Question:
Consider markets for fresh vegetables and instant noodles. Consider that fresh vegetables are the best standard, while instant noodles are inferior. Suppose Congress bans widely used fertilizers and pesticides in vegetable farming. Without these inputs, vegetable yields fall due to increased decay and insect damage.
(a) Using a supply and demand diagram, explain how this policy affects the equilibrium price and quantity of fresh vegetables.
(b) Explain how the high price of vegetables affects the real purchasing power of the household.
(c) Assuming that vegetables are a normal good and instant noodles are a bad good, explain how the policy affects the demand for each good.
(d) Using a supply and demand diagram, show the change in equilibrium price and quantity of instant noodles.
(e) What is the unintended consequence of this human food system?
Solution:
Two aspects of this setup drive everything that follows: the average/low difference between the two goods, and the fact that regulation increases the cost of producing vegetables. Together they determine how policy affects prices, rates, and domestic consumption.
(a) Fresh vegetable market
The ban does not initially make consumers want fewer vegetables. It makes vegetables more expensive to supply. Without restricted inputs, farmers obtain fewer usable vegetables for a given amount of land, labor, and capital: some output is lost due to low yields, and some to pest damage. At any price, farmers are willing and able to sell fewer vegetables than before.
In the standard supply and demand framework, this is a left shift of the vegetable supply curve. The demand did not change at first. The market is fixed by a high valuation and a low valuation. Consumers pay more for vegetables and buy fewer of them.
(b) Purchasing power
The high price of vegetables reduces real household income. Average income has not changed, but a budget that once bought more goods now buys less, because one of those goods costs more. A family that wants its old value of vegetables must spend more money to get it, leaving less for everything else; A household with fixed vegetable income should accept fewer vegetables. Either way the budget limit is tight.
The magnitude of this effect depends on how large the vegetables are in the household budget. For most households the share is modest, so the loss of real income from this one price increase is real but small. It is important here not because it is big, but because it is a channel for the regulation of the vegetable market that reaches the other food market.
(c) Demand for each good
It is useful to distinguish the two different effects, because they act differently on the two properties.
The switching effect comes from changes in relative prices. Vegetables are now more expensive compared to instant noodles, so at the margin consumers are switching from vegetables to noodles, holding back real income.
The income effect comes from the loss of real purchasing power. Its direction depends on whether the good is normal or low. Vegetables are common, so lower real incomes push vegetable consumption down. Noodles are cheap, so low real income pushes consumption of noodles up.
For vegetables, substitution and income effects reinforce each other in reducing consumption. A higher relative price of vegetables causes consumers to move along the demand curve for vegetables, buying fewer vegetables. A reduction in real income also shifts the demand for vegetables to the left, because vegetables are a common good.
For noodles the two results point in the same direction. Substitution raises demand for noodles because vegetables are more expensive; the income effect also increases the demand for noodles, because noodles are cheap and real income falls. This is an interesting situation to analyze: it is because the noodles are low that the effect of income increases rather than reduces the effect of change.
(d) Instant noodles market
The regulation applies to the cultivation of vegetables, so the supply of noodles does not change. What changes, in the first case, is the need. From part (c), both the substitution effect and the income effect raise the demand for noodles, so the demand curve for noodles shifts to the right. Along the fixed supply curve for noodles, this produces a higher equilibrium price and a higher equilibrium price. Consumers buy more noodles and pay more for them.
There is a feedback effect that should be noted. As the price of noodles rises, noodles become less attractive than they were immediately after the shift in demand. To the extent that the two goods are substituted, this higher price of noodles raises the demand for vegetables relative to what it would otherwise be, slightly removing the leftward pressure on the demand for vegetables in part (c). This slows the adjustment but does not reverse it: the original vegetable supply shock is still there, so vegetables remain more expensive and less consumed than before the regulation, with no reason to think that the response is strong enough to eliminate the initial shock.
(e) Unintended consequence
The unintended consequence follows directly from pricing theory. Regulation aimed at limiting the chemical used in vegetable cultivation increases the cost of producing vegetables. Higher production costs reduce supply, raise prices, and lower the quantity consumed. Because families are facing limited budgets, high prices also reduce real purchasing power, and some consumers are substituting lower-quality goods for cheaper ones, including instant noodles.
Therefore a policy aimed at one end may harm the results of another. By making fresh vegetables more expensive, regulation can lead people to eat fewer vegetables and eat more processed, less nutritious vegetables than they otherwise would. The methodology is driven by the constraints, relative values, and limits within which households adjust, not for anyone’s purposes.
