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4.7 How does interfering with price help to meet different government objectives?

4.7.1 Stability objective
4.7.2 Equity objective
4.7.3 Efficiency objective

Thus far we have examined some of the instruments of market, price and trade policies and shown how to quantify their effects. We will now discuss the extent to which government interference with prices helps meet different national objectives. The module will end with a brief discussion of practical issues concerning the implementation of trade, price and market policies.

In module 2, government objectives were classified under five major categories. Our discussion will focus on three of these categories: the stability objective; the equity objective and the efficiency objective.

4.7.1 Stability objective

Instability in the price and/or availability of major commodities and inputs may result from fluctuations in supply and demand on either the international or the domestic market. In both cases, there are sound arguments for stabilising domestic prices, since abrupt changes often have undesirable effects on income distribution and/or resource use. In addition, they play havoc with both national and individual planning.

However, a stabilisation policy which attempts to freeze prices at a certain level, when long- or medium-term trends in international supply and demand are moving them away from that level, will usually have undesirable effects on farmers' incomes, consumers' surplus and the government budget. A stabilisation policy which evens out extreme inter-year fluctuations but keeps the domestic price moving in the same direction as medium-term border price equivalents is probably the most sensible one.

If domestic production can only be increased at costs which exceed world market prices, price interventions geared to the promotion of self-sufficiency may be unwise. The pursuit of self-reliance (in the sense of fostering economic prosperity) will be a more cost-effective route to stable food availability.

Similarly, market, price and trade policies often aim to stimulate domestic production and/or discourage consumption in an attempt to save/earn foreign exchange and prevent foreign exchange crises. Such a strategy, however, cannot be easily defended. Balance of payment problems should be tackled through appropriate macro-economic policies, in particular exchange rate adjustment. Policies which distort individual markets decrease the international competitiveness of the economy and are therefore likely to lead to deterioration of the balance of payments in the long term.

Box 4.4: The case of Alphabeta.

Alphabeta has experienced a decline in price for several of its export commodities and a resulting deterioration in its balance of payments. One conceivable policy reaction would be to provide support for producers of those commodities in an attempt to raise the volume of exports to its previous level. To the extent that such producer support would eliminate existing negative protection, this would be a desirable policy response. However, expanding exports beyond the competitiveness of domestic producers on international markets would be inadvisable.

Heavy dependence on a few commodities for the generation of foreign exchange incurs a higher risk of economic instability (a sudden change in the economic fortunes of the country). Countries often attempt to overcome this problem by diversifying their export trade. This strategy may require a degree of protection for the production of new export commodities. Justification for this will depend on whether the direct welfare costs involved are less than the macro-economic benefits associated with greater foreign exchange stability.

4.7.2 Equity objective

Arguments in favour of interference are often based on equity criteria. Price distortion is justified on the grounds of income redistribution between and within the various groups of consumers and producers. Interventions will often be effective in achieving redistribution objectives of this nature, particularly when the proportion of producer or consumer income affected is large.

However, the problem is that market, price and trade interventions do not only affect the distribution of income. They also affect the structure of production and consumption. This, in turn, may have international trade and welfare implications. The desired effects of income redistribution must therefore be balanced against any negative welfare effects resulting from structural changes.

Moreover, income transfers resulting from market policies tend to be non-specific in terms of who benefits and who pays. For example, a general low-price policy for food benefits not only poor urban consumers (who may be the policy target group), but also consumers in other income classes who could afford to pay unsubsidised prices.

Sometimes it may be possible to avoid this non-specific policy effect by concentrating on commodities of particular importance for the target group (i.e. by implementing self-targeting policies). For example, if cassava is consumed largely by the poor, subsidising its consumer price is likely to have the desired effect. However, self-targeting policies are not always feasible

Regardless, it is always worth asking whether more cost-effective ways of achieving the same end are not open to government. In economic terms, alternative ways of affecting income distribution, without distorting the structure of production and consumption, may well be superior to interventions in the market place.

If direct transfers (in cash or kind) to the target group are feasible, they should be given preference over price policies. For example, food stamp or similar schemes for poor consumers are preferable to low-price food policies. A policy which works directly towards eradication of the cause(s) of poverty should be given priority over one which merely attacks the symptoms.

Direct income redistribution policies are not always easy to implement. Among other things, they may require substantial government expenditure, which may be difficult to finance.

Similarly, market policies are often implemented to increase government revenue (for example, through export taxes or low producer prices). Again, it must be emphasised that such measures often have negative side-effects, and these must be taken into account in any policy evaluation exercise.

Box 4.5: The case of Alphabeta.

Taxation through low producer prices often has negative effects on producer income distribution. Alphabeta's low-price policy for beef demonstrates this. Although herd size and sales levels are highly skewed, the policy affects both large and small producers. Direct taxation could instead be targeted towards larger producers, with more effective impact on income redistribution.

4.7.3 Efficiency objective

As far as economic efficiency is concerned, few arguments favour market intervention and price distortion. Where producers need incentives to embark on new enterprises, adopt new technology or enter the market, there may be a case for stimulating responses by offering price incentives. This is known as the infant industry argument for producer protection.

However, since policies of this nature tend to become entrenched, it is often difficult to abandon protection after achieving the initial purpose. The possible negative long-term consequences of such a policy must therefore be weighed against its short-term benefits.

Production may occasionally have pronounced positive or negative external effects which justify price intervention. For example, if there is overwhelming evidence that overgrazing is endangering the long-term sustainability of production in a particular area, there may be a case for lowering producer prices for animals raised there in order to reduce the incentive to keep so many.

In many cases, however, external effects do not result from production as such, but from a specific method of production or input use (this appears to apply to the problem of overgrazing). The appropriate policy response in such cases is to attack the root causes of the problem rather than some superficial or symptomatic aspect of the production system. For example, low market supplies of cattle may reflect the circumstances of a particular production system at a given point in time (e.g. the post-drought rebuilding of herds), rather than a deficiency in marketing infrastructure or in the price policy adopted.

A different issue, and indeed a difficult one, is the balance of protection offered to different sectors of the economy. In many African countries, the manufacturing sector is protected at the expense of the agricultural sector.

Box 4.6: The case of Alphabeta.

In Alphabeta, the protection of certain manufacturing industries penalises the agricultural sector. Resources have been attracted into the manufacturing sector, wages have increased and the terms of trade have moved against agriculture.

In such circumstances, the appropriate strategy would be to reduce distortion by decreasing protection for the manufacturing industry. Where this is not feasible, there may be a case for protecting agriculture in order to counter the effects of protecting industry. In this way, distortions in resource allocation can be balanced or redressed, but the number of policy measures multiplies, complicating the analysis.

Such a policy, known in economics as a second best policy, may well be justified, for the case against disadvantaging agriculture in developing countries is very strong. In the long run, however, an accumulation-of second best policies may make a return to best policy options increasingly difficult.

In considering alternatives to existing policies, the costs of using any additional administrative resources should be included in the analysis. Countries attempting to implement self-targeting policies may find themselves unable to do so because they lack the necessary institutional resources. Effective implementation of market, price and trade policies also depends on the existence of efficient institutions.

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