4 - The Effects of Rice Subsidies in Thailand - Lecture Notes

Case Snapshot

It is June 2014. Dr. Chairat Hiranyavasit and a team of economists must advise General Prayut Chan-o-cha, who has just seized power in a May 2014 military coup, on what to do with the rice price-support scheme launched in 2011 by the ousted prime minister.

The 2011 scheme:

• The government bought rice from farmers at a price 50% above the world market price.
• It planned to stockpile the rice (withhold supply), push the world price up, then sell later at a profit.

What actually happened:

• Thailand piled up unprecedented, unsellable stockpiles.
• India and Vietnam filled the gap Thailand left, so the world price did not rise.
• The program ran enormous fiscal losses, suffered fraud (100,000 tons "disappeared"), and the rice degraded in storage.
• Farmers went unpaid for months; some committed suicide; the fallout helped trigger the coup.

The decision: continue the scheme, stop it, or replace it - and design agricultural policy going forward.

The exam question type: a government sets a price above the market level and buys the surplus. Analyze the welfare effects, the deadweight loss, who really benefits, and why the policy failed.

Background - From the 2007 Rice Spike to the 2011 Scheme

• Rice is Thailand's most important crop: half of rural agricultural employment, and agriculture employs about 49% of the labor force. Agriculture, forestry and fishing were 8.4% of GDP (2013). Thailand was a top-three rice exporter with India and Vietnam.
• 2006 policy: the government bought rice below the world price, to encourage exports while guaranteeing farmers a buyer.
• 2007-2008 rice spike: the world price of rice shot up 198% as production lagged, oil and fertilizer costs rose, and major rice-producing countries restricted exports to protect their own consumers. Thailand did not restrict exports; farmers hoarded rice to sell high.
• 2011 scheme (the focus): the government bought rice at 50% above the world price and stockpiled it, betting it could manipulate the world price upward.

Core Theory - Price Supports and Price Floors

A price support is a price floor: a minimum price set above the market equilibrium.

A binding price floor produces a surplus - at the high price, quantity supplied exceeds quantity demanded. The price floor cannot survive on its own, because sellers competing to offload the surplus would push the price back down. To hold the floor up, someone must buy and remove the surplus.

That is exactly what Thailand did: the government became the buyer of last resort, paying the support price and stockpiling whatever private buyers would not take. A price support of this kind is therefore really a subsidy financed by the taxpayer, plus a growing government inventory.

Welfare Analysis - Surplus and Deadweight Loss

The Price-Floor Diagram

Price
  |              S (domestic supply)
  |             /
Ps|------------/------------------  support price  (= 1.5 x world price)
  |           /|               |
  |          / |               |
Pw|---------/--|---------------|---  world price
  |        /   |               |\
  |       /    |               | \   D (private buyers' demand)
  +------/-----+---------------+--\------ Quantity
            Qd                Qs
  At the support price Ps:
    - quantity supplied  rises to Qs (farmers expand output)
    - quantity demanded  falls to Qd (private buyers buy less)
    - the government must BUY the surplus (Qs - Qd) and stockpile it

Sources of Deadweight Loss

The price support transfers money to farmers and imposes costs on taxpayers. The pure efficiency loss - the deadweight loss - comes from several sources:

1. Over-production. The support price Ps pulls farmers to expand output until their marginal cost equals Ps. But those extra units are only worth the world price Pw to buyers. Resources are spent producing rice worth less than it cost. The loss on the extra output is approximately a triangle:

   Deadweight loss from over-production  ~=  1/2 x (Ps - Pw) x (extra quantity)
   

2. Storage, spoilage, and waste. Thailand bought paddy (unmilled) rice, of which about 40% of the weight is waste. Stockpiled rice degraded; 100,000 tons simply disappeared from government granaries.

3. Resale at a loss. The government bought high and, to reduce the stockpile, sold low - much of it to foreign governments at deep discounts.

Because Thailand exported the rice, domestic consumers were not the main losers - the taxpayer was. In effect the government handed farmers (Ps - Pw) per ton and then absorbed the storage, waste, and resale losses on top.

Why the Plan to Raise the World Price Failed

This is the single most important analytical point of the case.

The scheme's hidden assumption: by stockpiling rice (withholding supply), Thailand could raise the world price and later sell high. That only works if Thailand has market power in the world rice market - that is, if it faces a downward-sloping, inelastic residual demand curve, like a monopolist or a dominant cartel member.

The reality:

• Thailand is one of several large exporters. India and Vietnam sell a very close substitute.
• When Thailand withheld rice, India and Vietnam simply expanded their exports and filled the gap. India even had its own stockpile, built up by restricting exports since the 2007 spike.
• So Thailand faced a highly elastic residual demand curve. It could not move the world price. It just lost market share - and lost its title as the world's number-one rice exporter.

