Government Intervention and Inequality: Question 3

Worked solution

Part (a): The free-market equilibrium

Scanning the table for the row where quantity demanded equals quantity supplied:

Only at $4.00 per kg do the two columns match, both at 500 tonnes per month. This is the free-market equilibrium.

Part (b): The surplus at the minimum price, and why it occurs

At the minimum price of $5.00 per kg, reading directly from the table: quantity demanded is 400 tonnes per month, while quantity supplied is 600 tonnes per month. The surplus is the difference: $600 - 400 = 200 \text{ tonnes per month}$

A minimum (floor) price is set above the free-market equilibrium price of $4.00. Because the supply curve is upward sloping, the higher price of $5.00 encourages farmers to offer more wool for sale (600 tonnes) than at equilibrium. Because the demand curve is downward sloping, the same higher price discourages some mills from buying as much wool as before, so quantity demanded falls (to 400 tonnes). With quantity supplied now exceeding quantity demanded at this price, the result is an excess supply, a surplus, of 200 tonnes per month. (This is the opposite of a maximum, or ceiling, price, which is set below equilibrium and causes an excess of demand over supply. A shortage.)

Part (c): The monthly cost of the buffer stock scheme

To prevent the market price falling below $5.00, the buffer stock agency must buy up the entire 200-tonne surplus every month. First convert tonnes to kilograms, since the price is quoted per kg: $200 \text{ tonnes} \times 1000 = 200{,}000 \text{ kg}$

Then multiply by the minimum price: $200{,}000 \times 5.00 = 1{,}000{,}000$

So the buffer stock agency must spend $1,000,000 per month buying the surplus wool.

Part (d): Assessing the scheme’s long-run success

Potential advantages: by buying up the surplus each month (and, in principle, releasing stored wool for sale in years when the free-market price would otherwise spike), a buffer stock scheme can smooth out the sharp year-to-year swings in farmers’ incomes that concerned the government, giving farmers a stable and predictable minimum price to plan around.

Potential problems: the scheme depends on wool being storable without significant loss of value, which is more realistic for wool than for a perishable crop, but storage and insurance still cost money on top of the $1,000,000 already spent buying the surplus. A more serious risk is that if the minimum price of $5.00 is left permanently above the true long-run equilibrium of $4.00, farmers will keep producing a 200-tonne surplus every single month; unless the agency can find buyers for its accumulating stock (for example, by releasing it during a future shortage), the stockpile, and the government’s total spending, will simply keep growing, which is not financially sustainable indefinitely. The scheme’s success therefore depends heavily on setting the minimum price close to the underlying equilibrium and on demand or supply conditions eventually shifting so that the built-up stock can be sold off, rather than on the price floor alone.

Judgement: the scheme can support farmers’ incomes reasonably well in the short-to-medium run, but without careful management of the minimum price level and a realistic plan for eventually releasing the accumulated stock, its long-run success is far from guaranteed.

Final answers

• (a) Free-market equilibrium: price $=$ $4.00 per kg, quantity $=$ 500 tonnes per month.
• (b) Surplus $=$ 200 tonnes per month, because the minimum price is set above equilibrium, raising quantity supplied and lowering quantity demanded.
• (c) Monthly cost of the buffer stock scheme $=$ $1,000,000.
• (d) Likely to help in the short run, but long-run success depends on the minimum price being close to equilibrium and on storage/disposal of the stockpile being manageable, otherwise the surplus and cost keep growing.