NATIONAL LAW INSTITUTE UNIVERSITY

BHOPAL

ECONOMICS PROJECT
On
PRICE FLOOR:
MINIMUM SUPPORT PRICE and
INDIAN AGRICULTURE

Submitted to
Prof Rajesh Gautam
Submitted by
Kunal Sharma
2013 BALLB 63

Contents
PRICE FLOOR: A Brief Introduction..............................................................................3
Understanding The Principle:...................................................................................... 4
MARKET EQUILIBRIUM................................................................................................ 4
GOVERNMENTS ROLE AND FUNCTION........................................................................9
Minimum Support Price............................................................................................ 10
and The Indian Agriculture....................................................................................... 10
Effects of Price Floor................................................................................................. 12
Short Term Effects:................................................................................................ 12
Long term Effects:................................................................................................. 13
Review of Literature................................................................................................. 15
1.

Pulse of the nation....................................................................................... 15

2.

Price Floors for Emissions Trading................................................................15

3.

An economic analysis of Price dynamics in the presence of a Price floor:....16

The case of American Cheese............................................................................ 16

4.

Some variance effects of a floor price scheme for wool:..............................17

A two period analysis......................................................................................... 17

5. Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post
Marketing Permits or Ex Ante Production Contracts?.........................................18
Conclusion................................................................................................................ 19
Bibliography............................................................................................................. 20

PRICE FLOOR: A Brief Introduction

What is Price Floor? Price Floor or floor below which prices are not allowed to
fall is nothing but the lowest legal price that a commodity can be sold at. It is
an economic mechanism of price control used by the government of
countries to prevent prices from being too low so that fair prices for goods
are available to the sellers of such goods.
The underlying principle of Price Floor is the concept of Market Equilibrium.
For a price floor to be effective, it must be set above the equilibrium price. If
it's not above equilibrium, then the market won't sell below equilibrium and
the price floor will be irrelevant..
In a mixed socialist economy such as ours where the government steps in to
protect the interest of the people such Price flooring is very vital to facilitate
the welfare function of the government.
The most common price floor is the minimum wage--the minimum price that
can be paid for labour. Price floors are also used often in agriculture to try to
protect the farmers and Minimum Support Price (MSP) found throughout our
countrys Public Distribution Shops or Fair Price Shops.
Thus, through this study we will be able to understand Price Floor as a tool of
welfare economics in India, its uses and the principles on which it works on,
in a comprehensive and systematic manner.

Understanding The Principle:

MARKET EQUILIBRIUM
Broadly speaking, Equilibrium is a state of rest or balance due to the equal
action of opposing forces. In terms of Economics, Equilibrium Price is the
price toward which the invisible hand drives the market. At this point, the
upward and downward pressure on price is equal and the quantity demanded

equals the quantity supplied. The market mechanism naturally present in

most markets consists of these counterbalancing pressures. Equilibrium can
occur in all types of markets, but the commonly assumed model for its
occurrence is the perfectly competitive market. When a market is in
equilibrium, there is no excess supply or excess demand. Equilibrium
quantity is the amount bought and sold at the equilibrium price. It may be
understood by a simple table, known as a schedule (table 1), and a graph
(Fig 1):
Table 1
Price of Commodity
10
16.25
20

Quantity Supplied
25,000
37,500
45,000

Quantity Demanded
50,000
37,500
30,000

(Fig 1)

Explanation of the Schedule (table 1) and Graph (Fig 1):

In economics, we typically use a two-dimensional graph that has the price of
the good or service on the Y-axis (vertical axis) and the quantity that people
are willing and able to buy (or willing and able to sell) on the X-axis
(horizontal axis).
Each point on the graph represents the corresponding price and quantity
demanded. At Rs. 10, the producer produces 25,000 units of the commodity
as opposed to a demanded quantity of 50,000 thus showing a shortage of

supply. At Equilibrium price (which is Rs. 16.25 here), the quantity of goods
demanded is exactly equal to the quantity of goods supplied. While at Rs. 20
the quantity supplied is 45,000 units as opposed to a lesser quantity
demanded f 30,000 units which leads to an excess in supply.
To understand the Price Floor model, we must understand these two main
concepts regarding Market Equilibrium i.e. the creation of excess supply and
excess demand as explained by Fig 2:

(Fig 2)

Here (Fig 2) it can be seen that any price (P1) above the Equilibrium Price
(EP) leads to the creation of excess supply (the blue shaded region) whereas
at price (P2) below the Equilibrium Price (EP) excess demand is created or
there is a shortage in supply(as seen in the red shaded region).
Here we concern ourselves with the excess supply that is created as a result
of raising the price above the equilibrium price.
It may be noted that if the price is set below the Equilibrium Price it would be
ineffective as the price would be lower than the Equilibrium Price and thus
non-binding on the producers.