The general lesson: a single supplier (or a would-be cartel) cannot raise the price by cutting its own output when close substitutes and other suppliers exist who do not cooperate. The lone supplier that cuts output simply hands its customers to rivals. This is the cartel-instability / competitive-fringe problem - the same reason OPEC needs every member to cut, and a lone member who cuts just loses sales.

Comparative Advantage and Trade

Why does Thailand grow so much rice in the first place?

• Thailand's factor endowments: extensive wetland, a large low-skilled rural labor force, but limited capital and skilled labor.
• Comparative-advantage logic (Heckscher-Ohlin): a country exports goods that use its abundant factors intensively. Rice is land- and low-skill-labor-intensive, so Thailand has a genuine comparative advantage in rice and gains from specializing and trading.

But the price support pushed production past the efficient point: farmers expanded onto marginal, unsuitable land outside irrigation zones. Producing rice that the world values at only Pw, at a marginal cost of Ps, erodes the gains from comparative advantage rather than exploiting them.

Negative Externalities of Over-Production

The subsidy inflated rice output, and the extra production generated negative externalities - costs imposed on others that farmers do not pay:

• Water depletion. Rice is extremely water-intensive: the rainy season needs about 600 cubic meters of water per rai, the hot season about 990 cubic meters per rai, with two harvests a year. Farmers expanded outside normal irrigation zones and competed with households and industry for scarce water.
• Water and soil pollution. Heavy use of synthetic fertilizer caused runoff, polluting water and soil and lowering rice quality and growth.
• Deforestation and land degradation. Cultivated land expanded from 10,667,000 rai to 11,000,000 rai, clearing land and degrading soil.

Because the private cost of growing rice is below the social cost (which includes water depletion and pollution), the market over-produces even without a subsidy - and the subsidy makes the gap worse.

Pricing Water - A Marginal-Cost Tool

To manage the water externality, the government used a rising block tariff for water: the per-unit price increases as usage rises - from 17.00 THB for the first 10 cubic meters up to 32.50 THB per cubic meter above 3,000 cubic meters.

The economics: this is an increasing-marginal-cost / progressive pricing scheme. By making heavy users pay a higher price at the margin, it forces them to internalize the scarcity and externality cost of water - a practical approximation of a Pigouvian tax, which sets price equal to marginal social cost to correct an externality. It also rations a scarce resource toward its highest-value uses.

Who Actually Benefited - Subsidy Incidence

The scheme was sold as help for poor family-run rice farmers. Trace where the benefit actually went - this is subsidy incidence.

• 76% of farmland was owned by landlords, not by the farmers who worked it.
• Farmland rent quadrupled in four years - Exhibit 7 shows monthly rent rising from 500 to 2,000 baht per rai between 2010 and 2014.
• The economic mechanism - capitalization: when a subsidy raises the return to farming, farmers compete for the fixed factor (land), bidding rents and land prices up. The subsidy gets capitalized into land rents. The benefit flows to the landowner, not the tenant farmer.
• Large players also captured much of the gain: 44.66% of exported rice came from just five large corporations (Asia Golden Rice, Capital Rice Group, C.P. International, Thanasan Group, Riceland International).

The general principle: the party that legally receives a subsidy is not necessarily the party that economically benefits. The benefit settles on the owner of the most inelastically supplied input - here, land.

Government Failure and Political Economy

The case is a textbook government failure: an intervention meant to help produced an outcome worse than the market, because of political incentives, poor information, and administrative waste.

• Vote-buying / political business cycle: the scheme was launched largely to win the farming vote for the 2011 election.
• Public choice - concentrated benefits, diffuse costs: farmers are a concentrated, politically powerful, electorally over-represented group (rural districts are over-weighted in the voting system). Taxpayers bear diffuse costs and do not organize. So an inefficient policy can be politically durable. Add rent-seeking by the agricultural lobby and elites with farming interests.
• Corruption and fraud: 100,000 tons vanished from granaries; the scheme was riddled with fraud.
• Unintended behavioural responses: farmers hoarded, stretched output, and planted marginal land; rice quality fell.
• Political instability: the program's collapse helped justify the 2014 military coup. A policy meant to buy support ended up destabilizing the government.

The Fiscal Cost - Working the Numbers

Purchases, Sales, and Costs

From Exhibit 4, the three program years (figures in THB):

The Net Loss

Total paddy purchased = 21,476,354 + 22,476,596 + 10,796,154
                      = 54,749,104 tons

Milled rice (paddy is 40% waste, so 60% usable):
   0.60 x 54,749,104  =  about 32,849,462 tons

Total spending = rice cost + other costs
   Rice cost  : 336,069 + 353,156 + 181,249  = 870,474 million THB
   Other cost :  25,119 +  26,289 +  12,628  =  64,036 million THB
   Total                                     = 934,510 million THB

Total sales revenue = 57,743 + 70,617 + 51,750 = 180,110 million THB

NET CASH LOSS = 934,510 - 180,110 = 754,400 million THB
             ~= USD 22.2 billion   (at 34 THB per USD)

And that is before counting what is still unsold: about 18.7 million tons sat in government storage, degrading, plus the 100,000 tons lost. The government recovered under 20% of what it spent.

