The optimal approach for subsidization

The major Chinese policy actions employed by the national government, discussed in before, cover producer support measures, general services and consumer support measures. In turn, producer support measures cover both domestic and trade policy measures.

Regarding the food price subsidies, since 1992, China has paid subsidies to urban consumers to offset the price increases of food products.^c Although some of the subsidies are still paid, there has been a significant decline in the level of budgetary expenditure on them.

84  Figure 17: Comparison of different type of prices for Wheat, 1990 - 2003

Protective prices were prices set by the government, at which the state guaranteed to purchase all output of specific commodities offered for sale to the state. The protective prices were generally above the market price (except for soybean). There were two major problems with the implementation of this measure. First, the SGEs were expected to undertake state procurement at protective prices and to operate as a commercial enterprise marketing grains at a profit. It is reported that many SGEs sought to depress prices paid to producers or even rejected purchases of grains they believed could not be easily on-sold–profit-seeking behavior not in accordance with the income supporting aims of state procurement at guaranteed prices.

Second, budgetary constraints for many sub-national governments in major grain producing regions resulted in the policy being under-funded; payment for state purchased grains could not always be made in cash or in a timely manner.

Conversely, for wheat, domestic prices were lower than the international indicator price, suggesting that domestic and trade policies prevented farmers from receiving as good a return on their wheat crop as was possible on world markets. Benefits from this subsidy may accrue indirectly to the majority of farmers through reduced costs faced by farm service providers, such as harvesting companies.

85  In the beginning of this period, government applied a subsidy that was designed to ameliorate the impact of the food price increases, rather than calculated to fully offset the additional food costs faced by individual urban consumers. Following the initiation of the subsidy, each subsequent food price rise entailed an associated subsidy level increase. The subsidized food prices could be expected to increase the quantity of food demanded, thus increasing prices further, and potentially contributing to an inflationary spiral.

Table 2: China’s crop variables and prices for wheat, 1993-2007

Year Harvested

2007 23,721,075 46,076 4,100,004 258.40 340.02 2006 23,613,067 45,934 4,130,004 220.02 204.34 2005 22,792,462 42,753 4,600,004 165.10 168.21 2004 21,626,074 42,519 4,800,003 165.55 151.22 2003 21,997,075 39,318 4,500,004 186.63 149.36 2002 23,908,072 37,765 4,400,004 127.58 138.37 2001 24,664,068 38,060 4,800,004 126.86 119.54 2000 26,653,326 37,382 5,000,004 118.26 105.39 1999 28,855,019 39,466 5,100,002 144.48 113.08 1998 29,775,167 36,851 5,050,001 162.58 136.19 1997 30,057,020 41,018 5,200,001 169.49 179.15 1996 29,611,057 37,340 5,100,001 189.80 201.81 1995 28,861,315 35,414 5,120,003 173.03 145.97 1994 28,981,966 34,263 4,900,078 126.00 132.27 1993 30,236,410 35,187 5,100,081 123.92 134.75

AGGREGATE 395,353,173 589,346 71,900,198 2457.7 2419.67

AVERAGE 26,356,878 39,290 4,793,347 163.85 161.31

Source: FAO

As for other transition or developing economies, the results have to be interpreted carefully bearing in mind recognized limitations with respect to policy and commodity coverage, and data availability. In addition, the macroeconomic and institutional framework within which agricultural policy measures have been applied may have an impact on the

86  results. Thus, the market price support(MPS) element may capture the effects not only of agricultural policies as such, but also macroeconomic policies (in particular through the exchange rate) and of imperfect price transmission from the border to the farm gate level.

Nonetheless, other aspects such as a long-lasting inefficient downstream sector, a large share of agricultural production consumed on farms, not strong price transmission compared to grown-up market economies, and data collection systems covering behind the changes in the economy, may distort the measured level of support.

Figure 18: Chinese % PSE by commodity, average 2000-2003

Figure 19: Distribution of producer support by commodity, 2000 – 2003 average

87  6.4. Data Analysis

Before enter in the analysis itself, is important to remark that in this sense, the whole thesis proposal is a conceptual model, which involve political, economical and econometric measures. In this sense there are some basic assumptions that make the model feasible and logic to work. These are as follow:

9 The market prices are set under the supply and demand economic model of price determination in a market. Logically, China’s wheat market is a competitive market, and price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium (partial or general) of price and quantity.

9 Eventually, there are no trade barriers for commerce. Despite the fact that is something relatively uncompleted now, the tendency in following years and according to WTO regulations for the future will be minimized to 0.

