines the distribution of goods and services.
Producers supply goods to those consumers who are able to buy at the prevailing market price.
OR
Producers supply goods to those consumers who have effective demand.
6. It determines how to produce/ it determines the type of technology to be used in production.
Producers employ cheap but efficient techniques of production. The aim is to maximise profits through minimising costs.
7. It guides consumers when making choice of which goods to buy.
Holding other factors constant, consumers buy more units of a commodity whose price is low and fewer units of a commodity whose price is high.
8. It ensures efficient allocation of resources.
Resources are allocated to producing those goods with the highest prices. Producers get the incentive to supply goods at high prices in order to get high profits.
9. It determines income distribution.
Income is distributed among producers depending on the price at which they supply and sell their goods. Therefore, producers who supply goods at high prices earn more incomes than those who supply goods at low prices.
10. It provides an incentive for economic growth.
This arises where high prices encourage high production of goods and services. As more goods and services are produced, economic growth is attained.
11. It ensures production of better quality products because of competition among producers.
Producers compete for the available market in order to supply their goods. Due to this competition, better quality goods have to be produced so that producers maintain and increase the level of demand for their goods.
IMPLICATIONS OF PRICE MECHANISM
POSITIVE IMPLICATIONS (MERITS)
NB:
Here we focus on the positive outcomes/ desirable outcomes (good things) which arise from price mechanism.
1. It promotes consumer sovereignty.
Individual households make their own decisions since the consumers influence what is to be produced. The goods and services which consumers demand for are the ones produced and supplied. The consumer becomes a king in influencing productive activities.
2. It ensures efficiency of firms.
Firms strive for efficient operations so as to survive competition and sell at high prices since high prices lead to high profits. This enables producers to expand their scale of production and become more efficient
3. It encourages competition which leads to production of better quality goods and services.
Consumers are more willing to pay a high price for high quality goods. Therefore producers strive to get the high prices by improving the quality of commodities.
4. The profit motive encourages innovations and inventions (research).
Due to the profit motive, producers develop new and better techniques of production. The improved methods of production result into increased output of better quality which is sold at high prices. This enables producers to get more profits.
5. It avails a wide variety of goods and services to consumers.
Price mechanism generates competition among producers. This gives rise to a greater variety of goods and services in an economy. Consumers are able to exercise choice and their standard of living is improved.
6. It leads to efficient allocation and utilization of resources.
Price mechanism enables producers to allocate the scarce resources in the production of those goods needed by the consumers. Producers allocate more resources to those goods whose demand is high and fewer resources are allocated to those goods whose demand is low.
7. It leads to increased employment opportunities.
As prices of goods rise (increase), producers supply more of those goods. Producers expand their scale of production and more people get employed in production units.
8. It promotes incentive for hard work among producers leading to increased production.High prices of goods motivate or encourage producers to work hard and supply more goods to consumers. This promotes economic growth in the country.
9. It reduces the costs of administration due to limited or no government intervention.
The forces of demand and supply guide the allocation of resources without government interference using price controls. The government does not incur costs of enforcing minimum and maximum prices.
10. It helps to reward the various factors of production in the factor market.
Factors which enable production of goods with high demand and prices are paid higher rewards. However, those factors whose output has low demand and low prices are paid low rewards.
11. It encourages flexibility in production.
Producer use the price and profit signals to change from less profitable to more profitable economic activities. For example a coffee farmer may change from the growing of coffee to the growing of vanilla should the price of vanilla become higher than that of coffee.
12. It encourages arbitrage which benefits producers.
Producers transfer goods from areas with low prices to sell them in areas with high prices. This benefits producers because they earn more revenue from sales and subsequently make higher profits.
NB:
Arbitrage is the practice of transferring goods from areas with low prices to areas with high prices in order to gain from the difference in prices. For example if a bag of in Jinja costs shs 120,000 and it costs shs 150,000 in Kampala, a trader may transfer bags of sugar from Jinja and sells them in Kampala so that he gains from that difference in price.
NEGATIVE IMPLICATIONS / DEMERITS/ DEFECTS/ WEAKNESSES/ SHORTCOMINGS/ DISADVANTAGES OF PRICE MECHANISM
NB:
Here we focus on those undesirable outcomes or bad things associated with price mechanism.
1. It leads to consumer exploitation by producers due to ignorance or market imperfections.
Price mechanism assumes that a consumer has perfect knowledge about the market conditions. However, many consumers are not aware of price changes and new goods on the market and thus they are exploited by profit – hungry producers.
2. It leads to emergence of monopoly and its negative consequences.
Price mechanism creates private monopoly because of excessive competition which forces inefficient firms out of production and efficient firms take over the market. The monopoly firms restrict output in order to charge high prices. They also supply low quality goods due to absence of competition in the market. This leads to exploitation of consumers.
