Chapter 6

Welfare effects of governments Policies

1.0 Introduction
Governments around the world typically intervene in agriculture to influence product and
input markets. In developed countries governments typically utilize a wide variety of
measure to raise and stabilize farm incomes and to direct resource use to socially desirable
outcome. Frequently used measures include tariffs, quotas, and subsidies designed for trade
protections or enhancement, and direct payments (subsidies) and price supports designed to
increase domestic farm income.
This chapter examines the economic and welfare effects of different government policies
for the agri-food sector. It is designed to address the question “Does it really matter which
policy we use as long as the policy achieves our objectives—eg. Higher farm incomes,
trade protection or more export sales, etc.?”. This chapter will show that each policy may
create different economic and welfare impacts, and that some generate lower welfare losses
and transfers than other. From an overall social welfare standpoint, these transfers and
welfare losses can be very important
In this chapter social welfare effects will be measure using the concepts of consumer and
producer surpluses, as described in section 5.0 of chapter 3. To simplify the measurement
of welfare effects, only straight line supply and demand curves will be used (without kinks,
etc.)
2.0 Tariffs, Import Quotas and deficiency payments in importing countries
Tariffs, import quotas, and deficiency payments to farmers will be examined together
because all three are often used to protect and raise the income of domestic producers in
importing countries.
2.1 Tariffs
The social welfare effects of import tariff has an impact in both the importing and exporting
country. Prior to the imposition of the tariff, the trade relationships between the two
countries are diagramed in figure 6.1 and as discussed in section 3.0 of chapter 3. In figure
6.1 Pi represents the pre-trade equilibrium price in the importing country while Pe
represents the pre-trade equilibrium price in the exporting country. Pw represents the world
price after trade which is shown in figure 6.1 as equal in both countries. ED and ES
represent the excess demand and supply curves, while the quantity demanded and supplied
in the importing and exporting countries are represented by Di and Si and De and Se
respectively
 Importing Country World Market Exporting Country
D S ES

Pi
Pw Pw Pw

ED

S1 D1 Q1 D1 S1

Figure 6.1 Price, production, and quantity traded under free trade
Importing Country World Market Exporting Country
D S ES

Pi
Pt
Pw

ED

S1 D1 Q1 De Se

6.2 Price, production, and quantity traded under an import tariff

The introduction of a tariff is shown in figure 6.2 by the downward shift of the excess
demand curve to ED, as the tariff acts as a tax on consumption. The new quantity
demanded and supplied in the importing and exporting countries are represented by Di and
Si and De and Si respectively. The impacts on the importing and exporting countries are
shown in more detail in figure 6.3 and 6.4
D S1

Pi
A B C D
Pw

E F

Si Si ” Di” Di
Figure 6.3 Welfare effects of tariff (import quota and deficiency payment) in the importing
country

Pw
J K L
H I M
P1

N O

Di Di” Si” Si
Figure 6.4 Welfare effects of a tariff (import quota) in the exporting country
As shown in figure 6.3 the impact of the tariff in the importing country is to raise domestic
prices to Pi to increase quantity supplied to Si and to decrease quantity demanded to Di.
This results in decrease in imports from Si- “Di” to Si- Di. The welfare effects can be
identified by the geometric areas A-F.
1. “A” is an increase in producer surplus, as producers produce more with the higher
price “Pi”. This area is transfer from consumers as they pay more for the increase in
quantity supplied.
2. “B” is the extra cost to produce the increase in supply above what it would cost to
import the same quantity, and represents a dead weight social welfare loss to
society, since the resources representing area “B” could have been used to produce
something else in the country.
3. “C” is revenue that is collected by the importing government from domestic
consumers. The final benefit of area “C” depends on how the government uses the
taxes.
4. “D” is the loss in consumer surplus when consumers reduce their consumption
because of the higher price “Pi”. This area represents a dead weight social welfare
loss because it is not a transfer to another group in society.
5. “E” & “F” represent saving in foreign exchange for the importing country and
losses in foreign exchange to the exporting country. The are not social welfare
losses to the importing country because they represent the opportunity cost of
buying the imports.