(Fig 3)
Here (Fig 3) the Price F is lower than the desired Equilibrium Price which is
the price at which maximum satisfaction to both consumers and producers in
a market is achieved. Therefore to be effective, the price must be set above
the Equilibrium Price. As mentioned earlier, at Equilibrium Price the quantity
of goods supplied and demand are exactly equal. When the price is set
above the Equilibrium Price, then there is a possibility that there will be an
excess supply or a surplus. If this happens, producers who can't foresee
trouble ahead will produce the larger quantity where the new price intersects
their supply curve. Unbeknownst to them, consumers will not buy that many
goods at the higher price and so those goods will go unsold. This is the
underlying principle of Price Floor. In this scenario the invisible hand of
market forces here will naturally drive the prices downwards in case of
excess supply to bring it back to the equilibrium price.
An example below showing both the Schedule (table 2) and Graph (Fig 4) of
the Price floor is given below.

Table 2
Price of Commodity
10
16.25
20

Quantity Supplied
25,000
37,500
45,000

Quantity Demanded
50,000
37,500
30,000

(Fig 4)
Here the price F (20) is above the equilibrium price (16.25) E because it is
supposed that the price E does not provide incentives to the farmers to
produce. Therefore to promote such production by farmers government
keeps the price at Price F. As a result of such pricing above the Equilibrium
Price E there as can be seen from the diagram (fig 4) is created, a surplus in
the market (as shown in the shaded region) as farmers expand their output
and supply.

GOVERNMENTS ROLE AND FUNCTION

The Indian economy is a Mixed Socialist economy i.e. while retaining the free
market feature, the government steps in to regulate and deregulate the
prices as and when it is required for the welfare of the people. The
government uses the economic tool of Price Control to carry out such
functions. Price Floors and Price Ceilings are such Price Controls, examples of
government intervention in the free market which changes the market
equilibrium. They each have reasons for using them. Price Ceilings are
maximum prices set by the government for particular goods and services
that they believe are being sold at too high of a price and thus consumers
need some help purchasing them. Price ceilings only become a problem
when they are set below the market equilibrium price. On the other hand,
Price Floors are minimum prices set by the government for certain
commodities and services that it believes are being sold in an unfair market
with too low of a price and thus their producers deserve some assistance.
Price floors are only an issue when they are set above the equilibrium price,
since they have no effect if they are set below market equilibrium price.
Here we discuss how the government in India plays a role in setting such
Price floors which play an important welfare function.

Minimum Support Price

and The Indian Agriculture
The Minimum Support Price (MSP) Scheme is a scheme of the Government
of India (GOI) to safeguard the interests of the farmers. Under this Scheme
the GOI declares the minimum support Prices of various agricultural
produces and assures the farmers that their agricultural produce will be
purchased at the MSP, thereby preventing its distress sale. The Food
Corporation of India (FCI) acts as the Nodal Agency of the GOI. The Minimum
Support Prices were announced by the government of India for the first time
in 1966-67 for Wheat in the wake of the Green Revolution and extended
harvest, to save the farmers from depleting profits. Since then, the MSP
regime has been expanded to many crops.
Currently, the MSP is announced by the Government of India for 25 crops at
the beginning of each season viz. Rabi and Kharif. The following are few of
the crops covered in the two seasons as shown in the following table.
Kharif Crops
Paddy
Jowar
Bajra
Maize
Cotton

Rabi Crops
Wheat
Barley
Gram
Masur (lentil)
Mustard

The market price can sometimes be so low that farmers cannot make enough
money to support themselves. In such cases, the government steps in and
sets a price floor. The rationale is that if there is a fall in the prices of the
crops, after a bumper harvest, the government purchases at the MSP and this is
the reason that the price cannot go below MSP. So this directly helps the
farmers.
The government decides the support prices for various agricultural
commodities after taking into account various recommendations of
Commission for Agricultural Costs and Prices, views of ministries and state
governments and other relevant factors.

10

(Notice that when the price is artificially raised above p*, the quantity
supplied exceeds the quantity demanded. Such a situation is called a
surplus: farmers produce many more crops than buyers want to buy at the
new, higher price.)

Effects of Price Floor

The argument for price floors is usually that the government has to protect
suppliers from having to sell their goods at an unfairly low price. They are
often meant to protect suppliers that are considered to be important because
they provide a necessity. However there are various short term and long

11

term effects of such Price floor which are considered by many as negative
effects on the economy.