3. It promotes income inequality.
Efficient producers whose goods are highly demanded receive higher incomes than the inefficient producers. Therefore the efficient producers get access to most of the resources in the economy. This creates income disparity with its associated disadvantages of exploitation of the poor by the rich.
4. It encourages divergence between social costs and private benefits.
Price mechanism does not consider the negative effects inflicted on the society as producers exploit the natural resources. Private investors benefit through profit maximization without taking into account social costs. For example when forest trees are cut down to get timber, there is a danger of deforestation and its negative impact on the environment, pollution created by private enterprises, over exploitation of resources. Unfortunately, these social costs are not considered under price mechanism.
5. It leads to unemployment.
This is due to automation (use of capital intensive techniques of production) and out competition of inefficient firms making people who were employed in those firms to lose jobs. The unemployed people experience low standards of living.
6. It leads to economic instabilities like inflation, price fluctuations and balance of payments problems.
This is due to absence of government intervention.
7. It leads to underutilization of resources.
Price mechanism creates excess capacity in certain cases. Producers abandon production of those goods which are not highly demanded. This leaves some resources to be idle or underutilized.
8. It leads to wastage of resources due to wasteful competition.
Price mechanism brings about stiff or cut-throat competition among private investors. Excessive competition among producers leads to resource wastage.
9. It fails to allocate resources in priority sectors i.e. it does not provide public and merit goods/ it ignores socially profitable ventures.
Price mechanism is not used to provide public goods such as public hospitals, roads and schools. The provision of such socially desirable goods is done by the government.
10. It does not respond quickly or adjust quickly to structural changes in an economy.
Price mechanism does not respond to circumstances requiring rapid structural changes such as privatization, modernization of agriculture, liberalization of trade, alleviating effects of natural disasters, etc. Such rapid structural changes call for government intervention.
11. It leads to distortion of consumer choices through persuasive advertising.
As private investors try to capture market for their goods, they undertake persuasive advertisements. As a result, many consumers end up buying goods which they would not have bought and thus their choices are distorted.
12. Foreign dominance of an economy is prominent most especially if the economy is open.
13. It leads to disappearance of cheap goods from the market because private individuals only venture in activities that enable them maximize profits.
14. It makes government planning difficult since it is associated with a number of uncertainties.
METHODS/ WAYS OF INTERFERING WITH PRICE MECHANISM
1. Use of taxation policies.
For instance adoption of Progressive taxation policy helps in redistributing income in an economy because the tax rate increases with increase in the tax payer’s income i.e. it takes a higher proportion of income of the rich than the poor hence narrowing the gap between the rich and the poor. Taxation can also be used to influence resource allocation whereby for sectors government wants to promote, no taxes are levied on their activities while for sectors and activities that government finds less desirable, high taxes are levied on them.
2. Provision of public goods by the government.
For example the provision of better transport network in form of roads helps in the movement of goods from areas where they are in plenty to those areas where goods are scarce. Hence shortages of goods created through the market forces of demand and supply are solved or checked.
3. Encouragingthe setting up of consumer protection associations.
These help in sensitizing the consumers about the ways in which they can be exploited by profit – hungry traders. The consumers are educated on how they can safeguard themselves against buying expired goods and adulterated goods as well as other forms of exploitation by traders.
4. Anti-monopoly legislation
Government enacts laws aimed at checking monopoly powers of private producers or investors. This is aimed at reducing consumer exploitation associated with monopoly firms.
5. Setting up regulatory bodies to minimize social costs.
Such bodies set laws which govern exploitation of resources, laws that protect wetlands, laws that enforce proper disposal of industrial wastes, etc. A case in Uganda is The National Environment and Management Authority (NEMA) that was set up to protect the environment.
6. Setting up and strengthening bureau of standards.
A bureau of standards is in charge of inspecting goods being produced to ensure that certain quality specifications are fulfilled before goods are put on the market. A certification mark is given for goods that fulfill the required quality standards and this protects the health of consumers.
7. Licensing.
The government puts certain restrictions on the licensing of traders such that licenses are given to only those traders or enterprises approved by the licensing department. This checks the carrying out of illegal or illicit trade.
8. Planning for the economy.
Economic development plans are drawn up by the government to guide the allocation of resources in both the private public sector. The aim is to avoid misallocation of resources associated with price mechanism.
9. Subsidization of firms especially those providing essential and merit goods.
The government offers subsidies to firms to produce essential goods and services so that the consumers are able to get such goods and services at lower prices.
10. Adoption of price legislation policy/ control.
Price controls are taken to even out fluctuations in prices. The government can either set a maximum price to protect consumers or a minimum price to protect producers depending on the economic situations at that time.
