Minimum Support Prices and Inflation

Each party publishes a laundry list of big dreams it is trying to sell to the voters. Nevertheless, these manifestos are not just meaningless but also show the intellectual bankruptcy of our political parties.

Politicians are knowledge-proof. When it comes to basic principles of economics more so. I think it is less because of politicians lack intelligence but more so because the people themselves are not educated enough to understand basics of economics.

One of the good example is of minimum-support price for agricultural produce and inflation control. Both of them are contradictory but find a place side by side in BJP’s manifesto. A lot of people who have concern for farmer tend to support this “minimum support price” system which in reality helps absolutely no one including the farmer himself. This is not very hard to see. United States started giving minimum support prices to wheat during great depressions and as a results had to buy and burn few million tons of wheat while people on streets starved.

Prices is a good way through which market regulates itself. Suppliers tend to supply more at higher prices and less at lower prices. On the other hand, buyers tend to buy more at lower prices and less at higher prices. These two forces collide to reach an equilibrium. This equilibrium is extremely important simply because it ensures that resources flow to the institution who uses them most efficiently. Efficiency also means prosperity on the contrary inefficient use of resources means poverty. When government interferes with the prices determined by demand and supply it causes inefficiency and more of poverty, government than does more price controls to tackle these inefficiencies leading to more poverty.

The problem with minimum support price

When government decides to give minimum support price to an agricultural produce it means

1. If no one buys farmer’s produce at price > X government will buy it at price X.

In cases where no one is willing to buy this stuff at price X farmers rush to the government and government ends up buying large amount of food grains. Farmers might get a relatively good price here, but everyone else who depends on wheat is a real loser. This means bread bakery will not get any wheat unless it shells out X or more for the wheat. Which they will have to recover by increasing the prices of the bread. Once the prices of the wheat go up every poor person who eats bread either has to shell more money or eat less bread. This results into starvation and inflation. The market price of wheat is less than X also means that there are already very few buyers at price X and since government puts a floor on the price, the buyers even reduce further.

This can even be a disaster as it is already happening in India. For example North Indian plains grow ample of wheat. South India even though does not produce wheat consumes good amount of wheat. There is a strong incentive for the farmers in north to sell their wheat in south or any other place where it is expensive enough. Thus even though south does not produce wheat it continues to flow to the south simply because people in south are paying more.

If government decides to give a support price of X which is same or higher than what people in south are paying. Farmers in north India would simply sell all their wheat to government in north India. People in south India are then at the mercy of government to transport that wheat. In most cases government can not do so and it simply rots in the government godowns in India. Here is a real picture of a government godown.

This means that poor people in south India suffer even though there is enough wheat out there to feed them. The solution to the problem is not that government should transport that grains to South quickly. It wont, simply because there is 0 incentive for any one to do that. The solution is that simply stop buying grains for farmers in North and let them figure out where it is to be sold.

There are secondary effects of this as well. Wheat is also used in polymer industry. If the government sets a ceiling price it may also mean that the polymer industry too ends up buying wheat at higher price leading to lower output and losing an competitive edge in international market and as a results loses a potentially larger market for the future (and higher prices for farmers in future).

If the wheat is cheap it may happen that smart entrepreneur may setup a polymer factory to make use of this advantage. Evidence shows that in such cases the prices of the commodity see much higher levels than what it could have seen with government imposed price floor.

But is farmer helped?

But people would argue that the poor farmer is helped and will not commit suicide. (There are more people poorer than poorest of farmer but they do not commit suicide at higher rate, poverty to farming is probably special.)  The reality is opposite. Every penny that the farmer earns is taken away by others in the form of inflation. Of course government can subsidies everything to the poor farmer including food itself and put the financial burden on other tax payers. But it also means imposing a penalty on everyone who is not a farmer which also means a less competitive manufacturing sector, less competitive service sector lower profitability, lower salary for everyone else. Disgruntled businesses shut down or chose another country. It seems it is cheaper for Indian Refrigerator makers to ship all the raw material to Brazil, make parts there, assemble it in South Africa and sell it in India than manufacturing it in India itself.

The hard reality

Farmers in India have got insulated from the reality because of these government policies. But this is only temporary. For example India grows some of the very high water intensive crops such as rice. This is because of MSP as well as subsidized water supply. In the absence of MSP or water supply the farmers would have got forced to switch to a more water efficient crop or use water more efficiently. But it does not happen and out water tables go down at an alarming rate.

The land itself can be used for alternative uses. For example in Goa you can either run a paddy field or build a resort on it. Building a resort, a pub or even a holiday home is a very good alternative use of land in Goa. People in Sawantwadi do not have the luxury of thee alternative uses but Goans do simply because land in Goa is limited but Goa is a famous tourist destination. If government gives support price to agricultural produce, farmers might tend to keep their farm land into agriculture thus driving the land prices high and higher prices of flats, hotels and so on. Eventually, this additional cost would have to get recovered other services that Goans and tourists use daily.

All this trouble is created by actually wasting government money on inviting this trouble. I am pretty sure that for each additional 0.1% of goan land that gets NA (Non agricultural status) the prices of homes, hotels etc. go down by a little.

Unfortunately Goans are less likely to see. For a common man it is easier to blame a Delhite buying holiday homes in India and demanding some phony special status to the state where this sort of things would be banned. It is likely that in such case with unavailability of investment there will be actually less supply of homes than before with higher prices than now.




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