Short Term Effects:

In the short run, a price floor will have no effect on the supply curve. Due to
the Price floor effect, consumers pay a higher price and decide to reduce
their purchases, while producers find they are guaranteed a higher price
than before and they raise production. This will increase the quantity
supplied if the price floor is binding, that is, the price is higher than the
market price. This causes surplus of the product and a deadweight loss.
Example: Lets say that the price of wheat is falling so the government
imposes a price floor on wheat at Rs 10/kg. If the market were left to itself,
wheat would eventually fall to Rs.8/kg. Once again it is clear that less wheat
is going to be bought at Rs.10 than at Rs.8 which means there will be a
chronic surplus of wheat. The excess would either spoil, be discarded, or be
purchased by the government. Producers who would go bankrupt if the price
were allowed to reach equilibrium would be able to remain in business
because of the artificially high price. Those producers would consider this to
be a benefit.

The benefit to producers of the price support is equal to the gain

in producer surplus (represented in blue).
The cost to consumers of the price support is equal to the loss
in consumer surplus (represented in red).
The cost to the government of the price support is equal to the cost of
the surplus in the market (represented in gray).

12

However, since the consumers ultimately pay taxes for the government to
purchase the surplus, the total cost to consumers (in the short run) of the
price support is the sum of the loss in consumer surplus and the cost of
the government purchasing the surplus off the market.

Long term Effects:

In the long run, a binding price floor will induce market entrance in perfectly
competitive markets, which will cause supply to increase -- this is
represented as an outward shift of the supply curve -- because firms will be
able to sell their product at above their average total cost, which creates an
economic profit. Since prices cannot fall, this means that economic profits
may not fall to normal, inducing continued firm entrance and ever-larger
surpluses, and this may make the price floor impossible to maintain in the
long run.
In the above mentioned example of the government setting a price floor for
wheat, the consumers who are paying more for wheat or buying less wheat
than they want would consider it a penalty. Producers would benefit by not
losing their jobs. The overall economy is penalized because people who
would otherwise have to produce something thats more in demand are able
to stay in an inefficient business. Similarly, when the government imposes a
minimum wage to provide a fair wage to workers the effects include higher
wages for some people along with unemployment (chronic surplus of workers
as businesses will hire fewer people due to the higher cost of labor),
bankruptcy of marginal producers, rise in prices. These are included as some
of the negative effects of such Price flooring in the long run.

13

Review of Literature
1. Pulse of the nation
Editor, The Hindu

The Editor, Business Line in his editorial article dated July 26, 2013 has
revealed the need for MSPs for pulses like gram, chana, etc. in the country.
He starts by emphasizing the fact that India being a chronic importer of
pulses has done well in the recent years in terms of domestic production but
highlights the grim fact that the prices are much lower than required there
being no adequate floor price set by the government for the same. Quoting
the recent price crash in Chana prices, he stresses that the government must
incentivise the farmers to grow more pulses as they have various nutritional
values (considering the nutrition deficiency in the country) and also functions
as a nitrogen fixer.
He is of the opinion that if this continues it will discourage farmers from
producing pulses. He urges the government to ensure that farmers get the
officially declared MSPs for the crop to be harvested a couple of months from
now. In the absence of physical procurement support, these MSPs have
meaning only on paper and the new National Food Security legislation may
aggravate this, given its sole focus on guaranteeing a minimum quantity of
cereals as a legal entitlement to two-thirds of the population. This will, in
turn, further skew our public resources and procurement efforts.

2. Price Floors for Emissions Trading

Peter John Wood and Frank Jotzo

Wood Peter and Jotzo Frank (2009) in their article Price Floors for Emissions
Trading have revealed the advantages of Price flooring for emission trading
and have given suggestions for the same on how the government can tackle
the issue at hand. They have discussed the advantages of price flooring for
emissions trading and implied that Price floors need to be carefully designed
to avoid budgetary liabilities, and to avoid barriers to international trade in
permits. They further argue that the most direct approach of a government
commitment to buy back permits at a threshold price is unlikely to be viable,
especially in the context of international permit trading, because it implies
large contingent budgetary liabilities but that an alternative approach of a
minimum reserve price for auctioned permit, could yield the desired effect,

14

but could be ineffective if the share of auctioning is small. They have used
various economic tools of research such as graphs, schedule and other
relevant data to support the same.
Concluding, price floors could fulfill an important supporting role in ensuring
effective and efficient climate change mitigation, they can be implemented
without compromising vital aspects of emissions trading, and their budgetary
properties may turn out to be highly attractive to governments.
3. An economic analysis of Price dynamics in the presence of a Price floor:
The case of American Cheese
Jean-Paul Chavas and Kwansoo Kim

