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Applied Economics Oz Assignment Solution
Free market refers to a market scenario that operates independently with the help of autonomous demand and supply. Depending on supply and demand situation price and quantity are determined in the market. The equilibrium price works as an invisible hand to adjust and reinstate equilibrium position. The government however often intervenes in the market intelligence with the objective of increasing welfare of the sellers or buyers’ group. Government settles the maximum and minimum price in the market. Setting a maximum price that is below the equilibrium price is called price ceiling while setting a minimum price that is above the equilibrium price is called price floor. Price floor is most commonly observed in case of agricultural product. The paper evaluates the imposed price floor on Australian wool.
For an agricultural commodity government intervenes a set a legal minimum price to ensure a certain income to the farmers. An example of implementation of such reserve or floor price is what happened to the Australian wool industry. The scheme of wool reserve was started since 1970. The policy of price floor though ensures a high price for producers of wool, there are other consequences of the policy as well that distorts the market. The side effect of price floor exceeds that of its welfare consequences (Ville & Merrett 2016, pp.337-352). Hence, Australian government should abandon the such intervening policy and let the industry free to operate subject to demand and supply situation. Given below are the three reasons in support of free market environment in the wool industry.
Reason 1: Price floor and market distortion
Any form of price intervention in the market drives away prices from the position of market equilibrium. There are some people who win while others lose. In the context of overall economy, there is a loss in terms of economic surplus. In Australia, government initiated a policy of setting a reserve price of wool (abs.gov.au 2018). This policy indicates that even if market forces drag price down the reserve price, producers of wool would still get the higher reserve price. Whenever market price exceeds the reserve price, the producers would receive market price. The objective was to safeguard the producers from any dramatic drop in prices.
The Australian government established the Australian Wool Corporation (AWC) in order to purchase wool from the producers if the market was below the reserve price. The Corporation sells the excess wool back to the market when price recovered. The policy worked successfully for almost 20 years (Dragusanu, Giovannucci & Nunn 2014, pp.217-36). Producers of wool enjoyed considerably high price whenever market price slipped below the reserve price.
Failure of the policy arose due to the fact that government did not consider associated other consequences of reserve or floor price (Miller & Rose 2017 pp. 191-224). Henceforth, the scheme of reserve price led to a terrible consequence. This can be understood in terms of following demand and supply model.
Figure 1: Consequences of price floor
Under normal circumstances, price of wool settles at P0. This is where supply and demand curve meet. Corresponding to the market equilibrium producers supply quantity of Q0 in the market. Now consider, the reserve price is set at P1. At the reserve price is above equilibrium, it is an example of binding price floor. At the reserve price, supply of wool exceeds that of the demand. Supply is indicated as Q1S while demand is at Q1D. The excess wool has to be bought by AWC (Bond & Goldstein 2015). The excess quantity that AWC need to purchase from farmers is (Q1S - Q1D).
A significant problem arose when demand for wool started to decline. Despite decrease in demand, government did not reduce the reserve price. The continuous purchase of wool resulted in huge buffer stock for AWC. Purchase and maintenance of such a large buffer stock cost the government a lot. The increased price exerts huge pressure on general consumer and producers of wool in the form of heavy burden of tax.
Reason 2: Supply and Demand: Crisis in the wool industry
The artificially higher price was proven disastrous on its own way. The higher wool price instigates the wool producers to supply more wool in the market. Buyers on the other hand facing high price lowered their demand. The supply from wool producers reached far beyond that would be supplied in the free market condition (Griffith & Watson 2016, pp.594-609). Buyers of wool on the other hand adjusted their supply and demand by reducing their demand for wool and switching to other substitute textile. Mismatch in the supply and demand condition ended with a large stockpile of wool that remain unsold in the market.
The industry then has to borrow a large sum of money to pay the inflated price for its own industry’s produce. The interest cost, cost of shed and storage exert huge cost burden on AWC. The government however continues this policy with the hope that price would increases in future. The sensible way to escape the cost burden was to abandon the scheme of reserve price. Instead of doing that, AWC went to the decision of taxing the wool producers (Day 2016, p.1). This was expected to lower the wool production and helped to match supply with demand. The likely outcome of this policy has been illustrated below.
Figure 2: Effect of tax in the wool market
In this situation the buyers of wool are still charged a reserve price (above the equilibrium) and therefore their demand remained unchanged. However, after the tax producers received much lower price (Maxwell 2018, p.11). This leads to a decline in wool production to match the existing demand.
The taxation policy however worsens the situation further instead to doing any well-being. This explains the fallacy of the policy and underlying rationale. Supporters of the policy argued shortage in the demand could be met by market promotion. With this faith, government spent a large portion of tax on it (Abbott 2015, pp.87-106). In the long run, the policy however turned out to be disastrous. The policy experience pointed towards an unjustified faith of government and policy makers to intervene the wool market.
Reason 3: Political fallacy of the reserve price scheme
An important factor responsible for turning situation in the wool market worse unwillingness of the policy makers to confess their mistakes associated with the reserve price scheme. The delayed in shutting down such policy which highly escalated the cost burden. Australian government latter used its political power to force AWC to lower wool price (Sheng et al. 2017, pp. S169-S193). Following the scheme, producers, processors and traders of wool and common Australian tax payers suffered a huge lose. The estimated total cost was nearly $12 billion and can be even more. The policy thus considered as the largest corporate disaster in the history of Australia.
The reserve price scheme is a policy that aims to set a minimum binding price in the market. The objective though is to benefits the producers but it is not free from associated cost. The paper discusses disastrous effect of implementing a price floor in Australian wool industry. The immediate impact of reserve price scheme is to create a surplus in the market. In order to make such policy successful government needs to stand there to purchase the surplus. For Australian wool industry, it was the responsibility of AWC to purchase the excess wool. The storage and maintenance of piled up wools imposed a huge cost on government. It then decided to tax the wool producers to reduce the cost. The policy of taxation even worsens the condition. It is therefore efficient to leave the free market to operate in its own way.
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