Wouldn't it be nice if you received at least 90% on all of your schoolwork, even if you missed quite a few points? The professor told you that regardless of how well your paper is written if they give you their study guide, your score will be 90%. Once written, you can hand the paper in for a guaranteed 90%. If you think it deserves better than 90%, you can hand it into a different professor, who will give you more than the 90%, but you'll have to pay the first professor $20 for using their study guide.
That is sort of how price supports work, except with minimum prices rather than grades. If you want to be sure you understand, keep reading!
Price Supports Definition
The definition of price supports is prices that the government sets and maintains by buying surplus goods. To be effective, price supports must be set above the market equilibrium price of the good in question, otherwise, there would be no need to set a minimum price.
Price supports are prices that are set above the market equilibrium price by the government and are kept there through government purchases of surplus goods.
Price supports work to guarantee a producer a minimum price for their goods. To keep the prices of goods high and maintain the profits of producers, the government's solution was to buy up enough of the goods in the market to put upward pressure on the price. If the equilibrium price of a good is $5 for 10 units, but the government would rather the price be $8 for 10 units, they would buy enough of the good to create a shortage in the market. This shortage would then force prices to rise.
Price supports are generally seen as helpful to the producers of the goods because they guarantee them higher profits. However, higher prices that are good for producers are usually not good for the consumers that have to pay them.
Minimum Support Price
The minimum support price (MSP) is the lowest price to which the market can fall without the government intervening. It can be seen as a subsidy to make the production of a wider variety of products more attractive. This works by having the government announce the MSP for a good prior to production. Then, the producers will know the minimum profit they can make off of the good. When the good is ready to be sold, if the market price is higher than the MSP, the producer will sell at the market price. If it is lower than the MSP, the producer will sell to the government instead and collect the MSP.
Price Support vs Price Floor
There are several differences between a price support vs a price floor. A price support is similar to a price floor in that it creates a minimum price level for the market. A price floor is a lower bound for the price of a good below which it cannot be legally priced.
A price floor is a legal limit of how low a good is allowed to be priced.
A price support is not a lower limit on the market like the price floor is. The price floor actually prevents the market price from dropping below the set price, where the price support is only a benchmark. Once the benchmark is passed, the government will bridge the gap by giving the producer the MSP.
Another difference between price supports and price floors is who has to deal with the repercussions of implementing these policies. Both price floors and price supports create an overproduction of goods in the market. This overproduction, or surplus of goods, creates the issue of what to do with these excess goods that cannot be sold at a lower price due to the price floor or price support. With a price floor, the extra goods are the problem of the producer. The government mandated the price floor and expects the supplier to adjust their behavior. With price supports, the government has promised the producer to buy the goods at the support price, making the goods the property of the government and thus the burden of what to do with the goods rests with the government.
Effect of Price Support on a Market
The effect of price support on a market is that it raises prices, creates a surplus, and increases producer surplus. Price supports can take different forms depending on the government's policy. A government can either choose to enforce a production quota on producers or it can incentivize them to reduce their production. But first, let's look at the effect a price support, in general, has on the market.
Fig. 1 - Effect of a Price Support on a Market
In Figure 1, the price support is set above the equilibrium at Ps which means that the entire market price has increased. At this price on demand curve D, the quantity demanded by the consumer is reduced to Q1 from Qe, but at that price, the supplier wants to produce at Q2 since it is so profitable. This results in the shaded area F, which represents a surplus of goods in the market. To deal with this surplus and make up for the difference between Q1 and Q2, the government will buy quantity QG from the supplier, which shifts the demand curve to the right, to D+QG. D+QG is demand plus the quantity that the government buys (QG).
With these goods, the government can either hold on to them, destroy them, or donate them. The first two options are usually frowned upon since they are so wasteful and there are people that are in need of the goods. The third is the most viable, but it is also difficult to turn it into reality due to the logistical difficulty.
As you can see, after the price support is implemented, the gain for producers areas B, C, and F, while the loss for consumers is areas B and C. Such a large producer surplus indicates that it is profitable to produce at that price since so many producers are willing to produce, however, the loss for consumers tells us that there are fewer consumers willing and able to buy at such a high price.
Ideally, consumer and producer surplus should balance each other at market equilibrium. If you'd like to learn more about it, have a look at these explanations:
- Producer Surplus
- Consumer Surplus
An alternative to the government buying the goods and having to figure out what to do with them is providing an incentive to reduce production. For example, the government will pay farmers to not farm a portion of their land. They will pay producers to reduce production or not produce at all. They can also set a production quota that restricts the amount of a good that a producer can bring to the market.
Benefits from Price Supports
The benefits from price supports are mostly felt by the producers in the market. The producers are the ones who enjoy the higher prices and a guaranteed sale to the government. Because the government's demand is the difference between what the consumers demand and the quantity supplied, the producers can manufacture as much of the good as they want at that higher support price. The government buys this quantity to maintain the price support and keep it above the market equilibrium price.
The government wants to keep producers in business because of what it means for the economy. If prices fall so low that manufacturers can not afford to keep going, they will have to shut down. This costs workers their jobs, and then they cannot pay their rent and consume which is again bad for businesses, and so on.