9 The conceptual model itself, work under classic economic principles, but it’s relevance relies in how a pure business concept itself (in this case revenue management) can be applied in governmental policies decision in order to increase its economic welfare and promote low costumer prices and guarantee food security in benefit of general population.

From all data presented, and in order to find the optimal price under the basic pricing approach, the data output was to find the price response curve in term of the willingness to pay (w.t.p.) and under the assumption that all potential demand (D) will be targeted between the maximum price (world price or producer price) and the minimum possible (world price or producer price) depending on the year’s tendency analyzed to apply a subsidize, but theoretically between the maximum price in the market (world or domestic) and 0.

88  Table 3: Price Gap, consumption, sensitivity and elasticity, 1993-2007

Year Price Gap 2002 10.79 (2,191,785) (203,131,140) 0.01845 138.37 2001 (7.32) (921,993) 125,955,328 0.00610 126.86

In this sense, it’s important to remark the tendency of wheat which compared with other crops tends to be very volatile, but never the less, in terms of the relative production amount, demand and change regarding the change in prices, relatively inelastic.

How can this be interpreted? Well, demand is so big and usually cannot be fulfilled with domestic production, but on the other hand, each farmer’s production (no matter how big is) cannot influence in the prices established by the market, that means, wheat as a commodity is offered according the market price, cause it’s demand is almost equal to the entire market.

Buyers are totally indifferent among the offerings of different sellers, and among them there is a perfect knowledge about all prices being offered, and they will buy the product only from the lowest price seller.

89  The seller as mentioned before is relative small to the total size of the market. In this scenario, has no pricing decision –his price is set by the operation of the larger market.

Quoting a popular text inside pricing and revenue optimization (Phillips, R., 2005, 39 pp.) “In a competitive market, each firm only has to worry about how much output it wants to produce.

Whatever it produces can only be sold at one price: the going market price.”^o

Under this assumptions is possible to elaborate the so called curves and find the optimal price with an incremental cost (marginal cost) set by the cost of produce one unit (in this case tone) in that year:

Table 4: China’s price response curves, incremental cost & margin for wheat, 1993-2007

Year D (tonnes) Slope Price Response Curve d(P)

Incremental Cost (USD/tonne)

Margin (USD/tonne)

2007 105,633,866,000 310,669,566 105633866000 - 310669566P 140.42 199.60

2006 104,254,259,000 473,839,919 104254259000 - 473839919P 141.99 78.03

2005 105,143,982,000 625,075,691 105143982000 - 625075691P 142.53 25.68

2004 105,224,849,000 635,607,665 105224849000 - 635607665P 143.60 21.95

2003 108,087,305,000 579,152,896 108087305000 - 579152896P 137.95 48.68

2002 109,844,131,000 793,843,543 109844131000 - 793843543P 138.01 0.36

2001 112,035,916,000 883,146,114 112035916000 - 883146114P 138.87 -12.01

2000 112,957,909,000 955,165,813 112957909000 - 955165813P 141.89 -23.63

1999 113,679,686,000 786,819,532 113679686000 - 786819532P 146.26 -1.78

1998 113,896,196,000 700,554,779 113896196000 - 700554779P 147.10 15.48

1997 113,960,844,000 636,119,699 113960844000 - 636119699P 148.14 31.01

1996 113,433,186,000 562,079,114 113433186000 - 562079114P 147.66 54.15

1995 113,818,329,000 657,795,348 113818329000 - 657795348P 147.10 25.93

1994 112,354,733,000 849,434,740 112354733000 - 849434740P 147.50 -15.23

1993 112,345,914,000 833,735,911 112345914000 - 833735911P 147.92 -13.17

Source: FAO

Finally, all the data processed and after make the mathematical procedures to find the intended variable, is possible to find the optimal price sustained in the price response curve and willingness to pay for each year, which in the case is less then both prices (world and

90  producer price) the subsidy is not necessary to apply cause high market prices “pull” the enough the world or producer price to exceed the optimal. In this sense, the amount of subsidy encountered (which theoretically is negative) can be applied from producer as investment in their own infrastructure or research to boost production in their crop’s techniques.