11. Setting up government owned firms to compete with private monopolies.
Government can set up non-profit making enterprises which are vital to the society. Such enterprises can compete with the private producers thus reducing on consumer exploitation.
12. Carrying out nationalization of private enterprises.
This is done to ensure that all essential goods and services are produced and supplied by nationalized enterprises at fair prices.
NB:
Nationalization is…
13. Rationing of scarce commodities.
It involves direct action by the government to distribute the scarce commodities to the public at fixed prices in limited quantities. This is done in periods when goods are scarce in order to reduce consumer exploitation by the traders. For example in 1986 – 1987, the government of Uganda used this policy by rationing the supply of essential goods like sugar, salt, soap to consumers through local councils.
14. Controlling/ fighting inflation.
The government through the central bank uses a restrictive monetary policy to reduce the amount of money in circulation. This reduces the purchasing power of households/ public. Consequently, aggregate demand falls and prices become stable.
15. Use of buffer stocks.
A buffer stock is a system or scheme which buys and stores stock in times of plenty and releases the stocks in times of scarcity. The buffer stock is managed by the government and it helps in stabilizing prices of goods on the market.
REASONS FOR GOVERNMENT INTERFERENCE IN PRICE MECHANISM
Due to the weaknesses or defects of price mechanism, government interferes in the allocation of resources through the forces of demand and supply for the reasons below;
1. To reduce consumer exploitation by the profit – hungry business community.
This arises due to consumer ignorance/ market imperfections. The profit – hungry traders exploit consumers through over charging, sale of fake products, product adulteration, sale of expired goods etc. Such trade malpractices call for government intervention through setting up and strengthening the bureau of standards.
2. To control monopoly power in an economy where consumer preference is ignored.
The government intervenes by imposing heavy taxes on the profits of monopolists. The aim is to fight the dangers associated with private monopolies such as overcharging of consumers and production of poor quality goods.
3. To reduce income inequality.
The government intervenes through progressive taxation so as to reallocate resources and attain equity in income distribution.
4. To minimise social costs that arise as private investors pursue their private gains.
Such costs include over exploitation of resources, pollution of the environment, deforestation among others. The government intervenes by setting up regulatory bodies that enact laws geared to protecting the environment by regulating the actions of firms during resource exploitation.
5. To reduce unemployment which arises as inefficient firms are outcompeted.
The government intervenes by subsidising the inefficient firms to enable them lower their production costs and survive the stiff competition. This guards against unemployment.
6. To reduce economic instabilities like inflation i.e. to stabilize the economy.
The government intervenes through price controls to ensure stability in prices of goods and incomes of producers.
7. To cater for the provision of public goods.
Goods such as public roads andnational security cannot be provided through the market forces of demand and supply hence a need for government interference.
8. To encourage production and consumption of merit goods.
These include education, medical care and safe water. A case in Uganda is the funding of the Universal Primary and Secondary Education by the government.
9. In order to plan for rapid structural changes in the economy that cannot be handled by price mechanism.
Structural changes such as rehabilitation of basic infrastructure after periods of war, privatization and modernization of agriculture call for government interference.
10. For purposes of avoiding duplication of activities.
The government intervenes by setting up one public enterprise to run an activity. This avoids wastage of resources.
11. To control distortion of consumer choices.The government intervenes by legislating prices of commodities so as to avoid consumer exploitation by the producers in form of persuasive advertising.
12. To encourage investment in areas that may appear risky[T2] .
13. To provide goods needed by the poor.
In some cases, government subsidises such goods so that they become affordable to the poor people in the economy. The aim is to improve the quality of life of the poor people.
LIMITATIONS OF PRICE MECHANISM
In this case, we focus on those factors that slow down or distort the effective allocation of resources through the price mechanism. A student needs to be well versed with the assumptions of price mechanism.
1. Government intervention/ interference.
In most economies, government interferes with the inter-play of market forces through price controls and taxation policies. This discourages some producers and they reduce the amount of goods supplied on the market. In this case, supply does not match with the consumers’ demand and price mechanism is distorted.
2. Ignorance of the producers and consumers.
Generally, producers and consumers do not have perfect knowledge of the market conditions. Some producers tend to supply goods without judging the condition in the market. Consumers too are not always aware of the availability of certain products and their prices. This creates slow response between demand and supply hence limiting price mechanism.
3. Existence of monopolies
There are many monopolies who tend to be price makers. They always restrict output in order to charge high prices and exploit consumers. They do not supply goods according to the demand by the consumers and this distorts the use of price mechanism in the allocation of resources.
4. Limited entrepreneurial skills.
Poor organization of factors of production and failure to take risks limits producers from responding to consumers demands. Producers fail to supply those goods needed by consumers and this slows down the operation of price mechanism.
5. Under developed infrastructure.
A poor road network limits the supply of goods to areas where they are needed. Consumers may desire to buy goods but are not accessible due to poor transport and distribution network.