Price Supports: Drawbacks
While price supports are good for the producer, overall social welfare usually suffers. Consumers have to find a way to cope with the higher prices and the government must cope with all the excess inventory it is buying. Also, much of the government's revenue comes from taxes. Consumers pay those taxes so in a way, what the government pays the producers essentially comes out of the consumer's pocket.
Fig. 2 - Welfare Cost of Price Supports to Society
Figure 2 shows the cost of price supports to society. The cost to the government is shown by the shaded areas in Figure 2. The cost to society as a whole is the shaded areas less the area of the triangle formed by the three pink dots, which is the part of the increase in producer surplus that is not canceled by the decrease in consumer surplus.
Price Support Examples
The biggest price support example is the agricultural industry in the US. Since the 1930s, US farmers have benefitted from agricultural price supports that have allowed them to continue to produce the US's food supply and then some. The price supports are applied to goods like corn, soybeans, wheat, and rice.1 The government will set the support price for these agricultural goods before the farmers plant their fields so that they know what they can plant that will generate a profit.
If a farmer does not have the funds to plant and maintain their crop through to harvest, the government can issue the farmer a non-recourse loan. This is a loan where the holder is not punished for not paying the loan back. The crops that the farmer yields are the collateral for the loan. The size of the loan is determined by how much the farmer is theoretically able to produce and how much it would sell for at the support price. The farmer then takes these funds to farm their fields and can then give the crops to the government and not pay back the loan or if they can score a higher price for their goods on the market, they can sell the goods there, pay back the loan, and keep the difference. Regardless of how the farmer finds their production level, they know they will be able to sell their crops at the support price.
Sometimes, the government will pay farmers to not cultivate their fields in order to reduce production but still generate a profit for the farmer, or whoever owns the land. This is a form of production quota. These unused fields are referred to as land banks and are a solution to the problem of overproduction and wasting crops.
Price Supports - Key takeaways
- Price supports are prices that are set above the market equilibrium by the government to keep the prices of the good higher.
- Price supports benefit the producer the most since they are the ones who collect the profit from the higher prices.
- A producer can choose to sell below the support price unlike with a price floor that legally prevents the good from being priced lower.
- Consumers are the ones that lose out as a result of price supports since they have to bear the burden of the higher price.
- A repercussion of price supports is a surplus of goods in the market that have to be dealt with. The government will buy this surplus to avoid it putting downward pressure on the price.
References
- Sahar Angadjivand, U.S. Farm Commodity Support: An Overview of Selected Programs, Congressional Research Service, April 2018, //sgp.fas.org/crs/misc/R45165.pdf
Frequently Asked Questions about Price Support
Price supports are prices that are set above the market equilibrium price by the government and are kept there through government purchases of surplus goods.
A price support is not a legal lower bound for the price of a good whereas a price floor is. Producers can choose to sell their goods below the support price.
The main effect of a price support on a market is that it increases the price of the good.
Price supports cause an increase in the price of the good, create a surplus, and increase the producer surplus while reducing consumer surplus.
An example of a price support is the agricultural price support that farmers receive in order to keep the price of crops high enough for the farmers to earn an adequate income.
Final Price Support Quiz
Question
What is the Laffer curve?
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Answer
Laffer Curve depicts the relationship between the tax rate and tax revenue.
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What does the Laffer curve show?
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It shows that as tax rates increase from 0%, tax revenue increases; however, after a specific tax rate, tax revenue begins to fall, reaching zero at a 100% tax rate.
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Is the Laffer curve valid?
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The Laffer curve is valid as an economic theory. Nevertheless, its practical implications are not agreed upon by economists.
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How to graph a Laffer curve?
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The tax rate is plotted on the horizontal axis, while the tax revenue is plotted on the vertical axis. At the tax rate of 0%, tax revenue is zero. An increase in the tax rate up to the maximum tax rate leads to increased tax revenue. As the tax rate climbs past the maximum tax rate point, tax revenue begins to fall until reaching zero at a 100% tax rate.
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Why is the Laffer curve important?
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Laffer Curve is critical because it was widely used in the US federal government policy and affected many people.
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Who gave the concept of the Laffer Curve?
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Arthur Laffer is an economist who, in 1974, came up with the idea of the curve, later named after him, that shows the relationship between the tax rate and tax revenue.
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What does the Laffer Curve plot?
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Laffer Curve plots the relationship between the tax rate and tax revenue.
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What is the income effect?
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The income effect occurs when individuals decrease their working hours after the wage increases. This is because people demand more leisure when their income is higher.
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What is the substitution effect?
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The substitution effect occurs when individuals increase their working hours in response to a wage increase. Working has become more attractive compared to leisure when the wage is higher.
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Critiques of the Laffer Curve suggest that the labor supply curve is ____
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There is no consensus on how the behavior of individuals would change in response to tax cuts.
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It is practically impossible to calculate the effects of a tax cut because elasticities of demand and supply in the labor market are difficult to calculate.
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A quota is a regulation set in place by the government that restricts the quantity of a good over a certain period.
