Buffer Stocks

A-level Economics

a Government intervention against unstable commodity prices

buffer stocks market failure unstable commodity prices diagram economics a level exams

Definition: A buffer stock is a government intervention to try and correct the market failure associated with unstable commodity markets.

Commodity markets are unstable - especially for agricultural products.

What do we mean by unstable?

We mean prices in those markets are volatile - they change a lot.

Why would they change a lot in the market for agricultural goods?

Let's take for example, the supply of wheat. This heavily depends on a number of things. The most important would probably be the weather. The weather from year to year is never the same. Therefore, we can never expect the same production of wheat. Some years will be good, some will be bad. This affects the market supply curves every year.

The other thing with this market, is that products are seasonal. You can't produce crops whenever you like - you have to wait for the right season. Once produced, you have to wait a long time before you can produce again. This affects the elasticity of supply - causing the curve to be inelastic. This highly affects prices in the market.

*A good harvest is highly dependent on many factors so we can't expect the same level of production every year. This is why we have buffer stocks.*

So how is this a market failure?

Well ask yourself – wouldn’t social welfare be greater if we had predictable crop yields and farmers had predictable incomes? Without government intervention, many farms would have already ceased to exist because of the highly volatile nature of this market – for many farmers it would not be profitable to continue trading.

Volatile prices also have a profound effect on the level of poverty. If you’re on the poverty line and then one year the price of food increases by 25%, then this would be very bad news for you – it would harm your lifestyle and you couldn't afford a healthy diet. This would affect not just you, but also everybody around you. It could mean an increase in starvation and even criminal activity. This is not a good thing for our society.

The free market doesn't maximise welfare on its own. Government intervention would improve social welfare. That's how we know the market fails.

How does a buffer stock work?

A buffer stock is an available intervention method to correct this market failure.

When supply is abundant, the government buys from the market and adds to its own stockpile. When supply is scarce, the government would then release this supply into the market.

[A simple solution really?]

First of all, a minimum and maximum market price is set. The price in the market is allowed to fluctuate within this band. If the market price drops below the minimum price, it means supply is too high this year (or perhaps demand is too low). In this case, the government would buy up the excess supply and begin adding to its own stockpiles. They would buy up the excess at the minimum price.

If the price exceeds the maximum price, it means either supply has fallen this year or alternatively, demand is very high – either way there isn’t enough supply in the market to cope. The government would respond by releasing supply into the market from its own stockpiles. The government would sell its supply at the maximum price.

Have a look at the diagram below:

Remember - supply curves are perfectly inelastic because once you have a crop yield, you often have to wait till the next year to get the next crop yield. If demand goes up, you cannot instantly start producing more crops in response.

On the diagram above you will notice 2 supply curves.

The first, is when there is a good harvest. Supply is abundant this year. Take a look at Point A. Supply is so high that it has pushed the market price down to P1, below the minimum price. There is now excess supply in the market between Q1 and Q4. The government will buy this up at the minimum price and add the product to its stockpile.

The second supply curve, is when there is a bad harvest. Supply is poor this year – perhaps due to bad weather. Take a look at Point B. Supply is so low that it has pushed the market price up to P2, beyond the maximum price. There is now a shortage of supply in the market between Q2 and Q3. As there is a shortage, the government would now sell its product in the market at the maximum price.

[Remember: the government buys up at the minimum price and it sells at the maximum price]

So by doing this, the government keeps prices in the market within a band. This makes the market a bit more predictable, which is a good thing for farmers and for consumers.

How much does it cost the government in total?

The price they pay is the minimum price. The total cost would be the total quantity they buy, multiplied by the minimum price.

In the case above, it would be Minimum Price x Q4Q1.

How much revenue does the government make when they sell their stock?

They sell at the maximum price. The revenue they make would be the maximum price multiplied by the quantity they sell.

In the case above, it would be Maximum Price x Q2Q3.

What could go wrong with this intervention?

The minimum price could be set incorrectly. Too high, and the government will spend excessive amounts of money - not good for taxpayers
Unusual harvest patterns. If there are 10 years of good harvests, the government would have bought continuously for 10 years. They would spend excessively. If there are 10 years of bad harvests, the government would run out of stock
Expensive to store + other running costs
Some products are perishable and will go out of date
Farmers have the incentive to overproduce. They are guaranteed a big buyer when times are bad (the government). They may just start producing more and more - more than what is needed. Their income is protected as the government will just buy any excess up. So there is no risk for them (a moral hazard). This is a waste of scarce resources and a waste of taxpayer money