Figure 6.4 shows the remaining impacts of the tariff in the exporting country. In the
exporting country, the tariff reduces the price to Pw, increases domestic quantity demanded
to Di and decreases quantity supplied from Si to Si”. This results in a decrease in
exports from Di”- Si”, to Di, - Si. The welfare effects can be identified by the geometric
areas H-O
1- H&I together represent an increase in consumer surplus, as domestic consumers buy
more of the good when its price falls to Pi
2- H-L together represent a loss in producer surplus as producers produce less and
receive a lower price
3- J is a dead weight social welfare loss, as this area is not captured by any other
group.
4- K represents the revenue obtained by the importing country from exporting country
producers. This is a social welfare loss in the exporting country but not a dead
weight social welfare loss because it is transferred to the importing government.
 5- L is A Dead Weight Social Welfare Loss, as This Area is not Recaptured by others
6- M & O reporting the opportunity cost of resources that are saved by the reduced
production. these resources may be used for the activities in the exporting country
and therefore do not represent a net social welfare loss.
7- N is the additional cost that consumers must pay for their increased quantity
Demanded, And Therefore Is Not A Social Welfare Loss
8- N and O together report loses in foreign exchange to the exporting country and
saving in foreign exchanges in the importing country.
2.2 Import Quotas
Import quotas represent restrictions on physical quantities that may be allowed into the
country. tariffs, on the other hand, operate by imposing additional costs on the imported
product. Both measures are used to reduce imports, however, and therefore create many
similar welfare effects
The introduction of a quota is shown in figure 6.5 as a perfectly inelastic excess demand
curve once the limit of the quota is reached. This perfectly inelastic portion of the excess
demand curve shows that regardless of the price, no further quantity of the product may be
demanded in the importing country once the limit of the quota has been reached.
Importing Country World Market Exporting Country
D S ES

P1
Pt
Pw

ED

S1 D1 Q1 D1 S1

Figure 6.5 Price, production, and quantity traded under an import quota
The welfare effects of the import quota may be compared to those of the tariff on the same
graphs for the importing and exporting counties by examining the case where the quantity
of imports allowed under the quota is just equal to the quantity that would be allowed under
the tariff. for this example, refer again to figures 6.3 and 6.4.
In Figure 6.3 the welfare effects of a quota are the same as for the tariff, except that area C
available to producers in the exporting country rather than received as revenue by the
government of the importing country. A similar effect occurs in Figure 6.4 for area K in
some circumstances, however, the importing government: may try to Capture part of the
benefits from area C and K by auctioning off import licenses to either domestic importers
or foreign exporters. 
Police Note: The GATT / WTO agreement is based in part on converting the protection
value of import quotas into comparable tariffs which would initially allow for the same
level of imports. This process is called "tariffication," and is designed to provide the Same
level of initial protection with tariffs as was provided by the import quota. The tariff levels
are then required to be reduced gradually over time to enhance trace.
2.3 Deficiency payment subsidies to producers in the importing country
in some cases, an importing country government might choose to increase domestic farm
incomes by providing their producers with subsidies instead of trade protection. The
welfare effects of using a deficiency payment subsidy to producers to achieve a target price
level also can be illustrated in Figure 6.3  To make comparisons between the tariff, quota
and deficiency payments easier, assume that the level of deficiency payment is just
sufficient to increase the effective price to Pi, the same level as achieved under the tariff
and quota. This would require a deficiency payment of Pi- Pw. If the subsidy would be
available on all production by the farmers and the farmers knew in advance that they could
expect the subsidy, the effective domestic price to the producer would be Pi. This price
would generate an increase in quantity supplied to Si.  The price to consumers, however,
would not change from Pw, as only the production side would be affected.  As a result, the
quantity demanded would remain at Di.
The welfare effects are as follows
1- A represents an increase in producer surplus, as producers increase quantity
supplied in response to higher effective prices. Area A is transfer from taxpayers
(government) rather than consumers, as occurs under a tariff or quota
2- Government must pay area A + B to producers for the increased production
3- B represents the additional costs of domestic production over the cost of importing
the product, and is a dead-weight social welfare loss
4- Since there is no change in consumption, area C and D do not exist.
5- F remains a payment of foreign exchange to exporting country producers
6- E is now provided through domestic production rather than imports. This area
represents a loss of foreign exchange earnings to the exporter and a savings of
foreign exchange to the importer, but it is not a dead weight social welfare loss.
Policy Note: In the GATT / WTO agreement, tariffs are preferred to quotas because they
are more price responsive. The tariff represents a wedge between the world price and the
equilibrium world price. As the world price moves up and down the "wedge" also will
move up and down.
Many governments prefer tariffs because they generate revenue. Producers on the other
hand, tend to prefer import quotas because they are more certain and cannot be
circumvented by pricing products low enough to enter the importing country even with the
tariff. Both tariffs and import quotas raise prices over free trade and are regressive, as the
poor must pay more for food.
Deficiency payment subsidies provide fewer welfare distortions than import quotas and
tariffs, and are superior from a social welfare standpoint. They also are less regressive,
because they do not raise domestic prices and payments to producers are made
by taxpayers, rather than consumers Deficiency payment subsidies, on the other hand,
encourage more domestic consumption and imports, there by saving less foreign exchange
than tariffs or quotas
3.0 Canadian supply management
The two main principles of Canadian supply management system are to directly control
output to stabilize quantities and prices and to raise prices where necessary in order to
improve farmer incomes. Quantities are controlled by production quotas and prices are set
by administrative criteria (costs of production, formula pricing, etc.) rather than by the free
interaction of supply and demand. Because prices under supply management usually are
higher than world prices, the domestic market is in a potential import situation and must be
protected from imports by import quotas or tariffs.
The domestic welfare effects of supply management are diagramed in Figure 6.6 In panel
(A), S and D represent the original supply and demand at the farm level. The supply curve
with supply management follows the original supply curve up to the level of the supply
management quota at Qsm where it becomes a completely inelastic (vertical) supply curve.
Once the supply management quota is reached, the supply cannot be increased by changing
the price. This results in the price Psm under the supply management system, rather than
the original price Pe.
 D S´
D
Psm S S
B C

