The prices are fixed on the basis of one or more of the following criteria: 1. Cost of Production 2. Ruling Prices Criterion 3. Parity Price Criterion.
Criterion # 1. Cost of Production:
The average cost or the bulk line cost of production calculated with the help of cost accounting technique can be made a basic for determining the level of minimum support prices. Another variant of cost accounting method is the budgeting technique.
In this approach, the cost of recommended farm practices and their average yields are taken into account to estimate the cost per unit of output. The cost of production criterion of fixing administered prices is desirable to the extent, it protects the primary producer against any loss due to an unexpected fall in prices.
There are, however, problems of assigning appropriate values to family labour and management input in calculating the cost of production. Move over, the concept of an average cost per unit of output (generally used as the basis for price fixation under this criterion) is nebulous in view of the wide variations in agro-climatic conditions and farm practices.
In other words, the variability of cost between different farms is very high. This, In turn, implies that this approach for fixing support prices for agricultural products may not cover the cost of production on every farm.
Criterion # 2. Ruling Price:
This criterion requires that the price be linked to moving average of market prices in the recent past. The advantage of this approach is that it builds the effective of demand trends into price fixation while the cost criterion ignores this aspect altogether.
The importance of this criterion, Therefore, lies in coordination the demand growth with supply growth over the relevant time periods. In the event of an excess supply outlook, demand effect should influence the price fixation via the moving average of market price.
However, in an economy where the prices might have been kept deliberately low in the past, the moving average may not properly reflect the market trends. Even otherwise, the prevailing prices, often fail to provide necessary incentives for an increase in production on long term basis.
Criterion # 3. Parity Approach:
Parity price is the price that purchases for the seller of a unit of an article as much of the other things and services as he could purchase with the same unit in a given base period. In other words, parity signatures the relationship of the administered farm prices with some index of prices paid by the farmers.
The parity approach may, thus be utilized to stabilize inter-relationship between agricultural and non-agricultural products as well as among those of different agricultural products. Parity ratio may be conceived in a number of ways.
Some of these are:
(i) Parity between prices of all agricultural commodities and all non-agricultural commodities.
This is calculated as:
We know that the purchases of manufactured commodities made by the farmers consist of agricultural inputs as well as consumer goods. Parity ratio calculated in this manner, therefore does not distinguish between protection given to the farmer as a producer and as a consumer. This method, is, however, useful when we want to know or adjust the movement of terms of trade between the agricultural and the manufacturing sector.
(ii) Parity between prices received for the farm products and prices paid for farm inputs.
This is calculated as:
This concept of parity is useful when the objective is to protect the interests of the farmer as a producer. A rising parity ratio will indicate favourable movement of the terms of trade for the farming sector.
(iii) Parity between prices of individual agricultural commodities and’ general agricultural prices.
This is calculated as:
This concept of parity is useful for bringing about adjustment in crop mix for the purpose of achieving planned targets of production in respect of certain crops. Parity ratio should be made favourable for those crops whose production is required to be boosted.
Parity approach, obviously delinks the administered prices from the cost of production. Sometime, this can create disincentives for the producers.
None of the above criteria is free from drawback. As such, the price fixing authorities do not base their decisions totally on one criterion. They rather consider not only the guidelines suggested by the foregoing approaches but also many other factors while fixing the prices.