6. Inability to forecast future trends.
Failure of producers to anticipate increased demand in future gives rise to low output and this leads to scarcity of goods. Alternatively, over production can occur where producers anticipate increased demand yet actual demand is low. This creates a gap between demand and supply hence price mechanism is distorted.
7. Limited capital.
Inadequate supply of real and money capital leads to low output. This makes producers to supply less than what is required by consumers. As a result, shortages of goods arise on the market hence limiting the operation of price mechanism.
8. Limited skilled labour.
The existence of few people with the necessary and relevant skills makes supply not to respond to the demand of consumers because of fewer volumes of goods being suppliedhence limiting the effective operation of price mechanism.
9. Immobility of factors of production.
Some factors of production do not move with ease from one place of work to another or from one geographical area to another. Therefore producers may fail to increase output hence supply does not respond to demand thus limiting the operation of price mechanism.
10. Irrationality of producers and consumers.
Price mechanism assumes that producers and consumers are rational which is not always true. Many producers and consumers are not guided by a calculating mind.
11. Reliance on imported goods.
This makes local consumers to have little influence on prices, quality, designs, etc of such imported goods.
12. Band wagon effect.
Many people consume certain commodities because they have seen others consuming them. Therefore price mechanism may not operate since such consumers are not rational.
PRICE LEGISLATION/ PRICE CONTROL
Price control is where the government fixes prices of commodities that is either maximum price to protect consumers or minimum price to protect producers.
OR
Price legislation is the deliberate government act of fixing price either above or below the equilibrium and it becomes illegal to sell below or above respectively.
Price control or legislation takes two major forms namely;
1. Maximum price legislation.
2. Minimum price legislation.
MAXIMUM PRICE LEGISLATION
This is the setting/ fixing of prices of commodities by the government below the equilibrium price above which it becomes illegal to sell or buy a commodity. It protects consumers.
The result of maximum price legislation is a maximum price/ price ceiling.
Maximum price/ price ceiling
Refers to the price set by the government below the equilibrium price above which it becomes illegal to sell or buy a commodity. It protects consumers.
Illustration
OPe = equilibrium price
OQe = equilibrium quantity demanded or supplied
OPc = maximum price/ price ceiling
It should be noted that no seller is allowed to sell above OPc which is the maximum price.
MERITS OF MAXIMUM PRICE LEGISLATION
1. Protects consumers from exploitation by producers through over charging.
2. Controls monopoly power since monopoly to a greater extent is a price maker.
3. Avails commodities to all groups of people in the economy. A maximum price makes the commodity affordable to all people and therefore more units are bought.
4. Reduces income inequality because it reduces the profits of producers and expenditures of consumers.
5. Controls inflation because the price is set below the equilibrium price and it is illegal to sell or buy above it.
6. Widens consumers’ choice thereby improving on peoples’ standards of living.
7. Helps to increase on aggregate demand thus stimulating investment and economic growth.
8. Discourages production of harmful products such as alcohol, cigarettes, marijuana, etc and this benefits the entire society.
9. Discourages importation of expensive commodities and encourages exports. This increases the foreign exchange earnings of the country.
DEMERITS
1. Discourages entrepreneurship development since it reduces the profit margins of producers.
2. Results into shortages of commodities since the legislated prices tend to be less attractive to producers.
3. Leads to trade malpractices such as black marketing, hoarding of commodities, smuggling hence reducing the supply of goods and services in the market.
4. Results into production at excess capacity as a number of resources are not put into use.
5. It leads to rationing. This is because it creates scarcity of goods and as a result, the government is forced to restrict the consumption of scarce commodities on the basis of first come first serve hence leading to problems like long queues and nepotism.
6. It leads to increased government expenditure due to high administrative costs incurred by the government to employ the scouts and enforcement officials to visit all parts of the country so as to ensure that goods are sold at the legislated prices.
7. It leads to unemployment due to reduced levels of investment
8. Deflation may arise and this if not checked may lead to economic depression.
NB:
Rationing is the government act of selling scarce commodities to households in fixed quantities at fixed prices on the basis of first come first serve.
ASSIGNMENT
Outline the objectives of maximum price legislation.
MINIMUM PRICE LEGISLATION
Is the fixing/ setting of pricesof commodities by the government above the equilibrium price below which it becomes illegal to sell or buy a commodity. It protects producers.
The result of minimum price legislation is a minimum price/ price floor.
MINIMUM PRICE/ PRICE FLOOR
Refers to the price set by the government above the equilibrium price below which it becomes illegal to sell or buy a commodity. It protects producers.