Pe

A D

Qsm Qe Qsm

Figure 6.6 welfare effects of the Canadian supply management system.

The initial welfare effects are as follows
1. A is part of the original producer surplus and is unchanged by supply management
2. B is a gain in producer surplus and a loss in consumer surplus, representing a
transfer to producers from consumers
3. C is loss in consumer surplus as consumers reduce consumption. This area
represents a dead weight social welfare loss
4. D is a loss in the original producer surplus as producers reduce their level of
quantity supplied. This area also represents a dead weight social welfare loss. The
net gain to producers therefore is area B-D.
Over time further welfare effects also occur, as the extra profitability of the supply
management system gets capitalized back into the costs of quota. This effect is represented
in panel (B) by the shift in the supply curve from the kinked supply curve under supply
management to S´. The shaded area represents the capitalized value of quota which in time
becomes a cost to new producers and raises the supply curve to S´
4.0 Price Supports
Price supports are often used by governments to raise prices to producers. This measure is
typically used by exporting countries or countries shifting from an import to and export
basis because governments normally accumulate stocks which they must store and
eventually dispose of in foreign markets
The mechanics of a price support system are diagrammed in Figure 6.7. In this figure, the
original equilibrium price Pe is diagrammed for simplicity sake from the interaction of
domestic S and D only, but price supports also could be used in conjunction with an
equilibrium world price resulting from international trade. The price support level is
represented by Ps, which leads farmers to increase their quantity supplied from Qe to Qs
Because of the higher price, consumers reduce their quantity demanded from Qe to Qd.

Ps C
Pe A B D
E
F G
D

Qd Qe Qs
Figure 6.7 Welfare effects of price supports.
The welfare effects of price supports are as follows
1. A IS an increase in producer surplus and a decrease in consumer surplus. It
represents a transfer of welfare benefits from consumers to producers
2. B and C are increases in producer surplus from taxpayers Area B also is a loss in
consumer surplus
 3. B through G are purchased by government and stored and/or disposed of (often in
foreign countries) The overall welfare effect of area B-G therefore depends on what
governments do with the purchased commodity
4. D represents a dead weight social welfare loss when the commodity is disposed of
in the domestic market. It represents the cost of producing the additional product in
excess of the value of the product to consumers in the domestic market (area G). If
the commodity was disposed of in a foreign country the net global social welfare
loss would depend on the consumption value of the commodity in the foreign
country
5. E and F represent the amount of value (purchase costs) given up by consumers
when in they decrease their quantity demanded from Qe to Qd. These areas do not
represent social welfare losses as they are offset by the savings in expenditure.
6. G is the consumption value of Qe- Qs to domestic consumers. As noted in item 4
this area is relevant if the product purchased by government is redistributed back
into the domestic market
7. In addition to the above welfare effects, the overall impact of price supports also
may involve storage costs and losses if the product is sold at a loss (dumped) on
foreign markets. The size of these effects will vary and depends on the specific
conditions for each country and commodity.

