In yesterday's post, I discussed the minimum price in the Madagascan market for vanilla, assuming that only the domestic market matters. It was based on this article from Le Monde. However, yesterday's analysis was a bit incomplete, because I ignored the role of international trade in vanilla. So, let's revisit the market and introduce international trade.
The market without a price control is shown in the diagram below. The domestic price of vanilla is P0, and if there was no international trade then Q0 vanilla would be traded. However, Madagascar has a comparative advantage in the production of vanilla. In the market diagram, that is represented by the world price for vanilla (PW) being higher than the domestic price (P0). If there is free trade in vanilla, domestic producers of vanilla have the choice between selling in the local market and receiving the price P0, or selling in the world market and receiving the price PW. It is no surprise that they will choose to sell in the world market. No domestic buyer is going to be able to buy vanilla unless they are willing to pay the world price. At the price PW, domestic consumers are only willing to buy Qd1 vanilla. Domestic sellers are willing to sell Qs1 vanilla - they well Qd1 of this to the domestic consumers, and the rest gets sold to the world market. The quantity of exports is equal to (Qd1-Qs1).
Now consider the areas of economic welfare (as we did in yesterday's post). If there was no international trade in vanilla, the consumer surplus (the difference between the consumers' willingness to pay and the price, or the consumer's economic rent) is the area AEP0. The producer surplus (the difference between the price and firms' marginal costs, or firms' profits or economic rent) is the area P0ED. Total welfare (the sum of consumer surplus and producer surplus) is the area AED. If there is free international trade in vanilla, then the consumer surplus decreases to the area AFPW. The producer surplus increases to the area PWGD. Total welfare increases to the area AFGD. Total welfare is greater with trade by the area FGE - this represents the value of the gains from international trade in vanilla.
Now, what happens when the government implements a minimum price in this market, where the minimum price is greater than the world price? That is shown in the diagram below. At the minimum price, PMIN, the quantity of vanilla demanded decreases to Qd2, while the quantity of vanilla supplied increases to Qs2. There is a surplus of vanilla equal to the difference between Qs2 and Qd2. Only Qd2 vanilla is traded in the market. This is the same outcome as yesterday. However, what happens to international trade? The quantity of vanilla exports falls to zero. International buyers of vanilla have the choice of buying vanilla from Madagascar and paying the regulated price of PMIN, or buying from the rest of the world market and paying the lower price PW. It should be no surprise that the export market for Madagascan vanilla collapses. The consumer surplus decreases to the area ABPMIN, while the producer surplus decreases to the area PMINBCD. Total welfare decreases to the area ABCD, and the lost welfare (the deadweight loss) is equal to the weirdly shaped area BFGC.
Now it becomes much clearer why Madagascan vanilla growers are unhappy. A binding domestic price control in an exporting country leads to a huge loss of producer surplus (grower profits), as well as a large deadweight loss.
One last point is worth noting. The demand and supply diagrams above assume that changes in the Madagascan vanilla market don't affect the world price. In fact, that is unlikely to be true, because as the Le Monde article notes, Madagascar produces 80% of the world's vanilla. A reduction of exports of Madagascan vanilla will almost certainly increase the world price of vanilla, so the gap between PMIN and PW should close. However, it is unlikely that it would close entirely. As the article notes:
Other producers such as Papua New Guinea and Uganda have also taken advantage of this to strengthen their position.
Madagascar is not the only producer of natural vanilla, and there are synthetic substitutes available as well. As I noted yesterday, price controls are almost always a bad idea. In a market where your country is an exporter, they are an even worse idea.
[HT: Marginal Revolution]
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