Illustration
OPe = equilibrium price
OQe = equilibrium quantity demanded or supplied
OPc = minimum price/ price floor
MERITS OF MINIMUM PRICE LEGISLATION
1. Protects producers from exploitation by consumers through under charging. This basically applies to producers of agricultural goods. The buyers are not allowed to get produce from farmers at a price below the legislated price.
2. Increases output levels because it encourages more production in an economy hence economic growth and development.
3. Enables producers to realize stable incomes since it minimizes price fluctuations.
4. Minimizes consumption of harmful products such as alcohol, cigarettes, marijuana, etc. This is because the price is set above the equilibrium price hence making the products unaffordable by consumers.
5. Increases government revenue because the government is in position to charge reasonable taxes on profits received by producers.
6. May help an economy to offset economic depression or recession since it tends to activate investments/ production in the economy.
7. Minimizes smuggling of goods to other countries since producers are satisfied with home prices.
8. Increases employment opportunities as a result of increased production of commodities and trade in the economy.
9. Promotes research due to the high profits received by the producers which leads to production of better quality products hence better standards of living.
DEMERITS
1. Causes surplus output because of excess production hence wastage of resources.
2. Leads to increased costs of productionsince it is a high price and mainly set for primary products which form a major part of raw materials especially for agro – based industries.
3. A minimum price in form of minimum wage makes labour expensive forcing producers to opt for alternative methods of production instead of hiring expensive labour e.g. some producers start using more machines compared to men. This results into technological unemployment.
4. Leads to storage problems due to unmanageable surplus.
5. Leads to reduction in social welfare because of high costs of living.
6. Leads to over exploitation of resources which leads to exhaustion of some non-renewable resources like minerals.
7. Leads to smuggling of goods into the country making government to lose a lot of revenue required to meet its expenditure needs.
8. It is inflationary since there is no maximum. A minimum price makes it only illegal to set a lower price but sellers can set any price above it.
9. Widens income disparities between producers and consumers since it increases the profits of producers and expenditure of consumers.
10. It encourages dumping of commodities to other countries. Dumping has negative effects on the recipient country such as closure of local firms due to their out competition, under utilization of local resources among others.
11. Farmers are discouraged in the long run in case the government fails to buy the surplus output.
NB:
1. Dumping refers to the selling of a commodity in the external market at a lower price than the one charged in the local market.
2. Price support is where the government buys the surplus output on the market arising from the fixing of the minimum price.
ASSIGNMENT
1. Outline the objectives of maximum price legislation?
2. Under what circumstances may government employ a price control policy?
3. Examine the effects of price control in an economy.
4. Why may the use of price controls be avoided in an economy?
CIRCUMSTANCES UNDER WHICH GOVERNMENT MAY EMPLOY A PRICE CONTROL POLICY
A price control policy may be employed under the following circumstances.
1. When consumers are being exploited. In this case, the government fixes a maximum price.
2. When there is existence of monopoly and its consequences → maximum price.
3. When essentials of life are unaffordable to consumers → maximum price
4. When there is need to reduce income inequality → maximum price
5. When producers are being exploited → minimum price
6. When there is desire to attain higher levels of output (economic growth) → minimum price
7. When there is need to maintain industrial peace → minimum price
8. When there is need to stabilize producers’ incomes → minimum price
9. When there is need to offset an economic depression/ recession → minimum price
10. When government wants to discourage production and consumption of harmful products → both
11. When there are price instabilities → both.
EFFECTS OF PRICE CONTROLS
POSITIVE EFFECTS
1. Maximum price protects consumers from exploitation by producers through over charging.
2. Maximum price controls monopoly power.[T1]
3. Maximum price avails commodities to all groups of people in the economy.
4. Maximum price reduces income inequalities.
5. Maximum price widens consumers’ choice
6. Maximum price helps to increase on aggregate demand
7. Maximum price discourages importation of expensive commodities and encourages exports. This increases the foreign exchange earning of the country.
8. Minimum price protects producers from exploitation by consumers through under payment.
9. Minimum price increases output levels.
10. Minimum price enables producers to realize stable incomes.
11. Minimum price increases government revenue.
12. Minimum price may help an economy offset an economic depression or recession.
13. Minimum price increases employment opportunities.
14. Minimum price promotes research.
15. Price control maintains price stability
16. Price control checks on the production and consumption of harmful products.
17. Price control eliminates trade malpractices such as black marketing, smuggling of goods, etc.
NEGATIVE EFFECTS
1. Maximum price discourages entrepreneurship development.
2. Maximum price results into shortages.
3. Maximum price results into production at excess capacity.
4. Maximum price leads to unemployment due to reduced level of investments.
5. Minimum price causes surplus output hence wastage of resources.
6. Minimum price leads to increased costs of production.
7. Minimum price leads to storage problems due to unmanageable surplus.
8. Minimum price leads to reduction in social welfare because of high costs of living.
9. Minimum price leads to over exploitation of resources.
10. Minimum price causes inflation since there is no maximum.
11. Minimum price widens income disparities between producers and consumers.
12. Price controls encourage trade malpractices such as black marketing, smuggling, etc.
13. Price controls call for establishment of marketing boards which leads to exploitation of consumers.
14. Price controls lead to misallocation of resources due to distortion of price mechanism.
15. It is expensive for the government to enforce price controls.
REASONS FOR AVOIDANCE OF PRICE CONTROLS
1. Fear of causing trade malpractices such as smuggling, black marketing, etc. Maximum price legislation leads to smuggling of goods to other countries while minimum price legislation leads to smuggling of goods into the country.
