AS Market Failure

Buffer Stocks

The prices of agricultural products such as wheat, tea and coffee tend to fluctuate more than the prices of manufactured products and services. This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand and supply are price inelastic. One way to smooth out the fluctuations in prices is for the government to operate price support schemes through the use of buffer stocks. But many of them have had a chequered history.

Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.

The diagram below illustrates the operation of a buffer stock scheme. The government offers a guaranteed minimum price (P min) to farmers of wheat. The price floor is set above the normal free market equilibrium price. Notice that the price elasticity of supply for wheat in the short term is very low because of the length of time it takes for producers to supply new quantities of wheat to the market. (Indeed in the momentary period, we would draw the supply curve as vertical indicating a fixed supply).

buffer stock scheme

If the government is to maintain the guaranteed price at P min, then it must buy up the excess supply (Q3-Q1) and put these purchases into intervention storage. Should there be a large rise in supply due to better than expected yields of wheat at harvest time, the market supply of wheat will shift out (see the diagram on the next page) – putting downward pressure on the free market equilibrium price. In this situation, the government will have to intervene once more in the market and buy up the surplus stock of wheat to prevent the price from falling.

It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow.

The problems with buffer stock schemes

In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the price is low and sell them onto the market when the price is high. However, they do not often work well in practice. Clearly, perishable items cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes.

Setting up a buffer stock scheme also requires a significant amount of start up capital, since money is needed to buy up the product when prices are low. There are also high administrative and storage costs to be considered.

The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly estimate the average price of the product over a period of time. This estimate is the scheme’s target price and obviously determines the maximum and minimum price boundaries.
But if the target price is significantly above the correct average price then the organization will find itself buying more produce than it is selling and it will eventually run out of money. The price of the product will then crash as the excess stocks built up by the organization are dumped onto the market.
Conversely if the target price is too low then the organization will often find the price rising above the boundary, it will end up selling more than it is buying and will eventually run out of stocks

The European Union Common Agricultural Policy has come under sustained attack for many years and there have been several attempts to reform the system.

Author: Geoff Riley, Eton College, September 2006

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AS Market Failure

Buffer Stocks

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