Table 5: Optimal price, price gap with the market price and subsidy to apply

Year P*

(USD/tonne)

Price gap (USD/tonne)

Producer

price World price Subsidy (USD)

Change in Trade Balance 2007 240.22 (18.18) 258.40 340.02 (1,986,796,383.44) -0.15 2006 181.00 (23.34) 220.02 204.34 (2,531,183,343.43) 1.80 2005 155.37 (9.73) 165.10 168.21 (947,938,650.02) -0.74 2004 154.57 3.35 165.55 151.22 308,359,070.09 -2.77 1997 163.64 (5.85) 169.49 179.15 (720,872,142.78) 0.50 1996 174.73 (15.07) 189.80 201.81 (1,665,898,411.74) 0.83 1995 160.06 14.09 173.03 145.97 1,440,589,488.81 5.91 1994 139.88 13.88 126.00 132.27 1,378,684,294.40 0.75 1993 141.33 17.41 123.92 134.75 1,852,689,192.06 -45.92

Source: FAO

So according to the results presented, inside the conceptual model, the continuing process of global integration carries with it implications for farmers and the related supplying and processing industries in many parts of the world, and impacts the world economy. An assessment of agricultural and trade policy impacts is bound to be complex and is often supported by quantitative policy analyses. The development of global models is now well established and has become an integrated part of world economies and world economic reviews.

91  Partial models consider the agricultural system to be a closed system without linkages to the rest of the economy. Exogenous variables are used to capture the effects of the rest of the domestic and world economy. Supply and demand relationships are represented by means of behavioral equations, which are used to estimate the parameters of the independent variables.

This single conceptual model implies that demand and supply interrelationships among agricultural products are captured. These partial equilibrium models are commonly applied to detailed trade policy analysis for a specific product. According to neo-classic theory, the producer is assumed to be a maximizer of profit or net returns, which are subject to some technical and institutional constraints. In this regard, economic theory suggests that the supply of products to the next highest level of the market channel depends on the expected profits accruing to the decision maker.

The government’s production plan as the producer’s technical constraints define the physical relationship between factor inputs and the maximum output level for the given technology, per unit of time. This can be closely related to government agricultural policies, international agreements, and so on. The constraints can be the food security, which is the major concern inside the productions policy, government’s budget for subsidization (in the case is applied), social welfare which is related to the capacity to integrate the final price for consumer and the incremental cost of production in farm, etcetera. To illustrate this physical relationship between output and factor inputs, consider a farm that uses land, labor, and other inputs (fertilizer and capital), in the production of the concerned commodity (for this study, wheat).

The profit maximization or cost minimization approach can now be used to derive the output supply response from the profit function by means of the first order conditions or in other words in terms of the willingness to pay. The subsidization function that includes the optimal price perceived by the farmers multiplied by the production amount for that specific

92  year must satisfy the following conditions, firstly, the supply and demand functions have to be linearly homogenous, secondly, it must be increasing in fixed quantities and output prices and decreasing in input prices, and thirdly, it has to be twice differentiable and must satisfy the condition of convexity in prices, both in domestic and world markets.

When the marginal product of a factor input is multiplied by the price, the value of the marginal product is calculated, which is the rate of increase of the producer’s revenue from additional employment of an input. In this sense, the objective function of profit maximization implies that the expected value of marginal product is equal to input costs, i.e. a farmer who maximizes profit will produce where the expected value of marginal product is equal to input cost or in this case the incremental cost. However, the first order condition is not sufficient for profit maximization and the second order condition needs to be integrated.

The basic Price and Revenue Optimization approach allows us to obtain the subsidization amount originated in the commodity supply and factor demand equations with partial differentiation scenario of the indirect profit function. The indirect profit function is defined as the maximum profit associated with the given product and factor prices. On the other hand, the “law of demand” states that the higher the prices, the less of a given good will be purchased.

This implies that the demand curve is downward sloping. For the ultimate buyer of food, demand could relate retail prices to amounts that will actually be consumed within a given time frame, not the same for the farmer’s price related to the input cost. However, the final consumer is not the only actor on the demand side. It’s possible to distinguish between two main categories of domestic demand, namely, demand for direct use and inventory demand.

The demand for direct use consists of primary as well as derived demand. Primary demand can be signified as the demand at a retail level where the individual consumer can make decisions based on price and preference, and this is the case for the wheat commodity because it’s a product that can be included in a perfect competitive market.

93  Expectations are determined by the expected utilization of the commodity (in our case wheat), product availability, and future changes in other market factors such as market prices and agricultural policies, there is where the revenue management concept can be implemented.

Although demand for direct use and inventory demand could be regarded as isolated from international markets, this is not the case since nations participate in an international market and also face export or import demand, as well other factors that can be constraint the model.

Nevertheless, there are some assumptions that had been already mentioned in previous chapter and under that one the model can be applied and be feasible.

94 

Chapter 7: CONCLUSIONS & FUTURE RESEARCH 

7.1. Main Conclusions

The mix of measures used to support farmers is dominated by market price support, a category known to be amongst the least efficient and most trade distorting means of providing agricultural assistance, but nevertheless, according with this thesis proposal, can be one of the most important tools to use in the future to regulate the WTO agricultural policies if applied in a correct manner. Optimizing farm support would therefore improve the efficiency of domestic resource allocation leading to net income gains nationally.