2. Fear of raising costs of production which arise out of high costs of raw materials resulting from minimum price legislation.
3. Fear of causing unemployment resulting from maximum price legislation which forces firms to close down as they cannot cover their average costs.
4. To avoid unmanageable surpluses and storage problems in case of a minimum price.
5. To avoid discouraging entrepreneurs through tampering with their profit margins in case of a maximum price.
6. To avoid high administrative costs on these price controls e.g. price support.
7. To avoid unnecessary distortion of the price mechanism which may lead to misallocation of resources.
8. Fear of reducing social welfare of the people due to high cost of living caused by minimum price legislation.
9. To avoid underutilization of resources in case of a maximum price.
10. Fear of causing shortages of goods and services resulting from maximum price legislation which discourages production.
AGRICULTURE IN RELATION TO DEMAND AND SUPPLY
The nature of demand and supply in the agricultural sector tends to be unstable and this in turn tends to make prices of agricultural products fluctuate more often compared to the prices of industrial products or manufactured goods.
AGRICULTURAL PRICE FLUCTUATIONS
Agricultural price fluctuations refer to instabilities or changes in prices of agricultural products over a given period of time.
CAUSES OF AGRICULTURAL PRICE FLUCTUATIONS
1. Divergence between planned output and actual output.
When the actual output of farmers is greater than the planned output, over production arises leading to a fall in prices for the planned output. However where actual output is less than the planned output, there is shortage on the market hence causing the prices to increase.
2. Long gestation period of agricultural products.
The long gestation period of some crops makes supply to be inelastic. Before harvesting season, there is a shortage of agricultural products in the market and this leads to an increase in prices. However after harvesting, supply of agricultural products is increased on the market and this leads to a fall in prices being offered to producers.
NB:
Gestation period is the time it takes before new supplies of goods reaches the market for example maize takes 3-4 months while mushrooms take 1 month.
3. Low income elasticity of demand for agricultural commodities.
The demand for agricultural products is not influenced by changes in income i.e. changes in income have minimal impact on the demand for agricultural products. During seasons of high supply, surplus is created on the market and this leads to a fall in prices. However, a fall in supply leads to an increase in prices.
4. Low price elasticity of demand (inelastic demand) for agricultural commodities.
The demand for agricultural products is inelastic such that even if prices change, consumers demand almost the same quantities. This implies that change in supply is not followed by change in demand hence leading to continuous change in price levels i.e. surplus output pushes the prices downwards and shortages push the prices upwards.
5. Changes in the costs of production.
Farmers incur costs of production in form of buying seeds, fertilizers, farm equipments, hiring tractor services etc. When they incur high costs of production, they increase the prices for their products and when they incur lower costs of production, they reduce the prices hence price fluctuations.
6. Perishability of agricultural products hence difficult to store.
Most of the agricultural products are perishable and thus cannot be stored for future use. This causes prices to fall during harvesting periods because farmers tend to sell all their produce. On the other hand during non-harvesting periods, there is severe shortage because little or nothing was stored during the harvesting period and consequently prices go up.
7. Bulkiness of agricultural products hence difficult to transport.
Agricultural products are bulky and this makes them difficult to transport from production areas to market centres. This leads to a fall in prices at the production centres and a rise in prices at the market centres.
8. Lack of co-operation among producers of agricultural products.
Presence of many farmers competing amongst themselves makes it hard to regulate output in order to stabilize prices. When producers enjoy high prices of products in one season, many farmers are attracted to grow the same crop in the coming season. This results into massive output leading to a fall in prices. When producers make losses, many farmers are discouraged and stop growing the crop. This results into shortages in the next season forcing prices to rise.
9. Heavy dependence on nature/ effects of changes in natural factors like weather, soils, etc which affect output levels.
Unfavourable climatic factors like prolonged droughts, floods, pests and diseases in some seasons result into low output leading to an increase in the price of agricultural products. On the other hand, favourable climatic conditions lead to greater output by the farmers resulting into declining prices of agricultural products.
10. Substitution of agricultural raw materials with artificially made raw materials by developed countries/ high competition from synthetic/ artificial fibres.
