2016 Case Study Question 1

a) Based on Figure 1, the value of India’s total imports in 2013 was about US$19b and the value in 2005 was US$5.5b. Therefore, the increase in the value of India’s total imports from 2005 to 2013 was about US$13.5b.

b) An effective minimum price which is set above the equilibrium price will lead to an increase in the price. When this happens, the quantity supplied will rise and the quantity demanded will fall which will lead to a surplus. Students should draw a minimum price diagram to show the surplus. According to Extract 2 (Paragraph 1), the Indian government purchases rice and wheat directly from farmers at minimum prices which can explain the general increase in the buffer stocks of wheat and rice shown in Figure 2. Due to the minimum prices for wheat and rice which led to the artificially higher prices, export competitiveness fell which could explain why the general increase in exports of wheat and rice shown in Figure 2 is smaller than the increase in the buffer stocks.

c) According to Table 1, the terms of trade index in India were higher in 2013 compared to 2005. An increase in the terms of trade index may occur due to a rise in the index of export prices or a fall in the index of import prices.

d) An increase in the demand for India’s agricultural products will lead to an increase in the price and the quantity of exports resulting in an increase in the value of exports and hence net exports. Extract 1 (Paragraph 1) states that India’s exports of agricultural products increased from about US$5b in 2003 to more than US$39b in 2013 which likely indicates an increase in the demand. When the price of India’s agricultural products rises due to an increase in the demand, the index of export prices will rise. When this happens, the terms of trade index will rise. Table 1 shows that India’s terms of trade index increased from 105.2 in 2005 to 131.1 in 2013.

e) India may specialise in the production of agricultural products due to its comparative advantage in producing the good. The production of agricultural products requires fertile land. India has a large amount of fertile land and hence has a comparative advantage in producing agricultural products. Extract 1 (Paragraph 1) states that India is a major agricultural exporter which likely indicates that it has a comparative advantage in the production of agricultural products. Therefore, based on the law of comparative advantage, India should specialise in producing agricultural products which will lead to higher exports and resulting in higher economic growth. This is particularly true in view of the fact that a large proportion of India’s exports go to developing countries which is stated in Extract 2 (Paragraph 3), and the fact that developing countries generally have a higher import growth of agricultural products compared to developed countries which may lead to a fast growth of India’s exports of agricultural products to these countries which is also indicated in the same paragraph. Extract 1 (Paragraph 1) states that India’s exports of agricultural products increased from about US$5b in 2003 to more than US$39b in 2013. It also states that India’s annual export growth of agricultural products of more than 21% over the past decade has been the highest of any country. These indicate higher exports and hence higher economic growth in India.

India may not specialise in the production of agricultural products despite its comparative advantage in producing the good. As world income rises due to factors such as globalisation, the demand for normal goods will rise. However, as agricultural products are a necessity with a low income elasticity of demand, the increase in the demand is likely to be limited which will lead to slow economic growth, other things being equal. Therefore, high dependence on the production and export of agricultural products in India is likely to lead to slow economic growth. According to Extract 3 (Paragraph 1), global commodity prices are weakening. As the demand for agricultural products is price inelastic due the high degree of necessity, this will lead to a smaller proportionate increase in the quantity demanded. When this happens, farmers’ income will fall and this is undesirable as farmers are generally low income individuals. If the Indian government increases subsidies to help farmers which will further hurt farmers in other countries, it may invite retaliation from their governments which is also stated in the same paragraph. Furthermore, it will exert a strain on the government budget which may force the government to reduce expenditure on infrastructure which is infamously poor in India to avoid a budget deficit and this may have adverse consequences for the economy in the long run. Extract 2 (Paragraph 1) states that government’s support for agriculture already hit US$85b in 2013/14 and was expected to reach a record high in 2014/15.

India may need to produce certain goods even though it has a comparative disadvantage. Some industries produce vital goods such as water and armaments, where over-dependence on imports may put the country at great risk in the event that international trade is disrupted which may happen in times of war. Therefore, the Indian government should produce these goods even if it has a comparative disadvantage. This is particularly true in view of the fact that India is a developing country where there are many low income households who are unable to afford a high price of water, and the fact that India has pretty hostile neighbours which include Paskitan and Bangladesh. Extract 2 (Paragraph 2) states that there are about 800 million poor people in India.

Evaluation: As high dependence on the production and export of agricultural products in India is likely to lead to slow economic growth, the government should speed up industrialisation to produce more manufactured goods to increase economic growth as manufactured goods have a higher income elasticity of demand than agricultural products. India has a large amount of low-skilled labour and hence has a comparative advantage in producing low value-added goods. Therefore, the government can attract foreign direct investment to realise the comparative advantage and this can be done through improving the country’s infrastructure and lowering the corporate income tax. In the longer term, India should move up the value-added chain by increasing its amount of high-skilled labour through education and training to develop a comparative advantage in the production of high value-added goods.

f) The Indian government provides financial support to farmers in the form of subsidy and minimum price.

Subsidy

A subsidy will lead to a fall in the cost of production which will lead to an increase in the supply. When the supply increases, the quantity will rise and the price will fall. As the subsidy will be greater than the fall in the price, the effective price will rise. Students should draw a diagram indicating the effects of a subsidy on the price and the quantity.

