Extra notes from the revision session

1) Extract 3: outline the arguments against Soviet style central planning.

More important for us as students of Economics are the following statements:

1. Compared with the suggestion of German left wing politicians price controls are not targeted to the least well off.
2. It is seen as “a throwback to Soviet style central planning”.
3. It is the “widest reaching direct government intervention in the pricing system since central planning was abolished”.
4. Centralised controls are “not an appropriate way of dealing with food inflation”.

These points can be understood by referring to the role of the price mechanism. The price mechanism is the system by which changes in the relative prices of goods serve to allocate resources in a market economy. This is achieved through the three functions of the price mechanism:

1. The rationing function – Price rations the supply of goods and if it is not allowed to fulfil this function then some other mechanism must be used (eg first come, first served, or coupon rationing).
2. The signalling function – Rising prices signal the existence of excess demand for the product. If price is not allowed to fulfil this role then the excess demand will go unnoticed and will manifest itself in the form of black markets.
3. The incentive function – Higher prices leading to higher profits provide producers with an incentive to increase output. Price ceilings remove the incentive to increase output.

Conclusion: Price controls, even if imposed for the best of reasons, do not solve the problem and they undermine the price mechanism. The Russian government appears to justify price controls in terms of the abuse of monopoly power within the market (ie in terms of market failure), but the choice of this weapon will simply replace market failure by government failure. Remember, this is an example of the law of unintended consequences where even well intentioned policies can create more significant problems as they seek to solve others.

2) Long term supply of food. Ideally a supply response would come from the 450m small holders in developing countries. Why would this be desirable?

World food production needs to become less reliant upon large scale farms in America and Europe. Ideally a large part of the supply response would come from the world‟s 450m small holders in developing countries. Why would this be desirable?

1. Poverty reduction: Three quarters of those who get by on less than $1 per day live on small holdings in developing countries.

2. Environmental benefits: Small holders in developing economies manage a disproportionate share of the world‟s water and vegetation cover, so raising their productivity on existing land would be more environmentally friendly than cutting down the rain forest.

3. Returns on Investment: It would be easier to boost grain yields in Africa from two tones per hectare to four than it would be to raise yields in Europe from eight tones to ten. The opportunities are greater and the law of diminishing returns has not yet set in

3) Who are the winners and losers from higher food prices?

4) Outline the social consequences from a rise in food prices.

The social consequences of inflation refer to the impact of inflation, on various groups within society. This can be expressed in terms of a well known quotation: “When I first started working I used to dream of the day when I would be earning the salary that I’m starving on now” (Anon). We know that there are gainers and losers from inflation, and so it has the effect of producing an arbitrary redistribution of real income from:

1. lenders to borrowers (through a decline in the real value of debts).
2. savers to borrowers (through a decline in the real value of debts).
3. those on fixed incomes to those whose income rises ahead of inflation.
4. the private to the public sector (through fiscal drag).
5. non-union workers to those in strong trade unions (in terms of ability to secure wage increases).
6. the economically weak to the economically powerful.

Food inflation is especially harmful to those on the lowest income. Income elasticity of demand for food is low, so if we go down through the income levels we find that the proportion of income spent on food rises. We can deduce from the stimulus material that food inflation has outstripped inflation in general. There was a 40% increase in the price of butter in Germany (line 3 of paragraph 3) and yet the eurozone inflation rate was 2.1% rising to 2.6% and 3% (line 6 of paragraph 3). Consequently, food inflation is not only significantly higher than general inflation, but it impacts primarily on those sections of society that spend the highest proportion of their income on food, ie the less well off.

Combating Inflation

Paragraph 3 of the Introduction introduces us to four strategies designed to cope with the problem of food inflation. Two of the strategies can be dismissed quite quickly, but the remaining two strategies need more detailed attention - especially as they are the subject matter of Extract 3.

“German left wing politicians have called for an increase in welfare benefits so that people can cope with price rises”. This can be regarded as a coping strategy – it enables the less well off (ie the people who are hardest hit by food inflation) to cope with the problem. However, it merely masks the problem rather than tackling it and there is an opportunity cost involved. It is the equivalent of a pain-killer which deadens the pain but leaves the medical condition unchanged. The rise in welfare payments will benefit the less well off and, in this sense, it could be said to be targeted assistance. However, people other than benefit recipients derive no benefit from this measure and, in addition, might be adversely affected by a tax rise to pay for the higher level of benefits, or a shift in government priorities away from other programmes. Therefore, welfare benefits not only disguise the problem but redistribute income. The only positive aspect of the policy is that it is a targeted measure.

The introduction also refers to the use of interest rate policy to combat inflation (lines 14-15 of paragraph 3). We know that monetary policy, in the form of interest rate changes, are now the prime weapon in controlling inflation. But, this is inflation in general rather than food inflation. Food inflation is not caused by cost push or demand pull within the countries of Europe but, instead, is global. Food inflation is the result of global supply and demand and not just UK or EU supply and demand. If interest rate policy is used to combat an inflationary problem which is limited to food, then high interest rates will be inflicted on the economy as a whole. Not only would such measures be ineffective on global food prices, but also they would be damaging to the economy as a whole.

The implication that must be drawn from lines 14-15 is that the solution lies in microeconomic measures directed at the food market. Now we turn to Extract 3 which contrasts two such measures

5) Outline the factors contributing to the rise in food prices worldwide. (20 mks)

6) Evaluate carbon trading as a means of reducing pollution.

7) Explain, using a diagram, how carbon trading operates in principle and practice.

8) From extract 2 – why end the buffer stock system. Also (Jan 2009) why start it again?

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