Some agricultural products like cotton face stiff competition from synthetic fibres like nylon, silk, polyester, etc. Where buyers prefer synthetic fibres to natural fibres, the price of natural fibres falls. However, when the demand for synthetic fibres declines, buyers resort to natural fibres and their prices increases.
11. Introduction of raw material saving techniques by developed countries (major buyers).
Raw material saving innovations have tended to interfere with planning output in the agricultural sector thereby causing instabilities in supplies and hence instabilities in prices of agricultural products.
12. Weak bargaining position of LDCs on the world market/ external determination of prices
The major buyers (MDCs) dictate the prices of agricultural products like coffee, cotton, tea etc. As a result, LDCs cannot secure stable prices for their products because the major buyers increase and decrease the prices since they are more or less price makers in the foreign markets hence price fluctuation.
13. Agricultural products are only minor inputs in the manufacturing sector.
The agricultural products used as inputs in the production of industrial products form a small part. E.g. in the manufacturing of cars, agricultural products are only used in the making of tyres making their demand inelastic.
14. Poor surplus disposal system/ machinery.
Developing countries are faced with a problem of poor infrastructure such as underdeveloped transport facilities making it difficult to transport the surplus to areas of scarcity. This leads to a fall in prices in the areas where there is surplus output and a rise in prices in areas of scarcity.
EFFECTS OF AGRICULTURAL PRICE FLUCTUATIONS ON AN ECONOMY
1. Price fluctuations lead to fluctuations in farmers’ incomes.
Incomes of farmers increase when prices increase and they decrease when the prices decrease.
2. Price fluctuations result into fluctuations in government revenue.
This is because government receives most of the revenue from taxing income and/ or property. Therefore fluctuation in income means fluctuation in tax revenue.
3. Fluctuations in prices of major export crops lead to instability in export earnings.
In seasons when export prices increase, export revenue for the government increases. However in seasons when export prices fall, export revenue also declines. This causes unstable export earnings from one season to another.
4. Government planning based on expected earnings from the agricultural sector becomes difficult.
When prices are fluctuating, it is not easy to predict what is to be earned from selling agricultural products. This complicates planning by the government in case the plans are to be financed by incomes from the agricultural sector/ agricultural exports.
5. Farmers get discouraged/ frustrated.
This leads to subsistence production hence a decline in economic growth and development.
6. Price fluctuations lead to rural urban migration with its negative consequences.
As incomes from agriculture become unreliable, the frustrated farmers (especially the young and energetic) migrate to urban areas looking for better employment avenues/ opportunities. Unfortunately, this migration is associated with many problems like open urban unemployment, high crime rate, development of slums, gambling, etc.
7. Price fluctuations lead to instability in exchange rates.
As export prices of agricultural products increase, a country’s foreign exchange earnings are improved. This results into greater foreign exchange inflow. This increased inflow of foreign currency results into a fall in exchange rates in the country. However, a fall in export prices of agricultural products creates a shortage of foreign currency in the country. This results into an increase in exchange rates.
8. Price fluctuations lead to instabilities in balance of payments.
An increase in export prices of agricultural products in a given season results into an improvement in the balance of payments position.On the hand, a fall in export prices of agricultural products in a given season results into worsening of the balance of payments position.
9. Price fluctuations result into unstable/fluctuating terms of trade.
When prices of agricultural exports increase, the terms of trade improve (become better). However when export prices decline, the terms trade deteriorate (become worse).
10. Investment in agriculture becomes uncertain.
This causes speculation as farmers regard investment in agriculture as a gamble and thus irrational use of land.
11. Price fluctuations lead to seasonal unemployment in the sector.
Some farmers may decide not to produce in a particular season because of the miserable prices obtained in the past season. Such farmers become seasonally unemployed.
12. Price fluctuations worsen income inequalities.
A decline in prices of agricultural products in some seasons makes farmers to earn less income than individuals employed in other sectors like the industrial sector, service sector, etc.
ASSIGNMENT
Why is there need to stabilize agricultural products?
POSSIBLE WAYS OF STABILISING AGRICULTURAL PRICES
1. Through operation of the buffer stock policy.
A buffer stock policy is one whereby the government through the market boards buys the surplus output from farmers, stores it and sells it during periods of scarcity. This helps to iron out fluctuations in supply, prices and incomes.
2. By use of the stabilization fund policy.
A stabilization fund policy is the deliberate attempt by the government of paying the producers less than the market price when prices and incomes are high and putting the realized difference into a fund and later using the fund to pay the producers higher prices than the market price when prices and incomes are low to avoid fluctuations in prices and incomes as would be dictated by the market forces.
3. Improving on storage facilities/ system
For example use of fridges to ensure proper storage of highly perishable products like milk, fish, tomatoes etc. This stabilizes supply and hence prices and incomes of agricultural producers.
