Contradictory Predictions on Supply Response under Stabilization: a Reconciliation

Two separate bodies of literature on stabilization give radically different results, yet these contradictions do not appear to have attracted any attention until now. The first arises from the neoclassical theory of stabilization and predicts that beneficial stabilization will always attract positive supply response. The second arises from the work of Newbery and Stiglitz and predicts 'perverse' supply response for highly risk-averse producers. In this paper, the differences which yield these results are described and some suggestions are made for a generalized model. CONTRADICTORY PREDICTIONS ON SUPPLY RESPONSE UNDER STABILIZATION: A RECONCILIATION One of the major grounds for proposing price stabilization schemes is the belief that, in the absence of stabilization, producers subject to risk will hold output below the socially optimal level. This belief is based on the neoclassical model of the firm under uncertainty, due to Sandmo (1971). A debate about the validity of this rationale for stabilization (Blandford and Currie, Colman, Quiggin and Anderson 1979) has proceeded in parallel with the large literature on buffer stock stabilization arising from the work of Waugh, Oi and Massell, in which risk considerations were largely ignored. The publication of a major work on the theory of buffer stock stabilization by Newbery and Stiglitz has put risk, and its effects on supply, at centre stage in the analysis of stabilization. However Newbery and Stiglitz do not refer to the neoclassical literature on stabilization and risk-reduction arising from the work of Sandmo. Results derived using the Newbery-Stiglitz framework differ in important respects from those which were taken as common ground by participants in the debate over the risk-reduction rationale for stabilization. Perhaps the most important area of divergence is that of supply response to stabilization, where the two frameworks yield directly contradictory results. For example, Quiggin (1983), using the neoclassical model, shows that price underwriting will always yield a positive supply response when producers are risk-averse. By contrast, Fraser (1988) using a Newbery-Stiglitz model, shows that underwriting will yield a negative supply response for sufficiently risk-averse producers. Similarly, Quiggin and Anderson (1981) show that price band stabilization will always yield a positive supply response when producers are risk-averse. Once again, the Newbery-Stiglitz model yields a contrary result (Fraser 1989). A number of the key results in the Newbery-Stiglitz framework depend on the surprising fact that individuals with a constant coefficient of relative risk aversion greater than 1 will display 'backward bending' supply of labor. This linkage between the theory of choice under uncertainty and the theory of labor supply under certainty is vitally important for the analysis of the long-run effects of stabilization. The purpose of this note is to examine the results of Newbery and Stiglitz and to compare their results with those which arise from an alternative formulation of the theory of the firm under uncertainty, due to Sandmo. It is shown that although the latter model supports the view that beneficial stabilization increases output, it is also possible for price policies which make producers worse off to yield increased output, and for policies which initially benefit producers to make them worse off in the long run. The Newbery-Stiglitz and neoclassical models Labor supply plays a key role in the analysis of stabilization undertaken by Newbery and Stiglitz, based on the assumptions that labor is the sole factor of production and has a zero opportunity cost (apart from the disutility of effort). The optimal labor supply problem may be written as (1) Maxx W = U(y) v(x), where: