The Government’s Activity on the Grape Market in 2013
Even though this is something that is taught to first year undergraduates, there is a need to repeat it over and over again: a free market distributes resources in such a way that the total welfare of society is greater under that arrangement than it would be in any other possible situation. The market equilibrium price is the very power through which resources are distributed between market participants (consumers and producers) in a desirable direction. In particular, a free market, primarily distributes the supply of a product to those consumers who value that product the highest. At the same time, a free market distributes supply to those producers who spend the least on the production of that product. All in all, a free market ensures the highest level of welfare for both consumers and producers.
Any possible government interference in a free market represents a political decision which would improve the wellbeing of one group of society to the detriment of another. Given the nature of such interference, the benefits obtained by one group are often less than the losses incurred by another. Furthermore, the benefit one group receives is visible whereas the loss suffered by another group tends to be invisible. There is also a time factor that should be taken into account. As a rule, the benefits to the beneficiaries occur much earlier than the delayed negative economic results of interference. All this eventually translates into aggregated economic indicators that could have been much better than they are in reality. However, since the negative effects of interference are invisible and lagging in time, the average voter fails to see the link between past interference and the ongoing situation. Nor does the average voter realize that overall economic welfare could have been greater than it is in reality. It should also be noted that politicians show amazing creativity in their application of the methods and forms of interference. We economists have to analyze those methods on a daily basis, however, we are often late in doing so because any novelty offered by politicians requires testing, piloting, double-checking, and statistical analysis. The key, however, is that regardless of the form of interference applied by the government to alter the market, it is fundamentally designed to directly or indirectly affect free market prices, thereby swaying the process of distribution in the direction desirable for the government – the aim being to enrich one segment of society at the detriment of another.
As politicians shun direct influence on market prices, they invent forms of interference which will change the equilibrium price via invisible means. I am amazed about one such recent invention from the Ministry of Agriculture concerning the government's plans for the 2013 grape harvest. The aim of this article is to demonstrate that the proposed government policy will not be conducive to the development of the grape growing sector, the wider agricultural sector or the economy as a whole. This policy is oriented towards the creation of economic stimuli that, in the short term, will increase the benefits to one segment of society at the detriment of another and, in the longer term, will further impede economic development.
To make things simple, let's assume that the decisions of politicians are not prompted by some special interests or corruption and they sincerely believe that they can improve the welfare of society. Our aim is to substantiate that the government's initiatives and actions, which at first glance seem attractive, will in fact have unintended and unexpected negative economic and social consequences that will inflict more harm on society than good. For example, when one country abolished free air travel for children aged from between two and six years, the decision affected the income of the average family so that the number of people undertaking long-distance road travel in that country increased. The aim of that government's initiative was generous – to improve safety in aircraft. However, as the number of car accidents increased as a result of the policy, in reality the overall level of safety in the country deteriorated.
Here, I will try to show readers the negative economic results which will come about from the government's creative policy regarding the 2013 grape harvest.
In a manner similar to 2012, this year will also see the operation of a headquarters for coordinating the grape harvest. Before they can sell grapes to wine producing factories, farmers will again have to register with local village administrators in order to determine when they can reap their harvest, which wine factories they can sell their grapes to, what the size of their harvest can be, et cetera. The government is no longer going to directly subsidize grape harvests. However, according to preliminary data, wine producing factories will purchase the Rkatsiteli variety of grapes at 1 GEL per kilogram and Saperavi grapes at 1.10 GEL. The novelty this time around is that the cheap agricultural credits project has been extended to include a fifth component – loans to winemakers. This enables wine producers purchasing grapes from the population to take out cheap loans, with a maximum interest rate of 15 percent, but the producer would only need to pay six percent of that interest with the state subsidizing the remaining nine percent.
Subsidies actually make farmers less competitive and production less modern. This thus leads to the degradation of the grape and wine market in the long term rather than its development.
Earlier, the government applied a mechanism of vouchers whereby wine factories that bought a kilogram of grapes at 0.70 GEL, on average, received an additional 0.30 GEL from the government. Thus the market price of grapes was made up to 1 GEL per kilogram. Besides, last year the government was itself the largest purchaser of grapes. For example, in 2012, state enterprises purchased about 63 percent of the total harvest, which meant that the private sector purchased much less than in previous periods. This year, the government does not plan to use vouchers or to conduct public procurements, but instead to directly finance entrepreneurs under the direct assistance rule. If entrepreneurs pay one lari or more for a kilogram of grapes they will receive a corresponding subsidy. The aim of the state initiative is to make farmers more competitive and wine production more modern.
To show the expected economic results, I will describe the processes which would have taken place in a free market; discuss the mechanism of resource distribution in both the case of the absence of a state initiative as well as in the case of its presence; compare the social welfare resulting from these two models; and, based on the obtained results, arrive at a conclusion as to whether the state will achieve the set goal of making farmers more competitive and production more modern.
Considering the statistical data of the past three years, the average price of grapes in a free market stands at 0.70 GEL. The quantity of the grape harvest in 2013 is expected to be approximately 120,000 tons. Assuming that the price elasticity of both demand and supply on the grape market is equal, the economic welfare of both customers and suppliers will be 84 million GEL, whilst the total welfare of society will be 164 million GEL.
