INTRODUCTION:
A supporting paper deals with this analysis and its implications in some detail - World Agricultural Markets in Principle and Practice. The following notes condense this material.
In addition, students are referred to the following as 'back-up' references:
Ritson & Harvey (eds), 1997 - CAP and World Markets, especially Chapter 17, and also Johnson, D.G. (1991) World Agriculture in Disarray, 2nd ed., Macmillan (especially Chapter 7)
And:
McCalla & Josling, Agricultural Policies and World Markets, Macmillan, 1985, deals with the analytics in some detail.
Tyers, R. and Anderson, K, 1992, Disarray in World Food Markets, a Quantitative Assessment, Cambridge, especially Chapter 4, p 128 ff.
Padberg, D.I, Ritson, C., and Albisu, L.M., 1997, Agro-Food Marketing, CAB International, especially chapter 4 (by Carman, H.F.)
ESSENTIAL ELEMENTS OF THE ANAYSIS - SPATIAL EQUILIBRIUM "MODELS"
Note - the following notes DO NOT deal with Foreign Exchange markets. - to follow up on this aspect of international markets, you need to read the paper above, or follow up on my first year economics principles notes: where the major elements of International Trade and the Foreign Exchange market are dealt with.
Why does trade occur? A simple answer is that people who want to buy something are willing to pay at least as much as others require to produce and sell the thing. Economic analysis of trade is thus, in essence, the analysis of relationships between buyers (demand) and sellers (supply). However, a differentiating characteristic of "trade" is the fact that the transaction between buyers and sellers is costly - transport, insurance etc. If these transactions costs cannot be covered by the difference between the buying and selling price, then the trade (transaction) will not occur.
In order to explore the implications of this concept of trade, we can think of two separated markets - one in one place (or at one time, or for one form of the product), the other at another place (time, form). The following figure shows two 'countries' or markets separated in time and space, one 'short' of the commodity (say wheat) and market 2 'long' in the commodity.
Figure 1
Exercise 1 : What are the slopes and intercepts of S1, D1, S2, D2? [remember that elaticities (e) show the responsiveness of supply and demand to price changes and can be represented as (%¶Q/%¶P), where ¶ signifies "change in" which is equivalent to [(¶Q/¶P)*(P/Q)], where ¶Q/¶P is the inverse of the slope of the curve (line) while P and Q show the price and quantity respectively around which the elasticity is assumed to hold. You are advised to use a spreadsheet to make these calculations!
The next figure shows the results of traders buying in Market 2 and selling in Market 1, as trade is opened up between these two markets. Notice, especially, the construction of the Excess Supply (XS) and Excess Demand (XD) curves here. The XS curve is, in effect, the export supply curve - the amount that market 2 is willing to export at each and every price. The XD curve is the import demand curve for market 1, the amount that this market is willing to import at each and every price.
Figure 2
Exercise 2: Given your answers above, what would you expect T1 and Pe to be?
The next figure shows the impact of transport and transactions costs on this simple market system. These costs "drive a wedge" between the buying price (the fob price) and the selling price (cif), where the gap between the two prices is sufficient to cover the full costs of transfering the product between the two markets.
Figure 3
Exercise 3: Suppose, now, that insurance and freight are estimated to be 30/tonne, what would you expect Ta, Pe, cif and Pe, fob to be?
An Aside on inter-temporal equilibria. Storage can be thought of as essentially a market between good and bad years, buying in good years and selling in bad. So we have an excess supply curve from the good year intersecting with an excess demand curve from the bad year. Thus, with no storage or carrying charges, the equilibrium price would be Pe (figure 2 above). More realistically, with storage and carrying charges, the market will balance when the difference between the buying price [Pg(s)] and the selling price [Pb(s)] covers the storage and carrying charges with the quantity stored (QS) equal to the amount bought into store in the good year (Qgs - Qdg) and to the amount sold from store in the bad year (Qdb - Qsb), in exactly the same fashion as in Figure 3 above.
The Effects of Policy Intervention - the EU case
Figure 4 shows the relevant part of Figure 2 (ignoring transaction and transport costs for simplicity) for the EU case of PROTECTING AND INSULATING its market from the world market (here simply shown as the net export or excess supply curve resulting from the aggregation (sum) of all the other countries in the world.
In the 'old CAP', this insulation and protection was achieved through taxing imports (the tax called a variable levy - WHY??). The import tax depresses the world price and increases the domestic EU price, and generates the shaded area as the revenues to the EU budget from the levy or import tax.
Figure 4
Over time, EU supply curves have shifted to the right, as structural and technical change have improved the 'competitiveness' of EU supplies (more produced at lower total costs), leading to the EU changing from a net-import position (Figure 4) to a net export position (Figure 5):
Figure 5:
Here, the exports from the EU are shown as negative excess demand, and imports by the rest of the world are shown as negative export (excess) supply in the RoW. Now, the EU has to apply an export subsidy to remove the surplus from the domestic EU market to maintain the internal EU price. The shaded area shows the costs to the European Budget of doing this.
Exercise 4: Can you identify the gainers and loosers from this policy intervention and estimate the relative sizes of their gains and losses in each (net importer, net exporter) case?
Some Basic Algebra and Definitions:
The effects of one country's policies on the world market depend on the elasticity of the world market excess demand (or supply) curve facing the country in question. To see how elastic or inelastic this excess demand is likely to be, we need to consider the basic defintions and relationships more formally - using some elementary algebra. THIS WILL LOOK COMPLICATED WHEN YOU FIRST SEE IT - BUT IT IS STRAIGHTFORWARD - JUST TAKE IT SLOWLY AND CAREFULLY AND YOU WILL BE ABLE TO FOLLOW IT, I PROMISE (JUST SWITCH YOUR BRAINS ON!!).