Advantages

  1. The producer surplus will increase due to a rise in the quantity and the effective price which will lead to an increase in farmers’ income and this is desirable as farmers are generally low income individuals. Students should indicate the increase in the producer surplus on the diagram.
  2. The prices of subsidised agricultural products will be lower for consumers and this is desirable as agricultural products are essential goods. This is especially true in view of the fact that India is a developing country where there are many low income households. Extract 2 (Paragraph 2) states that there are about 800 million poor people in India.
  3. The lower prices of subsidised agricultural products will lead to an increase in exports which will lead to higher economic growth. Extract 1 (Paragraph 1) states that India is a major exporter of agricultural products which indicates that an increase in exports of agricultural products is likely to have a large positive effect on economic growth.
  4. As subsidy works through the price mechanism, the market will clear.

Disadvantages

  1. Subsidy is costly and hence will exert a strain on the government budget and this may force the government to reduce expenditure on important areas such as education which will have adverse consequences for the economy in the long run. Extract 2 (Paragraph 1) states that government’s support for agriculture already hit US$85b in 2013/14 and was expected to reach a record high in 2014/15.
  2. Subsidy will lead to the loss of social welfare as it will lead to over-production. Students should indicate the welfare loss on the diagram.
  3. The prices of non-subsidised agricultural products will be higher for consumers as farmers divert resources from the production of the goods to the production of subsidised agricultural products. Extract 3 (Paragraph 2) states that farm subsidies have incentivised farmers to devote more resources to subsidised crops which lead to lower production and hence higher prices of non-subsidised crops such as fruits and vegetables.
  4. Although subsidy will increase farmers’ income, it will not prevent farmers’ income from falling in the event of adverse conditions for farmers such as an increase in the supply or a decrease in the demand for agricultural products.
  5. Subsidy is considered a protectionist measure and hence may invite retaliation from other countries. Extract 3 (Paragraph 3) states that other countries are likely to follow suit if India will not follow the WTO rules it has agreed.

Minimum Price

An effective minimum price which is set above the equilibrium price will lead to an increase in the price. When this happens, the quantity supplied will rise and the quantity demanded will fall which will lead to a surplus. Students should draw a minimum price diagram to show the surplus. According to Extract 2 (Paragraph 1), the Indian government purchases rice and wheat directly from farmers at minimum prices. Therefore, the quantity bought and sold will rise. Students should draw a diagram indicating the effects of a minimum price on the price and the quantity.

Advantages

  1. The producer surplus will increase due to a rise in the price and the quantity bought and sold which will lead to an increase in farmers’ income and this is desirable as farmers are generally low income individuals. If the government buys up the excess supply which is likely to be the case as the objective of the minimum price is to help farmers, the producer surplus and hence farmers’ income will rise and this is desirable as farmers are generally low income individuals. Students should indicate the increase in the producer surplus on the diagram.
  2. Minimum price will not only increase farmers’ income, it will also prevent farmers’ income from falling in the event of adverse conditions for farmers such as an increase in the supply or a decrease in the demand for agricultural products.
  3. Minimum price is not considered a protectionist measure and hence will not invite retaliation from other countries.

Disadvantages

  1. Minimum price is costly and hence will exert a strain on the government budget and this may force the government to reduce expenditure on important areas such as education which will have adverse consequences for the economy in the long run. Extract 2 (Paragraph 1) states that government’s support for agriculture already hit US$85b in 2013/14 and was expected to reach a record high in 2014/15.
  2. Minimum price will lead to the loss of social welfare as the expenditure that will be incurred by the government on buying up the excess supply can be channelled to alternative uses which can increase social welfare. Students should indicate the welfare loss on the diagram.
  3. The prices of the agricultural products with a minimum price will be higher for consumers. The prices of other agricultural products will also be higher for consumers as farmers divert resources from the production of the goods to the production of the agricultural products with a minimum price. This is undesirable as agricultural products are essential goods. This is especially true in view of the fact that India is a developing country where there are many low income households. Extract 2 (Paragraph 2) states that there are about 800 million poor people in India.
  4. The higher prices of the agricultural products will lead to a lower growth of exports which will lead to lower economic growth. Extract 2 (Paragraph 2) states that the Indian government implemented minimum prices for wheat and rice and figure 2 shows exports of wheat and rice increased by a small extent from 2005 to 2013.
  5. As minimum price does not work through the price mechanism, the market will not clear.

Evaluation: The Indian government should not use subsidy and minimum price as long-term measures to help farmers. As world income rises due to factors such as globalisation, the demand for normal goods will rise. However, as agricultural products are a necessity, the increase in the demand is likely to be limited which will lead to slow economic growth, other things being equal. The Indian government should speed up industrialisation to create more jobs in the manufacturing sector and provide education and training to farmers to fill in the jobs. This will not only increase farmers’ income, it will also increase economic growth as manufactured goods have a higher income elasticity of demand than agricultural products.

A more elaborate answer to 2016 Case Study Question 1 will be provided in the economics tuition class.

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