Government Intervention in Agriculture Chapter 11

Topics of Discussion Defining the Farm Problem Forms of government intervention Price and income support mechanisms Phasing out of supply management Domestic demand expansion Importance of export demand

Importance of Government Payments To Net Farm Income Importance of Government Payments To Net Farm Income Page 212 Pre FAIR Act FAIR Act 2002 Bill 2002 Bill More market driven ag. policy under FAIR Act (1996 Farm Bill) More market driven ag. policy under FAIR Act (1996 Farm Bill) FAIR = Federal Agriculture Improvement and Reform Act

The Farm Problem Many agricultural commodities exhibit inelastic consumer demand Individual farmers lack market power  In contrast to many manufacturers Interest sensitivity  Production credit  Capital purchases International trade important market  Tends to be more volatile Asset fixity and excess capacity

Page 199 Assume we have an inelastic demand for a particular crop Also assume that due to great weather conditions there is an increase in supply due to record yields  → A shift out of supply curve at every price Results in price falling relatively more than the market clearing quantity Q $ D S1S1 S2S2 The Farm Problem P1P1 P2P2 Q1Q1 Q2Q2 ΔPΔP ΔQΔQ Market Equilibrium

Page 199 What happens to total farm revenue when you have an inelastic demand and an increase in supply?  Total revenue under original equilibrium was area 0P 1 AQ 1  Total revenue under the new equilibrium is 0P 2 BQ 2 We know that total revenue to this sector has ↓, (i.e., 0P 2 BQ 2 < 0P 1 AQ 1 )  How do we know this? Q $ D S1S1 S2S2 The Farm Problem P1P1 P2P2 Q1Q1 Q2Q2 ΔPΔP ΔQΔQ 0 A B

Page 199 In contrast, with a relatively elastic demand curve, D 2  Shift in supply will result in price P 3 instead of P 2  Shift in supply will result in quantity Q 3 rather than Q 2  Compared to inelastic demand, a larger impact on quantity and less of an impact on price  What happens to total revenue? Q $ D1D1 S1S1 S2S2 The Farm Problem P1P1 P3P3 Q1Q1 Q2Q2 D2D2 P2P2 Q3Q3

Farms and ranchers in the aggregate exhibit conditions of perfect competition  Large number of producers  Producing a homogenous product (i.e., corn, soybeans, wheat, etc)  No one farmer has sufficient market power to influence the market equilibrium price If a single producer suffers a disastrous year in terms of yield, he alone will suffer as market price is not impacted

The Farm Problem Agricultural sector is one of the most highly capitalized sector in the U.S. economy  More capital invested per worker Farmers must obtain short, medium and long-term loans to purchase variable and fixed inputs → a change in interest rates will have a significant impact on production costs

The Farm Problem

High interest rates in the U.S. economy increases the value of the dollar in foreign currency markets  More units of foreign currency per U.S. $  Makes U.S. exports more expensive Many agricultural commodities (i.e., wheat, corn, soybeans, etc) are highly dependent on export markets  For many agricultural commodities excess supply relative to domestic market  Reduced export demand → Downward pressure on commodity prices

The Farm Problem Asset fixity refers to the difficulty farmers have in disposing of capital equipment such as tractors, combines, silos, etc when downsizing or shutting down the business  When commodity prices are low and farmers are downsizing the value of these assets may be quite low relative to purchase price

The Farm Problem Excess Capacity refers to the fact that the agricultural sector can produce more than it can sell  Can have times with significant stocks of storable commodities such as corn, wheat and cheese  →Downward pressure on commodity prices Technological change can shift the supply curve to the right for all prices  Leads to excess capacity

The Farm Problem Combined effect of asset fixity and excess capacity  ↓ in farm asset values when there exists surplus commodity stocks

Government Intervention in Agriculture There is a history of state and Federal government intervention in agriculture  Designed to improve economic conditions  Provide appropriate level of environmental quality as discussed previously In terms of improving economic conditions a number of intervention types  Adjusting production to market demand  Price and income support programs  Foreign trade enhancements

Government Intervention in Agriculture Adjusting production to market demand  ↓ amount of resources employed to produce a surplus product  Primarily land  Example: Pay farmers not to produce by requiring land normally planted to be idled  → supply will decline  → Market prices will improve

Government Intervention in Agriculture Every 5 years or so the U.S. Congress enacts legislation known as the Farm Bill  Food Security Act of 1985  Food, Agriculture, Conservation and Trade Act of 1990  Federal Agricultural Improvement and Reform Act of 1996  Farm Security and Rural Investment Act of 2002  Food, Conservation and Energy Act of 2008

Government Intervention in Agriculture U.S. Farm Bills  The primary agricultural and food policy tool of the U.S. Federal gov’t.  Concerned with both agriculture and all other programs under control of USDA  i.e., food stamp and WIC programs Purpose of Farm Bills  Amends/suspends provisions of permanent law  Re-authorizes/amends/repeals provisions of previous temporary agricultural acts  Enact new policy initiatives

Government Intervention in Agriculture S 1 →original supply curve Policies restricting resource use shifts curve to S 2 Market equilibrium moves from E 1 to E 2 Total revenue  Original: OP 1 E 1 Q 1  After move: OP 2 E 2 Q 2  Does total revenue increase?  Depends on demand elasticity Q $ D S2S2 S1S1 P2P2 P1P1 Q2Q2 Q1Q1 0 E1E1 E2E2