Excess demand in the rest of the world equals demand in the rest of the world minus supply in the rest of the world, by definition: XDR = DR - SR, by definition
So: ¶XDR /¶P = ¶DR/¶P - ¶SR/¶P; as the response of each side to a change (¶) in the (world) price P, - effectively just multiplying each part of the first equation by ¶/¶P [where ¶XDR simply means "a small change in XDR", ¶P means "a small change in P" so the whole expression ¶XDR /¶P simply means "the small change in XDR per unit small change in P" and so on through the rest of the expression];
Then, multiplying the LHS by P/XDR to turn it into an elasticity - of RoW excess demand with respect to a change in world price -, which in turn means multiplying each term on the RHS by the same term, to preserve the equality, gives:
¶XDR/¶P * P/XDR = ¶DR/¶P *P/XDR - ¶SR/¶P * P/XDR;
Now multiply the first RHS term by DR/DR (ie 1) and the second term by SR/SR (again = 1), and re-arrange terms: gives an expression in terms of elasticities on the RHS as well: So:
EXD = [¶DR/¶P * P/DR] *DR/XDR - [¶SR/¶P * P/SR] * SR/XDR;
" Guestimates" of these elasticities and knowledge of production and disappearance data for the world and for the EEC now allow some reasonable estimates to be made about the elasticity of excess demand facing the EEC.
eg for cereals,
let ED(row) be -0.5; ES(row) be +0.75;
XD(Row) has to equal XS(EC) for equilibrium in the world market - that is, for markets to clear with no unsatisfied buyers or sellers,
so XDR = XS(EC) = 30m.tonnes approx.;
DR = approx 450m tonnes for cereal grains (check this),
so SR = 420m tonnes.
So: EXD (for the EC) = -0.5 * (450/30) -0.75 * (420/30) = -0.5 * 15 -0.75 * 14 = -7.5 - 10.5 = -18 i.e. highly elastic.
But the general perception is that excess demand curves are typically quite inelastic (so that relatively small changes in EC exports would have significant effects on world prices - for most applications, the flexibility of world prices with respect to EEC exports (the reciprocal of the elasticity) is likely to be more useful). So what has gone wrong here? - THINK BEFORE YOU READ ON!
Answer
The elasticities are with respect to the world price, not to the ruling domestic prices in the rest of the world. Many countries protect and insulate their domestic agricultural industries from the effects of world prices.
If domestic prices do not change as world prices change, i.e the domestic policies insulate the domestic markets, then the elasticities of domestic supply and demand w.r.t. world price changes in the above expression are zero and the elasticity of excess demand will also be zero, i.e. the flexibility will be infinite (any increase in EEC exports will depress world prices to zero).
However, few countries can afford to totally INSULATE their domestic markets from the world price (e.g., the bigger the gap between domestic and world prices, the more costly in one way or another are domestic polices) hence there is some logic for movements in world prices to be translated, at least partially, into movements in domestic prices. There is also some empirical evidence of this, through correlations of world and domestic price changes.
Protection, i.e. a "wedge" between the domestic price and the world price, with domestic and world prices tending to move together, will make the elasticities more inelastic, cet. par. but will not reduce them to zero.
The more insulative and protective are domestic support policies around the world with respect to the world price, the more inelastic (the less flexible) the XD facing the home country, with obvious consequences for domestic policies at home.
We can see this as follows: go back to the expression for the EXD:
EXD = ED(row) * DR/XDR - ES(row) * SR/XDR
Now, to retrieve the expression for the EXD, we need to "transform" these domestic elasticities so that they reflect responses to the world price. We need the elasticities of domestic prices with respect to world prices - E(Pd/P) = [(¶Pd/¶P) * (P/Pd)]
Now multiply each term in the RHS by this elasticity:
¶DR/¶P * P/DR * [(¶Pd/¶P) * (P/Pd)] *DR/XDR - ¶SR/¶P * [(¶Pd/¶P) * (P/Pd)] * P/SR * SR/XDR {The terms in Pd cancel out, leaving the expression as before, try for yourself, so we have not changed the expression, merely expanded it.}
Now we have the complete expression:
EXD = ED(row) *E(Pd/P) * DR/XDR - ES(row) * E(Pd/P) * SR/XDR.
where E(Pd/P) = [(¶Pd/¶P) * (P/Pd)]
and the first term in the RHS of E(Pd/P) is: (¶Pd/¶P) - the "insulation" of the policies in the rest of the world, since this measures the rate of change of domestic prices in reponse to world price changes. (Note, in principle, the EC has set domestic prices which do not alter whatever the world price is, through variable import levies and export refunds, so this term might be thought to be zero for the EC, making the EXD of the EC, which the rest of the world faces, zero.
However, the consequences of world price changes will show up in the EC budget, which gets bigger as world prices fall, and hence exerts some downward pressure in turn on domestic (EC) support prices, so (¶Pd/¶P) is not zero for the EC, and has been estimated as about 0.5.)
The second term (P/Pd) measures the extent to which domestic prices are different from world prices (usually above in developed economies), ie the "protection" offered by the EC policy - actually the inverse of protection as normally measured ((Pd-P)/P) - , so that Pd > P and P/Pd < 1 (in the EC, for cereals, about 0.5)
So, for the EC cereals market, E(Pd/P) =0.5*0.5 = 0.25. If the Rest of the world behaves as does the EC, then this would reduce the EXD facing the EC to: - 1.875 - 2.625 = - 4.5, that is rather more inelastic than the first attempt above. In fact, many countries (especially the old USSR, China, non EC European countries etc. hav been even more protective and insulative than is the EC, so EXD for the EC may well be even more inelastic than this.
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