Question

I like to ask this question each year. To provide you with some color, consider in answering that right now the federal government purchases one in every five gallons of milk sold in the U.S. and that it is illegal for sellers to sell milk to me and you below a mandated minimum price (note that some other industries have wholesalers and retailers execute these arrangements voluntarily – it happened to us when we were selling Titleist Pro-V1 golf balls when they first hit the market over a decade ago). Furthermore, as if the milk market isn’t curdled enough, we restrict how much foreign dairy comes into the US and we then place tariffs on the stuff that does come in.

The following question has several subsections:

1. Suppose we have a completely free market for milk, with buyers and sellers free to produce and consume milk according to their own interests. Illustrate the total welfare and consumer and producer surpluses in the market for milk. Assume the market clearing price is $2.00.

2. Now suppose the government steps in and wishes to support struggling milk farmers by imposing a minimum milk price rule. Whereas milk sold for $2 per gallon in part (a), the new rule stipulates that no milk can be sold below a price of $3. Illustrate the new equilibrium in this market. Show the new consumer and producer surpluses and total welfare. Compare your answer to that in part (a). Is this program a good idea from an economic standpoint? Briefly explain where the losses come from. (for the sake of this problem, assume that all farmers rent all of their land 100% outright, but that land prices remain unchanged)

3. Suppose now that the government understands the extra costs implied by the solution in (b). As a result, they assume a program of purchasing all of the milk that consumers demand (the government buys at the mandated price) and then requires that consumers purchase a milk-ticket from the government which consumers must purchase (from the government) along with their milk directly from the government (the government will only issue as many milk tickets as are required to not force the government to purchase and dispose of any excess milk). Describe the equilibrium under this program. Illustrate the price(s) of milk, how much the milk-tickets will sell for, the consumer surplus, the producer surplus and the welfare from the program. Compare this welfare with your answer in part b. What is different?

4. Instead of the program in part c, assume the government imposes the price floor and then does nothing. However, all farmers rent their land from other landowners and now real estate prices adjust instantaneously. In other words, if something decreases the value of land, prices fall immediately, and if something increases the value of land, prices rise immediately. Show the new consumer and producer surpluses and total welfare. Compare your answer to that in part (a) and part (b) and part (c).

5. Think back to question (d). Describe what happens if the farmers are also the landowners. Can you think about when farmers would prefer this outcome to the one described in part a?

Answer 1

Answer (a): In a free market economy, the buyers and sellers are usually under no restriction and the price in the market is determined by the demand and supply functions. There is no external pressure of taxation or any restraint on the seller or on the buyer. IN a free market economy, both the buyer and the seller set up their optimal price and optimal demand respectively. Since the market clearing price or other words, the equilibrium price is $2, it means that at $2 , the producers surplus is optima, and so is the consumers surplus. The total welfare is also maximum at this price. At anything lesser or more than $2, the total welfare will decline as the welfare of either of the producers or the consumers will fall with the other party’s welfare rising.

Answer (b): With the imposition of the minimum milk price rule to $3 per gallon, the producer surplus will increase, as there is a 50% rise in the revenue that they would now be earning. Their surplus will be extra normal. Whereas, the consumers surplus will decline, as the consumer is now having to pay 50% more than what he needed to pay earlier. This will reduce the total surplus or welfare in the economy. Such an idea is good from the economic standpoint, as it is aimed at supporting the poor milk farmers, who manage their livelihood on the basis of their earnings from the selling of milk. However, it is important to note here that milk is an essential commodity and that the consumer will also want to buy it at any cost. Therefore, the sudden huge rate of price increase is not recommended. The rise in prices should be at a very minimal rate, which does not upset the equilibrium in the market, and also maintains the surplus of both the producers and the consumers.

Answer (C): The step taken by the Government, wherein the Government will buy all the required milk from the producers and the consumers will in turn buy the milk from the Government, does not make any substantial difference in the consumers surplus from the point of view of the consumer. The consumer is still having to the same 50% increased price for each gallon of milk. The only difference is that now the government is acting as a medium. However, from the producer’s point of view, there would be some benefit, as the producer will now not require caring about the selling of the milk, or worry about their loss, as the government will anyway buy the milk. We can assume here, that there will be a slight increase in the surplus of the producers.

Answer (d): Since the Government does nothing after fixing the price ceiling, the minimum price at which the consumer can buy a gallon of milk is $3. Now, since the milk farmers have rented their land from other land owners, the price of the land changes exogenously, and the shift I the price of land fluctuates the price of milk too. In this situation, the producer is in a better state of surplus. This is because, with the increase in the price of land, the price of milk increases highly, which is born by the consumer, however, with the decrease in the price of land, the price of milk cannot decrease below the standard $3. Therefore, the producer surplus remains all time beneficial, whereas the consumer surplus is very meager.

Answer (e): If the farmers are themselves the land owners, this would mean that the farmers are themselves able to generate and preserve all the benefits of the rise in the prices of land, and even when there is a dip in the land price, the farmer is never at a loss, as there is a price ceiling forced by the Government on the consumers. Therefore, the producer’s surplus is maximum in this scenario, whereas, the consumers are the recipients of the total negative surplus in the economy. The consumers are having to bear all the burden of the increase in the prices of land and are experiencing negative surplus from their transaction.