Saturday, 1 December 2012

Common Agricultural Policy Part 3 - Buffer Stocks

A tool at the EU's disposal within the CAP is buffer stocks. They can use these to either stabilise the prices of farm produce or to stabilise farmers income.

First case we'll analyse is the case of buffer stocks being used to stabilise prices of farm produce.

We have a market for a crop here, Q1 and P1 being the equilibrium quantity and price respectively. Lets assume one year there is a good harvest, supply increases to S1. We notice that this would create a fall in price, however as the policy is aiming to stabilise prices this isn't what we want. So, in order for this supply increase to come with stable prices, the governments need to buy up the difference between Q1 and Q2 and put them into buffer stocks. This means, the quantity available to the public is the original level of Q1, and therefore price won't change. 

Alternatively, if there is a bad harvest and supply falls to S2, a price rise would occur. The governments would have to intervene here and sell the difference between Q1 and Q3 to the market, releasing them from buffer stocks so the quantity available is the same and therefore the price remains stable. 

The areas on the diagram represent a few different things. Area a is an income that the farmers are guaranteed, even in the worst times. Area a + b is the normal income for a farmer, assuming that the harvest is a normal one. Area c is extra income the farmer would earn given a good harvest. Notice this policy of stabilising the farming prices has created more fluctuation in the farmers incomes, something the CAP aims to eradicate. Controversial.

Now, onto how buffer stocks can be used to stabilise a farms income. This involves using the elasticity formula. If elasticity of the good equals to 1, then the percentage increase in quantity is the same as the percentage fall in price. Therefore, if these are the same then the income of the farmer will remain constant. 

This diagram shows the principle of stabilising a farmers income using buffer stocks. We have an initial equilibrium of P1 and Q1, and supply increases because of a good harvest. This essentially means that a new equilibrium will be formed at P2 and Q2. However, at this point the farmers income has changed because demand doesn't have unitary elasticity. Therefore, the government needs to intervene. Using the curve above, we can see where the price and quantity should be for farmers income to remain stable: P2' and Q2'. So, what the government needs to do is buy up the difference between Q2 and Q2' and put them into buffer stocks. This means that the quantity now available will mean that price is at P2' and therefore farmers income will be stable. We can see this visually, the farmer has lost area c in terms of income due to the price fall,but gained area a + b due to the increase in quantity. These areas should be identical and therefore the farmers income has remained constant. 

This concept also works the other way if supply were to fall. Just in this case the governments would be releasing from the buffer stocks in order to regulate the price and quantity so that the farmers income remains stable. 

Buffer stocks is one method the government has to try and stop price fluctuations or income fluctuations, however it cannot be used to control both at the same time. Next up will be the use of subsidies for the same reasons. 


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