After state interference, wine factories will have a higher stimulus to buy more grapes and to do so at a higher price. This fact will shift the demand and supply curves towards the right and, as a result, some 120,000 tons of grapes will be sold at a price of 1 GEL per kilogram (if wine factories deem it worthwhile to use a cheap loan at the expense of paying a higher price). Consequently, the welfare of producers will go up to 120 GEL million whilst the welfare of consumers will go down to 48 GEL million. In fact, the benefits to producers increases by 36 GEL million because the rise in price will result in 1) an increase in the difference between production costs and income for efficient sellers; and 2) the emergence of marginal sellers into the market who did not deem it worthwhile to sell grapes at a higher price than 0.70 GEL because of high production costs. The welfare of consumers, however, decreases by 36 million GEL because the maximum value of consumers' payments remains unchanged and the real value of payments increases; consequently, the difference between the maximum value of payment and the price actually paid shrinks. Moreover, the number of marginal buyers who deem it worthwhile to pay more than 0.70 GEL increases. The state tries to maintain the maximum number of marginal buyers in the market because with each loan taken out, at a market interest rate of 15 percent, the state gives nine percent to a wine factory. In fact, if state interference affects the equilibrium price and the price for one kilogram of grapes increases from 0.70 GEL to 1 GEL, social welfare will, under equal elasticity of demand and supply, at best remain the same. The benefits to farmers will be of that amount that wine factories loose. However, we should also take into account the high probability that the price elasticity of supply is higher than that of demand – if a farmer fails to sell grapes at a specific price, he/she would be more ready to sell the product to customers at a lower price than wine factories would be ready to buy at a higher price. Proceeding from this conjuncture, it is more likely that the loss to consumers would be higher than the benefits to producers, which will decrease economic welfare.
But, let us assume that state interference does not change social welfare (the best case scenario). Will farmers become more competitive and/or wine factories more modernized, thus contributing to higher economic efficiency on the grape and wine market? With increased competitiveness and modernity we must assume that the quality of production or/and the level of production per hectare/time unit will increase in the future. In a free market, the most efficient participants are those who are the most competitive. However, subsidies provide the most benefit to those participants who are less competitive. In other words, the largest portion of welfare is put to the service of those farmers who struggle for survival in the market. Any of the farmers who do not deem it worthwhile to sell grapes for less than 1 GEL is a marginal seller; similarly, any of those wine factories that does not deem it worthwhile to buy grapes at a higher price than 0.70 GEL is a marginal buyer. Both of these marginals enjoy subsidies exactly like unemployed people enjoy unemployment allowances. Furthermore, given that such marginals remain on the market as a result of subsidies, productivity further decreases because subsidies distort the process of effective distribution of resources, for example, the process of the amalgamation of land plots by an efficient producer to create a large farm and thus further increase productivity through the economy of scale. Subsidies actually make farmers less competitive and production less modern. This thus leads to the degradation of the grape and wine market in the long term rather than its development. Consequently, in reality the result of subsidies is keeping the income of farmers growing grapes at the level they had in 2012.
What price does society pay for a strategy that maintains the status quo in the short term and causes the degradation of the market in the longer term? If wine factories receive an additional loan worth 0.30 GEL per kilogram of grapes purchased, the cost of total credit will be 36 million GEL. The share of the state subsidy in that amount will be 3.24 million GEL (nine percent). The source of the subsidies is tax revenues. Considering the size of the Georgian population, each citizen, including farmers, must pay one lari, on average, for this subsidy to be collected. 3.24 million GEL could have been spent on implementing other initiatives: on the construction of a 100-kilometer-long road; developing water pipeline systems in villages; improving the infrastructure of public schools, et cetera. One should also note that 3.24 million GEL, in reality, represents taxes paid by those companies that efficiently operate on the market, annually increase investments, expand the scale of production and help decrease unemployment. The government thus maintains the condition of farmers at the detriment of future economic growth.
All in all, based on an analysis of the planned government policy, the following conclusions can be drawn:
- The process of the efficient distribution of resources in a free market ensures the highest welfare to society, more than would be possible in any other arrangement;
- When state interference affects the market equilibrium price, the process of distributing resources conflicts with free market principles and, as a result, the revenues of one group increase at the expense of losses to another group and the welfare of society as a whole decreases;
- Even assuming that the government does not pursue any special interests or corruption, with politicians believing that they can do a beneficial job, good intentions can cause unexpected negative results which are very difficult to predict, measure and assess because they are often invisible;
- Shunning direct influence of market prices, politicians invent methods for indirect influence;
- The activity planned by the government for the 2013 grape harvest is precisely a case of a good intention having negative consequences;
- The weapon the government is using this year is somewhat lighter than that of 2012 and one cannot definitely claim that this indirect influence will affect the free market price. This will happen only in the case of marginal wine factories deciding to use cheap loans in return for paying a higher price for grapes. Negative results will only occur if the market price of grapes changes. In other cases, resources will be distributed according to free market principles, but the situation of farmers will deteriorate compared to 2012;
- One negative result is that the competitiveness of farmers will not increase, nor will wine factories become more modernized. Quite the contrary, the grape and wine market will degrade in the longer term. Moreover, resources will be re-channeled from effective sectors of the economy towards ineffective ones, thus adversely affecting future economic growth;
- In reality, the government activity aims at maintaining the condition of farmers at the same level of 2012.