Tuesday, February 1, 2011

Do you have a sweet tooth? Find out why government policies and industry "rent-seeking" make it expensive for you to enjoy your vice...

Through a combination of Tariffs and Quotas, the supply of sugar coming from foreign sources to the US is less than what it would be without these market interventions.  The graph below shows the result of these policies on the price of sugar, domestically and internationally:
Source: Carpe Diem
You can see a significant difference between the World price and the USA price through time. Using a basic supply and demand graph,  we can analyze why this is so.

Let's just look at supply first. Below we have one supply curve for Domestic Supply  and one supply curve for Domestic Supply PLUS Imports.  At P* we see the Domestic Quantity Supplied is "QS1" (Point "A") and at P* we see the Domestic Quantity Supplied PLUS Imports is "QS2" (Point "B").

The amount of sugar imported at P* is QS2 minus QS1.  Now we must insert a Market Demand curve, "Demand*" that intersects "Supply 1 Domestic + Imports" at Point "B". This assumes NO tariffs or quotas on sugar. The market is relatively free to set the price world-wide. The price is re-labeled "Pworld".

Assume the worst case scenario--the Federal government imposes tariff and quotas to the point where NO sugar is imported into the US at all.  In the graph below we take away "S1 Domestic + Imports" curve from the graph above.  We are only left with the Domestic Supply curve "S*Domestic".

FREEZE!!! Assume the market does not immediately recognize what just happened and the market price STAYS at "Pworld". At "Pworld" the Domestic Quantity Supplied is "QS1" BUT the Quantity Demanded is still at "Qd1".  The Market QUANTITY SUPPLIED IS LESS THAN the Market QUANTITY DEMANDED. If we subtract QS1("A") from Qd1("B") we will find there is a SHORTAGE of sugar in the market:
How does a market solve a shortage? Look at the nice neat triangle formed between Points "A", "B", and a new Point "C".  The market inertia will be for the price to INCREASE.  The price increases and consumers DECREASE their quantity demanded at the higher price, move from Point "B" to Point "C" (Law of Demand) and suppliers INCREASE their quantity supplied at the higher price, move from Point "A" to Point "C" (Law of Supply).  Both sides of the market will MOVE ALONG there respective Demand and Supply curves until a new market equilibrium is achieved at Point "C":

At Point "C" we have a new domestic price for sugar, "Pdomestic" and a new market equilibrium "Q*":
The result is the US has LESS sugar at a HIGHER price. 

Using welfare analysis, consumers have lost some Consumer Surplus. This means consumers get to enjoy less sugar ("Qd1 minus Q*) at a lower price ("Pdomestic minus Pworld").  The graph below shows this area of lost Consumer Surplus:
Domestic producers of sugar gain some Producer Surplus--at a higher price, "Pdomestic minus Pworld", they increase their quantity supplied "Q*minus QS1". The area of additional Producer Surplus reaped by producers is shown in blue below:
However, the producer gain in surplus is actually a net loss for society.  The additional domestic resources, the difference between Q* and QS1, allocated to produce sugar could have been used for something else--OPPORTUNITY COST of producing sugar that we could have imported.  If we had imported readily available sugar from foreign sources, consumers (domestic producers of products that use sugar) could have consumed more sugar at a lower price AND domestic resources could have been freed up to produce something else. The area of Producer Surplus is the opportunity cost to society for not engaging in trade with the rest of the world.

On the other hand (famous Economist hedge)...MAYBE this is a GOOD thing overall!  Extra Credit on the next test if you can find the bright side to the policies of tariffs and quotas on sugar...
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