In this video we will study buffer stock schemes.
By the end of this video you should be able to understand how buffer stock schemes work
and how to analyze them using a diagram.
Buffer stock schemes are designed to limit the impact of price volatility in the markets
for agricultural commodities.
The scheme essentially has two aims: (1) to protect the incomes of farmers and (2) to
protect consumers from high prices.
The government will purchase and store inventory during a good harvest, and release and sell
inventory when there is a poor harvest.
To see how they work, let’s see them in action on a diagram.
Given a market for an agricultural good such as tomatoes, the government will set a maximum
price at Pmax for what consumers should pay and a minimum at Pmin for what farmers should
receive.
The price of tomatoes, for instance, could fluctuate between these two prices and government
would not intervene.
Assume that supply is perfectly inelastic in a given time period, let’s say a year,
then supply could essentially range from Q1 to Q2 before the government would intervene.
At a supply level below Q1 the market price would be higher than the maximum price and
at a supply level greater than Q1 the price would be lower than the price minimum.
So what will the government do?
As long as the price is in this identified blue range, the government will not intervene.
However, suppose it has increased to S1, with a corresponding quantity of Q1.
Well now S1 intersects demand, or D, at the red point which corresponds to a price lower
than that guaranteed by the government to farmers.
Essentially, what the government will do is increase the demand for the product by purchasing
the excess supply that exists as demonstrated here by the distance between Q2 and Q1.
This increase in demand results in the minimum price being met.
Government purchases quantity Q2-Q1 thus increasing the market demand and maintaining the minimum
price for farmers.
The government purchases and stores the tomatoes to release during a poor harvest.
Suppose that happens in the following year and supply is limited to S1 with corresponding
quantity Q1.
The market price then rises higher than the price maximum, as indicated by the red circle.
The government then releases a quantity of tomatoes equivalent to the quantity Q2-Q3
thus increasing market supply to S3 and quantity Q3 which brings the market price back to the
maximum price and also raises revenue for the government.
The government has purchased tomatoes at a lower price and sells them at a higher price,
which should be profitable for the government.
However, there are a few key things to consider about this type of system.
Whilst the system sound great in theory, there are some very real issues regarding its implementation.
First, there are the costs associated with storage.
If the government is purchasing an agricultural commodity it also has to store it and this
can be quite costly for such large amounts of commodities.
Second, the government must have access to reliable information in order to set effective
price maximums and minimums.
Thirdly, it may promote inefficiency amongst farmers who are aware that they will have
their incomes protected.
There is less incentive to innovate and they also face less pressure from global commodity
suppliers.
If a minimum price is set, the government may need to enact protectionist measures against
cheaper foreign imported commodities to increase their price as well.
Fourth, in the case of tomatoes for example, they are a perishable commodity.
What would happen if there are a series of excellent harvests?
The government would have to continue to purchase tomatoes and potentially destroy them after
some time.
This could be argued to be a waste of tax payer money and is definitely economically
inefficient.
Fifth, to ensure these schemes are effective over the longer term, the government should
review supply and the prices set regularly to ensure they are not continuing to promote
inefficiencies.
By now you should have a better understanding of buffer stock schemes.
If you have any questions, leave a comment and let’s see if we can answer it together.
That’s us done for now and I will see you in the next one!