Chavas Jean-Paul and Kim Kwansoo (2005) in their article An economic

analysis of Price dynamics in the presence of a Price floor: The case of
American Cheese have provided useful insights on price dynamics in the
presence of a government determined price floor. In the paper they have
provided an econometric analysis of the effects of Price floor on price
dynamics and price volatility. Focussing on the Price floor providing a
censoring mechanism to price determination, they have specified and
estimated two competing models with dynamic Tobit specification under time
varying volatility. In their economic analysis they have revealed three
important findings. First, they documented how the price support programme
contributed to reducing price volatility and secondly they uncovered
evidence that such volatility-reducing effects are much stronger in the short
run than the long run. Thirdly they have also found that even under the
market regime scenario the support price can have significant positive side
effects on long run expected prices. They have supported the study with
empirical evidence on the dynamics of American cheese prices and their
changing volatility.
Conclusively they have evaluated the welfare effects of changing the price
support level indicating that although lower support prices reduce taxpayer
cost and aggregate welfare loss, they might not improve the relative
economic efficiency of transferring income from consumers and taxpayers to
producers.
4. Some variance effects of a floor price scheme for wool:
A two period analysis
J.H. Duloy

15

Duloy J.H. (1964) in his article Some variance effects of a floor price
scheme for wool: A two period analysis has revealed that for complete
cycles, a floor price scheme cannot be expected to have any significant
effect upon the mean level of either growers income or of receipts from
commercial sales of, in this study, wool. He gives the reason that because
of the absolute magnitude of changes in both buying and selling periods,
a scheme may be expected to have a more substantial impact upon the
variance of both growers income and of receipts from commercial sales.
Hence concluding, because the variance of the income of the individual
wool grower is likely to be greatly influenced by changes in local
conditions leading to changes in output and by cost changes, any
reduction in the variance of the aggregate is likely to be far less important
at individual farm level. Any increase in the variance of receipts from
commercial sales, and hence of export received of wool sold is likely to
lead to an intensification of the severity of periodic balance of payment
crisis. For the income stream of individual woolgrower the impact of the
external effect may predominate, and a fortiori for the rest of the
economy.
5. Managing Quantity, Quality and Timing in Cane Sugar Production: Ex Post
Marketing Permits or Ex Ante Production Contracts?
Sandhyarani Patlolla

In this paper titled Managing Quantity, Quality and Timing in Cane Sugar
Production: Ex Post Marketing Permits or Ex Ante Production Contracts?
Patlolla Sandhyarani (2010) highlights the issue that Sugar processors must
comply with a floor price for cane, but gur and khandsari producers are
exempt from the floor price. Thus, any effect of the sugar processors choice
of procurement method on the incentives facing farmers will depend on the
expected cane price in these competing unregulated markets. She has
developed a theoretical model of the Andhra Pradesh cane procurement
market that incorporates the government-mandated floor price policy that
applies only to the cane used for sugar processing, and compared the
processors profits under the probabilistic ex post permit system and ex ante
production contracts.
The main conclusion is that ex post permits creates competition among the
farmers to increase cane quality that brings higher profits to the processor at
the expense of higher costs to the farmers. This hypothesis is tested and not
rejected using data

16

from a survey of 205 cane farmers.

Conclusion
It is apparent that instituting a price floor is economically unsound but
refraining from instituting one doesnt mean that everything would work out
optimally for everyone. Price floors have negative long-term economic
consequences. The effects arent always noticeable because the price floor
could be set at a level that is commensurate with the market minimum. In
those cases it is as if the floor doesnt exist. They are still sometimes enacted
because of their short-term effect. A price floor has the immediate effect of
increasing the profit of producers. Without a price floor, some people would
lose their jobs and they might not have the skills to quickly find a new one or
they may not get a fair price for their hard earned produce in the market due
to the various exploitations they face in the market by middlemen etc. The
object of setting a Price Floor by the government is driven by its welfare
motive to protect the interest of the class of people who are most
substantially affected by rising and lowering prices of commodities upon
which the very livelihood and life of such people exists. Thus ours being a
welfare state, we take along everyone in our stride to achieve greater
economic growth keeping every individuals own economic goals in mind.

17

Bibliography

Internet:
Wikipedia.com
Investopedia.com
economics.fundamentalfinance.com
Indiabudget.nic.in
Articles from:
o www.jstor.com
o Econpaper.repec.org
Books:
Modern Economic Theory: KK Dewett
Principles of Micro economics( vol 1): N. Gregory Mankiw