4. Improving on transport system.
This involves construction of feeder and main roads linking production centres and market centres. A better transport system evens out surpluses by easing transportation of goods from production centres (areas of plenty) to market centres (areas of scarcity) thereby stabilizing prices of agricultural products.
5. Modernizing agriculture/ improvement in technology and carrying out extensive research.
This not only improves on the quality of agricultural products but also leads to a reduction in their gestation period. For example use of hybrid seeds with a short gestation period, taming nature through irrigation, etc. All these stabilize supply leading to stable prices over time.
6. Setting up agro-based industries.
Agro-based industries add value onto agricultural products. This helps to improve on the quality and prices of agricultural products.
7. Joining international commodity agreements.
International commodity agreements like international coffee agreement help to fix prices and quotas for the buyers and sellers of commodities to avoid fluctuations of prices on the world market resulting from excess supply.
8. Diversifying agriculture.
It is important to note that many developing countries depend on only one or two crops for export. As a result, fluctuations in the output or prices of the crop(s) may cause considerable instability in exports and incomes of those countries. To reduce the effects of dependence on one or a few crops, there is need to produce a variety of crops so that failure of one can be compensated for by the successful harvest of the other(s).
9. Development of forward (future) markets/ contract trade
This involves producers and buyers signing agreements specifying the amount, quality and price of a given commodity to be supplied in the future. In this way, changes in supply do not affect the price agreed upon hence stability in prices of agricultural products. Future trade can be arranged for both local and foreign trade.
10. Through price legislations.
The government of the concerned economy can carry out price controls by fixing prices of selected commodities.
11. Formation of co-operatives to control supply.
Co-operatives help to educate the farmers about the use of better farming methods, looking for market for the farmers’ output, regulating supply through a quota system, improving the bargaining abilities of farmers with buyers, etc. All these actions help to stabilize the prices of agricultural products.
12. Strengthening regional economic integration.
This improves the bargaining power of member states for their agricultural exports on the world market.
13. Diversifying and expanding the markets for agricultural products.
This involves extending and widening markets for agricultural products. It is done by searching for new buyers from other developing countries in Asia and in other parts of Africa.
14. Re-sale price maintenance system.
It is important to note that greater fluctuations are at times caused by middlemen and if prices at which consumers are to buy are set in advance by the primary producers, instability in prices may be minimized.
15. Subsidising farmers/ providing tax incentives to farmers/ stabilising costs of production.
This involves reducing taxes on farm inputs or provision of subsidies to farmers on farm inputs. This helps to stabilise costs of production and ensure stable supply and prices.
16. Providing affordable credit to farmers to buy necessary inputs.
This involves providing low interest loans to farmers through the local SACCOs and commercial banks to enable purchase of farm inputs. This leads to stable supply of agricultural products and thus stable prices.
EFFECT OF A CHANGE IN SUPPLY UNDER CONDITIONS OF INELASTIC DEMAND
With inelastic demand, small change in supply can have a large impact on changing price.
From the diagram above, it can be observed that a small increase in supply (represented by a shift of the supply curve to the right from S1S1 to S2S2) leads to a big fall in price from P2 to P1. Note that a fall in supply has a similar but opposite effect.
THE COBWEB THEORY
The cobweb theory is an economic model that attempts to explain the occurrence of price fluctuations in certain types of markets.
The cobweb theory is based on a time lag between supply and demand decisions. Since agricultural marketsare characterised by a time lag between planting and harvesting, the cobweb model can be applied to explain the occurrences of agricultural price fluctuations.
Because of this time lag, the output produced in a particular season is determined by the prices of the previous season.
Illustration of the cobweb model (Convergent cobweb)
From the above illustration, initially the equilibrium quantity supplied is OQoand the equilibrium price is OPo.
Assuming there is a shock in an economy for instance an unexpectedly bad weather, this will result in a fall in the amount of the commodity supplied on the market from OQo to OQ1 (A shortage is created). This results into an increase in the price of the commodity from OPo to OP1. This increase in the price above equilibrium attracts new farmers to plant the same crop and also makes the old farmers to plant more. Because of the time lag between planting and harvesting, much will be supplied in the next season i.e. output increases from OQ1 to Q2 (There is surplus output). This forces the farmers to reduce the prices of their products from OP1 to OP2. This fall in price discourages some farmers and they stop growing the crop and even those who remain in production end up planting less. This results into less output put on the market the next season (Quantity OQ3 is supplied which is less than demand) again forcing prices to rise from OP2 to OP3. This process will go on until equilibrium is reached after a number of oscillations.
From the illustration, it can be observed that the fluctuations spiral inwardly meaning that the forces of demand and supply work out to restore the equilibrium conditions. This is a case where demand is more elastic than supply (The supply curve is steeper than the demand curve)