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Deadweight loss is the combined loss of consumer and producer surplus due to the misallocation of resources.
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What is the purpose of a quota?
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Quotas are a type of protectionism meant to keep prices from falling too low or rising too high.
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___________ is the additional revenue foreign producers earn as a result of the domestic price increase associated with a reduced supply.
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True/False: Like a tariff, a quota only applies to imported goods.
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False, they can apply to production and exports as well.
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True/False: The benefits of a quota to producers outweigh the costs to consumers.
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False. The gains that producers make typically do not exceed the cost to consumers of these quotas.
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If a government wants to earn a share of import profits, should they employ a quota or a tariff?
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A tariff, quotas do not earn the government any money.
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What is a combination of a tariff and a quota called?
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If a country is experiencing a shortage of textiles because foreign prices are higher than domestic prices and producers are exporting all their goods, what can the government do?
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They can set an export quota to limit the number of textiles that can be exported.
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A firm is producing hundreds of thousands of cheap cars and flooding the market causing prices to fall. What can the government do to limit the number of cars this firm is producing?
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They can set a production quota that limits the number of cars this firm can produce in a year.
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When is a quota more effective than a tariff?
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A quota is more effective when the government wants to actively limit the amount of a good in the economy.
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How do import quotas increase domestic prices, and who benefits from this?
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They increase domestic prices by reducing the total number of goods available in the domestic market. Producers benefit because they are able to sell their goods at a higher price since they do not have to compete with foreign producers anymore.
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How do quotas cause deadweight loss?
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The quota prevents the market from reaching its natural equilibrium by keeping domestic prices above the global market price, making it inefficient.
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Why might a government choose to set a quota?
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To limit the amount of a good being imported, exported, produced, or harvested.
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How might quotas be used to protect natural resources?
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Quotas like Individual Transferable Quotas (ITQ) can be used to limit the number of natural resources that can be harvested, like fish and catch quotas that limit the number of fish that can be caught.
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A tariff is a tax on imported goods.
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True/False: All taxes are tariffs but not all tariffs are taxes.
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False, because a tariff is a tax on imported goods but there are other taxes that apply to domestic goods and those are not tariffs.
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A quota is a limit on the quantity of a good that can be imported.
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Quota rent is the profit that foreign producers are able to earn when a quota is put in place. The amount of quota rent is the size of the quota multiplied by the change in price.
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What are the four types of tariffs?
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The four types of tariffs are ad valorem tariffs, specific tariffs, compound tariffs, and mixed tariffs.
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An importer has to pay a 10.6% tax on a $56,000 car that they are importing. What type of tariff is this?
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You want to import 50,000 sticks of butter. At the border, they tell you that you have to pay $0.12 per stick. What type of tax are you paying?
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You are paying a specific tariff.
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Joe wants to start importing cheese. When he asks the government how much tariff he will have to pay, they tell him that he will have to either pay $4 on each pound of cheese or 20% of the value of the shipment. What type of tariff is this?
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This is a compound tariff.
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When Marge imports chocolate, she has to pay $10 for each pound of chocolate and 11% of its value. What type of tariff is this?
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Who profits from a tariff?
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The government and domestic producers.
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Who or what is negatively impacted by tariffs?
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Domestic consumers, importers, free trade, nations subjected to the tariff, and political relations.
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Why might a government set a tariff?
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The federal government imposes tariffs as a way to protect domestic industries, keep prices high, and as a source of revenue.
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What effect do tariffs have on free trade?
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Tariffs interrupt the flow of resources from one country to the next, risking reduced economic growth. This limits free trade because it prevents the economy from adjusting itself and finding equilibrium.
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What is a good or service called that is produced abroad and sold domestically?
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What is a good or service called that is produced domestically and sold abroad?
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True/False: For a good to be considered an import it has to be brought in by a domestic importer.
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False, a foreign company can also bring their goods over to sell them directly.
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What happens to the domestic price of a good when a country starts importing the good?
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The domestic price decreases because it has to compete with the world price.
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Why do imports not have an effect on GDP?
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Because GDP calculates the total value of goods produced domestically and even if we include the consumption of imports in the "consumer spending" section, it is canceled out when it is subtracted under the "imports" section.
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Does having a high volume of imports cause inflation?
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No, it reduces inflation and in some cases even causes deflation because if a nation consumes many cheaper foreign goods, domestic prices will have to come down to compete with the world price.
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Explain how having a high volume of imports affects the exchange rate.
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If a nation buys a lot of goods from another, they require the foreign nation's currency. This increases demand for the foreign currency which increases its value. The exchange rate will increase as the foreign currency becomes more valuable than the domestic one.
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What are some benefits to importing goods?
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They provide product diversity, more types of goods and services, reduce costs, and allow for industry specialization.
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What are imports that are considered consumer goods?
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Cell Phones, Toys, Games, Jewelry, Footwear, Televisions, Toiletries, Rugs, Glassware, Books, etc.
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How do imports increase product diversity?
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They introduce products into the market that may have not been available domestically.
Example: importing a special cheese that can only be produced in its native climate.
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