Price Support

Wouldn't it be nice if you received at least 90% on all of your schoolwork, even if you missed quite a few points? The professor told you that regardless of how well your paper is written if they give you their study guide, your score will be 90%. Once written, you can hand the paper in for a guaranteed 90%. If you think it deserves better than 90%, you can hand it into a different professor, who will give you more than the 90%, but you'll have to pay the first professor $20 for using their study guide.

That is sort of how price supports work, except with minimum prices rather than grades. If you want to be sure you understand, keep reading!

Price Supports Definition

The definition of price supports is prices that the government sets and maintains by buying surplus goods. To be effective, price supports must be set above the market equilibrium price of the good in question, otherwise, there would be no need to set a minimum price.

Price supports work to guarantee a producer a minimum price for their goods. To keep the prices of goods high and maintain the profits of producers, the government's solution was to buy up enough of the goods in the market to put upward pressure on the price. If the equilibrium price of a good is $5 for 10 units, but the government would rather the price be $8 for 10 units, they would buy enough of the good to create a shortage in the market. This shortage would then force prices to rise.

Price supports are generally seen as helpful to the producers of the goods because they guarantee them higher profits. However, higher prices that are good for producers are usually not good for the consumers that have to pay them.

Minimum Support Price

The minimum support price (MSP) is the lowest price to which the market can fall without the government intervening. It can be seen as a subsidy to make the production of a wider variety of products more attractive. This works by having the government announce the MSP for a good prior to production. Then, the producers will know the minimum profit they can make off of the good. When the good is ready to be sold, if the market price is higher than the MSP, the producer will sell at the market price. If it is lower than the MSP, the producer will sell to the government instead and collect the MSP.

Price Support vs Price Floor

There are several differences between a price support vs a price floor. A price support is similar to a price floor in that it creates a minimum price level for the market. A price floor is a lower bound for the price of a good below which it cannot be legally priced.

A price support is not a lower limit on the market like the price floor is. The price floor actually prevents the market price from dropping below the set price, where the price support is only a benchmark. Once the benchmark is passed, the government will bridge the gap by giving the producer the MSP.

Another difference between price supports and price floors is who has to deal with the repercussions of implementing these policies. Both price floors and price supports create an overproduction of goods in the market. This overproduction, or surplus of goods, creates the issue of what to do with these excess goods that cannot be sold at a lower price due to the price floor or price support. With a price floor, the extra goods are the problem of the producer. The government mandated the price floor and expects the supplier to adjust their behavior. With price supports, the government has promised the producer to buy the goods at the support price, making the goods the property of the government and thus the burden of what to do with the goods rests with the government.

Effect of Price Support on a Market

The effect of price support on a market is that it raises prices, creates a surplus, and increases producer surplus. Price supports can take different forms depending on the government's policy. A government can either choose to enforce a production quota on producers or it can incentivize them to reduce their production. But first, let's look at the effect a price support, in general, has on the market.

In Figure 1, the price support is set above the equilibrium at P_s which means that the entire market price has increased. At this price on demand curve D, the quantity demanded by the consumer is reduced to Q₁ from Q_e, but at that price, the supplier wants to produce at Q₂ since it is so profitable. This results in the shaded area F, which represents a surplus of goods in the market. To deal with this surplus and make up for the difference between Q₁ and Q₂, the government will buy quantity Q_G from the supplier, which shifts the demand curve to the right, to D+Q_G. D+Q_G is demand plus the quantity that the government buys (Q_G).

With these goods, the government can either hold on to them, destroy them, or donate them. The first two options are usually frowned upon since they are so wasteful and there are people that are in need of the goods. The third is the most viable, but it is also difficult to turn it into reality due to the logistical difficulty.

As you can see, after the price support is implemented, the gain for producers areas B, C, and F, while the loss for consumers is areas B and C. Such a large producer surplus indicates that it is profitable to produce at that price since so many producers are willing to produce, however, the loss for consumers tells us that there are fewer consumers willing and able to buy at such a high price.

An alternative to the government buying the goods and having to figure out what to do with them is providing an incentive to reduce production. For example, the government will pay farmers to not farm a portion of their land. They will pay producers to reduce production or not produce at all. They can also set a production quota that restricts the amount of a good that a producer can bring to the market.

Benefits from Price Supports

The benefits from price supports are mostly felt by the producers in the market. The producers are the ones who enjoy the higher prices and a guaranteed sale to the government. Because the government's demand is the difference between what the consumers demand and the quantity supplied, the producers can manufacture as much of the good as they want at that higher support price. The government buys this quantity to maintain the price support and keep it above the market equilibrium price.

The government wants to keep producers in business because of what it means for the economy. If prices fall so low that manufacturers can not afford to keep going, they will have to shut down. This costs workers their jobs, and then they cannot pay their rent and consume which is again bad for businesses, and so on.

Price Supports: Drawbacks

While price supports are good for the producer, overall social welfare usually suffers. Consumers have to find a way to cope with the higher prices and the government must cope with all the excess inventory it is buying. Also, much of the government's revenue comes from taxes. Consumers pay those taxes so in a way, what the government pays the producers essentially comes out of the consumer's pocket.

Fig. 2 - Welfare Cost of Price Supports to Society

Figure 2 shows the cost of price supports to society. The cost to the government is shown by the shaded areas in Figure 2. The cost to society as a whole is the shaded areas less the area of the triangle formed by the three pink dots, which is the part of the increase in producer surplus that is not canceled by the decrease in consumer surplus.

Price Support Examples

The biggest price support example is the agricultural industry in the US. Since the 1930s, US farmers have benefitted from agricultural price supports that have allowed them to continue to produce the US's food supply and then some. The price supports are applied to goods like corn, soybeans, wheat, and rice.¹ The government will set the support price for these agricultural goods before the farmers plant their fields so that they know what they can plant that will generate a profit.

If a farmer does not have the funds to plant and maintain their crop through to harvest, the government can issue the farmer a non-recourse loan. This is a loan where the holder is not punished for not paying the loan back. The crops that the farmer yields are the collateral for the loan. The size of the loan is determined by how much the farmer is theoretically able to produce and how much it would sell for at the support price. The farmer then takes these funds to farm their fields and can then give the crops to the government and not pay back the loan or if they can score a higher price for their goods on the market, they can sell the goods there, pay back the loan, and keep the difference. Regardless of how the farmer finds their production level, they know they will be able to sell their crops at the support price.

Sometimes, the government will pay farmers to not cultivate their fields in order to reduce production but still generate a profit for the farmer, or whoever owns the land. This is a form of production quota. These unused fields are referred to as land banks and are a solution to the problem of overproduction and wasting crops.