5.0 Target Prices and Deficiency Payment Subsidies for Producers in Exporting
Countries
Target prices and deficiency payments were major policy instruments in the U.S. up until
they were removed in the 1996 U.S. farm bill. This form of subsidy also has been used by
Canada to assist farmers and raise their income. The overall welfare impacts, however,
depend on the specific characteristics of the deficiency payment, and whether the quantity
that is eligible for deficiency payment is restricted or not Figure 6.8 diagrams the
mechanics of deficiency payments for 3 sets of conditions
1. No limit on quantity eligible for deficiency payments, with no trade involved and
all production absorbed in the domestic market
2. No limit on quantity eligible for deficiency payments with trade undertaken at a
world price
3. Deficiency payments limited to the original equilibrium quantity Qe
 S

Pi B C
Pe A D
H G F E
Pc
D

Qe Qs

Figure 6.8 Welfare effects of deficiency payments to achieve a target price

in Figure 6.8 the target level of returns is Pi, which represents the target price to the farmer
Depending on the restrictions for quantities eligible for deficiency payments, the level of
production and consumption may range from Qe to Qs and the actual level of deficiency
payment from Pi- Pe to Pi- Pc
In the first scenario of unlimited eligible quantities and domestic market impacts without
trade, farmers are provided a deficiency payment to bring their effective price up to Pi. This
encourages farmers to increase their quantity supplied from Qe to Qs Since there is no trade
in this scenario, all of the additional production must be absorbed in the domestic market
This extra quantity forces domestic prices to consumers down to Pc. in order to clear the
market
The welfare effects of this scenario are as follows
1. Government must pay A through H In many cases it is believed that governments
will only have to pay A-D, but the decrease in price to Pe requires government to
pay Pi- Pc on the total quantity produced of Qs.
2. A-C are increases in producer surplus paid for by the taxpayer
3. D and E represent a dead weight social welfare loss, as this represents the additional
costs of producing the additional product Qe - Qs in excess of its value to
consumers (area F and I)
 4. F-H are increases in consumer surplus paid for by taxpayers
In the second case of unlimited eligible quantities with international trade, the world price
has been diagrammed here at the original equilibrium price to simplify the diagram. In
reality the world price could be above or below the original equilibrium price. In this
scenario, farmers also respond to the higher effective price Pi by increasing quantity
supplied from Qe to Qs. The domestic price only falls to the world price, however, as some
of the extra quantity produced may be sold in the world market. This prevents the domestic
price from falling to Pe. as in scenario 1 As a result, consumers continue to face Pe. and
demand Qe. Quantity Qs -Qe is exported at price Pw- Pe
The welfare effects of scenario 2 are as follows
1. A-C are increases in producer surplus paid for by taxpayers in a similar fashion to
scenario 1.
2. Government must pay only A-D, as prices do not fall below Pw. (Pe in this case)
3. D is a dead weight social welfare loss, as it is the additional costs of producing the
additional product in excess of what is received for the product in the export market
4. There is no change in domestic consumer surplus and no other changes
In welfare in scenario 3 the amount of production eligible for deficiency payments is
limited to the original equilibrium quantity, Qe. Since farmers do not receive a higher
effective price than Pe. for their production in excess of Qe there is no incentive to increase
their quantity supplied beyond Qe. As a result, consumers only consume Qe, at price Pe.
The welfare effects of scenario 3 are as follows
1. A and B represent increases in producer surplus paid for by government Since there
is no change in quantity supplied or demanded, there are no other welfare effects
and no dead-weight social welfare losses
Policy Note: The various policy measures discussed in this chapter have different
welfare effects involving transfers and dead-weight social welfare losses the least
amount of distortion is caused by deficiency payments limited to the equilibrium
quantity, whereby there are no changes in quantity supplied or demanded and therefore
no social welfare losses. Canada and the U.S. have often tried to limit deficiency
payments to the equilibrium amount by restricting the eligible quantity to the historical
level of production or some other level of restriction