Historically, China and other’s economies were still applying a large number of distortive policies such as grain quotas, government fixed prices for selected crops and state trading. But domestic prices, including those set by the government, were usually fixed at levels close to world prices are necessary. So, budgetary support for producers has been low for small economies and high for strong economies. As a result, the level of support, as measured by the percentage PSE, although fluctuating was generally very fluctuant and in some cases the support gap comparing the proportional amount of money applies is very big.

Multilateral subsidization in agriculture would improve access to overseas markets and raise world market prices for agricultural commodities. It, therefore, would generate income gains for China’s farmers and generally as soon as all the countries agree to apply the same policy to all farmers till the amount of offer and demand get in equilibrium according to “the invisible hand”. At the same time, higher world market prices lead to higher costs for consumers of some agricultural goods, though some domestic consumer prices would fall with the assumed reduction in China’s own agricultural liberalization of commerce and increase of support. Because net trade constitutes only a small fraction of China’s agricultural output, the gain in farm incomes would be just about the same as the consumer loss due to higher prices, and China’s overall welfare would not be much affected.

95  The level of support in the 2000s increased, but remained far below the other big world economies average, especially in the first world. The increase in support may mean that, within the context of largely liberalized domestic commodity markets, producer prices started to adjust to reflect market conditions as well as border protection, in particular for imported commodities. Therefore, even as border protection declined, tariffs and other border measures will start to have a stronger impact even if they reduce considerably.

7.2. Specific conclusions

While China’s producer support is low, the level of support varies significantly across commodities, which is an indication of distortive policies, but then again, according to this thesis proposal, necessary policies in terms of feasibility and finds the point of accordance within WTO and OECD countries regarding the trade regulations. The distortions on wheat markets are still high, mostly due to state trading which continues to drive a wedge between domestic and world prices.

The mix of measures used to support China’s farmers is dominated by market price support and input subsidies, categories known to be amongst the least efficient and most trade distorting ways of providing agricultural assistance. In particular, low transfer efficiency means that only a small part of support is effectively received by producers, that why a well implemented level of support applied directly to this group will have a very high impact on the whole chain and will regulate the process, with the respective social benefits.

Total support to China’s agricultural sector places a relatively high cost on the Chinese economy. This is partly due to the economic importance of agriculture in a relatively poor economy, and partly due to large budgetary expenditures on general services. The share of producer support (the PSE) in the total support to the agricultural sector (the TSE) started to increase in the last few years, but the share of general services in the total is still very high, mostly due to large investments in agricultural infrastructure. The high share of general services can be viewed as a positive feature of China’s policy as such support is provided

96  through measures characterized by relatively low production-distortions. However, the share may be overestimated as the available budgetary data are very aggregated, which does not allow a clear distinction to be made between payments supporting producers and those improving the performance of the agricultural sector as a whole.

All market prices develop more strongly in the first years of the projection when import rise, compared to the later years when import dependency declines. With domestic cereal prices being increasingly determined by international grain price developments, implications for world markets become more and more important when discussing Chinese market and policy changes.

For a number of commodities, the effects of a partial multilateral subsidization would therefore be rather small. The effects of these policies individually are generally more pronounced in crop markets. A partial subsidization in all countries would generally result in higher world and domestic prices for most agricultural products and would therefore not only benefit Chinese producers, but at the same time negatively affect food consumers. This potential negative effect would be largely eliminated in a multilateral subsidization scenario where prices for the main food commodities would be either reduced (for this case, wheat).

Unilateral Chinese liberalization on the other hand will have minor effects on world prices but lead to larger declines in domestic prices. All policies remain in place in the scenarios, only their levels differ. Complete subsidization would be expected to have a more substantial impact. In addition, the results are conditional on the underlying baseline. A different baseline may lead to different results. Furthermore, the results will be dependent upon the commodities they intend to represent in the model which does not include all agriculture. Although the commodities represented are among the most protected, a fuller set of commodities would give a more complete picture of the effects of liberalization and

Unilateral Chinese liberalization on the other hand will have minor effects on world prices but lead to larger declines in domestic prices. All policies remain in place in the scenarios, only their levels differ. Complete subsidization would be expected to have a more substantial impact. In addition, the results are conditional on the underlying baseline. A different baseline may lead to different results. Furthermore, the results will be dependent upon the commodities they intend to represent in the model which does not include all agriculture. Although the commodities represented are among the most protected, a fuller set of commodities would give a more complete picture of the effects of liberalization and