For perspective: in 2011/2012 the government paid about 336,069,000,000 / 21,476,354 = 15,648 THB per ton of paddy, while private buyers were paying farmers only about 12,776 THB/ton (2011), 13,287 (2012), and 13,148 (2013). By mid-2014 the military regime was selling to China at just 10,096 THB/ton - far below the purchase cost.

The Recommendation

Dr. Hiranyavasit's options and their trade-offs:

• Continue buying above the world price: pleases politically powerful farmers, but is fiscally ruinous, environmentally damaging, and breaking this promise was the stated justification for the coup.
• Stop the scheme: halts the losses and honors the coup's rationale, but alienates farmers and cuts rural incomes in the short run.
• Replace it with a less-distorting instrument:
  • Decoupled / direct income support - a payment not tied to output, so it raises farm incomes without triggering over-production.
  • Crop or price insurance against bad harvests and price swings.
  • A guaranteed-buyer scheme at or below the world price (the 2006 model).
  • Investment in productivity - irrigation, infrastructure, research - which builds on Thailand's true comparative advantage.

The advice must weigh producers against consumers against taxpayers, and fold in environmental, social, and international costs, as well as arguments about national food security and national pride.

Exam Toolkit - Solving a Price-Support Case

1. Identify the instrument: a price floor / price support with the government as residual buyer of the surplus.
2. Draw supply and demand; mark the world price, the support price, and the surplus Qs - Qd.
3. Do the welfare analysis: producers gain, taxpayers pay, and the deadweight loss = over-production triangle + storage/waste + resale loss.
4. Test the market-power assumption: does the country actually face a downward-sloping residual demand? If close substitutes and rival suppliers exist, any plan to raise the world price by withholding supply fails.
5. Find the externalities of the induced over-production (here: water depletion, pollution, deforestation).
6. Trace the incidence: who really benefits? Watch for capitalization into land rents and gains captured by large producers.
7. Apply political economy: concentrated benefits versus diffuse costs, vote-buying, rent-seeking, corruption - this is government failure.
8. Compute the fiscal cost: total purchases + other costs - sales revenue; note unsold and wasted stock.
9. Recommend less-distorting alternatives: decoupled income support, insurance, productivity investment.

Formula Sheet

Support price        Ps = 1.5 x world price Pw   (50% above world price)
Subsidy per ton      = Ps - Pw = 0.5 x Pw

Surplus the government must buy = Qs - Qd
   (quantity supplied at Ps)  -  (quantity demanded at Ps)

Deadweight loss from over-production
   ~= 1/2 x (Ps - Pw) x (extra quantity produced)

Government / taxpayer cost
   = (Ps x quantity bought) + storage + admin  -  resale revenue

Net program loss = total spending - sales revenue
   = 934,510 - 180,110 = 754,400 million THB

Milled rice = paddy rice x (1 - 0.40) = paddy x 0.60

Subsidy incidence: the benefit is capitalized into the price/rent of the
   most inelastically supplied input (land).

Conversions: 34 THB = 1 USD;  1 rai = 1,600 sq m = 0.395 acre;
             1 unit of water = 1 cubic meter.

Practice Questions

1. Draw the supply-and-demand diagram for a price support set above the world price. Identify the surplus, who buys it, the gain to producers, the cost to taxpayers, and the deadweight loss.

2. Explain precisely why Thailand's plan to push up the world price by stockpiling rice failed. What condition would have had to hold for it to work?

3. The government bought 54,749,104 tons of paddy rice. Paddy is 40% waste. How many tons of milled rice does that yield?

   Answer

   0.60 times 54,749,104 = about 32.85 million tons.

4. Total program spending was 934,510 million THB and sales revenue was 180,110 million THB. Compute the net loss in THB and in USD at 34 THB per USD.

   Answer

   754,400 million THB, about USD 22.2 billion.

5. The subsidy was meant to help poor tenant farmers, yet farmland rent quadrupled. Explain, using the idea of capitalization, who actually captured the benefit.

6. List three negative externalities of the rice over-production and explain why a subsidy makes them worse.

7. Use the concepts of concentrated benefits and diffuse costs to explain why a fiscally ruinous farm subsidy can still be politically popular.

8. Recommend a less-distorting way to support farm incomes than a price support, and explain why it avoids the over-production problem.