Introduction to Price Supports

The Impact of a Price Support on a Market Outcome

We can understand the impact of a price support more precisely by taking a look at a supply and demand diagram, as shown above. In a free market without any price support, the market equilibrium price would be P*, the market quantity sold would be Q*, and all of the output would be purchased by regular consumers. If a price support is put in place- let’s, for example, say that the government agrees to purchase output at price P*_PS- the market price would be P*_PS, the quantity produced (and equilibrium quantity sold) would be Q*_PS, and the amount purchased by regular consumers would be Q_D. This means, of course, that the government purchases the surplus, which quantitatively is the amount Q*_PS-Q_D.

The Impact of a Price Support on the Welfare of Society

In order to analyze the impact of a price support on society, let’s take a look at what happens to consumer surplus, producer surplus, and government expenditure when a price support is put in place. (Don’t forget the rules for finding consumer surplus and producer surplus graphically) In a free market, consumer surplus is given by A+B+D and producer surplus is given by C+E. In addition, government surplus is zero since the government doesn’t play a role in a free market. As a result, total surplus in a free market is equal to A+B+C+D+E.

(Don't forget that "consumer surplus" and "producer surplus," "government surplus," etc. are distinct from the concept of "surplus," which just refers to excess supply.)

The Impact of a Price Support on the Welfare of Society

With the price support in place, consumer surplus decreases to A, producer surplus increases to B+C+D+E+G, and government surplus is equal to negative D+E+F+G+H+I.

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By Jodi Beggs

Government Surplus Under a Price Support

Because surplus in this context is a measure of value that accrues to various parties, government revenue (where the government takes in money) counts as positive government surplus and government expenditure (where the government pays out money) counts as negative government surplus.  (This makes a bit more sense when you consider that government revenues are theoretically spent on things that benefit society.)

The amount that the government spends on the price support is equal to the size of the surplus (Q*_PS-Q_D) times the agreed-upon price of the output (P*_PS), so expenditure can be represented as the area of a rectangle with width Q*_PS-Q_D and height P*_PS.  Such a rectangle is indicated on the diagram above.

The Impact of a Price Support on the Welfare of Society

Overall, the total surplus generated by the market (i.e. the total amount of value created for society) decreases from A+B+C+D+E to A+B+C-F-H-I when the price support is put in place, meaning that the price support generates a deadweight loss of D+E+F+H+I. In essence, the government is paying to make producers better off and consumers worse off, and the losses to consumers and the government outweigh the gains to producers. It could even be the case that a price support costs the government more than producers gain- for example, it’s entirely possible that the government could spend $100 million on a price support that only makes producers $90 million better off.

Factors That Impact the Cost and Efficency of a Price Support

​How much a price support costs the government (and, by extension, how inefficient a price support is) is clearly determined by two factors- how high the price support is (specifically, how far above the market equilibrium price it is) and how much surplus output it generates. While the first consideration is an explicit policy choice, the second depends on the elasticities of supply and demand- the more elastic supply and demand are, the more surplus output will be generated and the more the price support will cost the government.

This is shown in the diagram above- the price support is the same distance above the equilibrium price in both cases, but the cost to the government is clearly larger (as shown by the shaded region, as discussed earlier) when supply and demand are more elastic. Put another way, price supports are more costly and inefficient when consumers and producers are more price sensitive.

Price Supports Versus Price Floors

In terms of market outcomes, a price support is pretty similar to a price floor; to see how, let's compare a price support and a price floor that result in the same price in a market. It's pretty clear that the price support and the price floor have the same (negative) impact on consumers. As far as producers are concerned, it's also pretty obvious that a price support is better than a price floor, since it's better to get paid for surplus output than to either have it sitting around unsold (if the market hasn't learned how to manage the surplus yet) or not produced in the first place.

In terms of efficiency, the price floor is less bad than the price support, assuming that the market has figured out how to coordinate in order to avoid repeatedly producing the surplus output (as is assumed above). The two policies would be more similar in terms of efficiency if the market was mistakenly producing the surplus output and disposing of it, however.

Why Do Price Supports Exist?

Given this discussion, it may seem surprising that price supports exist as a policy tool that gets taken seriously. That said, we see price supports all the time, most often on agricultural products- cheese, for example. Part of the explanation may just be that it's bad policy and a form of regulatory capture by producers and their associated lobbyists. Another explanation, however, is that temporary price supports (and hence temporary inefficiency) may result in a better long-run outcome than having producers go in and out of business due to varying market conditions. In fact, a price support can be defined such that it's not binding under normal economic conditions and only kicks in when demand is weaker than normal and would otherwise drive prices down and create insurmountable losses for producers. (That said, such a strategy would result in a double hit to consumer surplus.)

Where Does the Purchased Surplus Go?

One common question regarding price supports is where does all of the government-purchased surplus go? This distribution is a bit tricky since it would be inefficient to let the output go to waste, but it also can't be given to those who would have otherwise purchased it without creating an inefficiency feedback loop. Typically, the surplus is either distributed to poor households or is offered as humanitarian aid to developing countries. Unfortunately, this latter strategy is somewhat controversial, since the donated product often competes with the output of already struggling farmers in the developing countries. (One potential improvement would be to give the output to the farmers to sell, but this is far from typical and only partially solves the problem.)