Government Intervention in Agriculture Another strategy to improve economic conditions is to directly support farm prices and income  Obtained by gov’t setting a price floor  Price floor supported by gov’t purchases surplus commodities  Dairy product price support program Another alternative is to support farm incomes through direct transfers  RMA and revenue insurance via the 1996 farm bill

Government Intervention in Agriculture A third approach to improving economic conditions is to impact foreign trade “rules of the game”  Establish tariffs on specific commodities  Set commodity quotas A tariff on a specific imported commodity  Essentially a tax  Increases it domestic price  Could make U.S. sourced commodity more price competitive→increased demand

Government Intervention in Agriculture A quota limits the quantity than can be imported for a particular commodity By restricting supply you again shift the supply to the left at every price  ↑ equilibrium price Q $ D S2S2 S1S1 P2P2 P1P1 Q2Q2 Q1Q1 0 E1E1 E2E2

Government Intervention in Agriculture Another alternative is to ↑ demand for U.S. agricultural products in foreign markets by reducing export price  The Federal gov’t can subsidize purchase of U.S. agricultural commodities  Example: The Dairy Export Incentive Program (DEIP)

Government Intervention in Agriculture Dairy Export Incentive Program  Initiated in 1985 and still in existence  Designed to ↑ dairy product demand: butter, non-fat dry milk and cheese  Develop export markets where U.S. products are not competitively priced USDA pays cash to exporters to sell U.S. dairy products at prices lower than the exporter's price  USDA makes up the difference

Government Intervention in Agriculture Low own-price elasticity and ↑ supply can cause farm incomes to ↓ sharply Lets review 4 agricultural policies that have been used to soften the effect of ↓ farm incomes  Loan rate programs  Set-Aside mechanism  Establishment of target prices  Counter-cyclical payments mechanism

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved. Dairy Product Price Support Program Program established in 1949 CCC offers to purchse nonperishable dairy products at a specified (intervention) price and in a specified form  Cheese  Butter  Non-Fat dry milk No-limit on amount that can be sold to the CCC

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved. Dairy Product Price Support Program Dormant when market prices are above intervention prices Activated when supply of products exceeds demand at the intervention price Previous versions set support prices to essentially set a minimum milk price  Now purchase price of products are explicitly set by newest Farm Bill

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved. Dairy Product Price Support Program Public policy issues  Effectiveness in establishing a realistic price floor  Distortion in allocation of milk and relative product prices  Impact on U.S. dairy trade

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved. Budget Costs of Dairy Price Supports

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved.

The Loan Rate Mechanism Commodity Loan Rate: Sets minimum prices for farmers that participate in the program  Commodities such as wheat, corn and cotton  Lets examine how this program works at the sector or market level for wheat Q $ D MKT S MKT PFPF QFQF 0 E

The Loan Rate Mechanism Wheat market  P F, Q F : market clearing price and quantity USDAwants to support prices at P G > P F  Quantity demanded = Q D  Quantity supplied = Q G  Excess Supply of Q G - Q D Q $ D S MKT PFPF QFQF 0 E PGPG QDQD QGQG Excess Supply

The Loan Rate Mechanism USDA’s Commodity Credit Corporation (CCC) acts as purchasing agent for the Federal gov’t.  CCC makes a loan to participating farms at the desired fixed price, P G  Loan plus interest must be paid back within 9-12 months  If not profitable to repay the loan due to low wheat price  Producer can repay the loan with collateral (the crop) as payment

The Loan Rate Mechanism The goal is to shift demand from D to D+CCC Q  → ↑ price from P F to P G  Consumer demand ↓ from Q F to Q D due to higher price Q $ D MKT S MKT PFPF QFQF 0 E PGPG QDQD QGQG D MKT +CCC Q

The Loan Rate Mechanism Total taxpayer cost of purchases to achieve the target price would be P G x (Q G – Q D ) = Area Q D ABQ G Q $ D MKT S MKT PFPF QFQF 0 E PGPG QDQD QGQG A B D MKT +CCC Q

The Loan Rate Mechanism The CCC store the surplus Q G -Q D at taxpayer expense  This approach has the unwanted effect of increasing supply from (Q F to Q G ) in a sector already plagued by surplus production

The Loan Rate Mechanism Q $ D MKT S MKT PFPF QFQF 0 E PGPG QDQD QGQG D MKT +CCC Q Consumer surplus declines from area to area 6  There welfare decreases by area 3+4 Producer surplus increases from area 1+2 to area  There is a welfare gain of area Total economic surplus increases by area

The Loan Rate Mechanism Q $ S FIRM PFPF qFqF 0 E PGPG qGqG The individual firm under free market conditions will produce quantity q F at price P F  Profit = area 1 CCC purchases → the price ↑ to P G  Participating farmers ↑ production from q F to q G  Profits ↑ by the area 2  Total profit = areas

The Set-Aside Mechanism Significant problem with the loan program  Successive years of low prices → government stocks of grains and other agricultural commodities can become quite large relative to production  →Large expenditures to pay for storage To control the size of these stocks, the 1990 Farm Bill adopted a set-aside requirement for program participation

The Set-Aside Mechanism Set-aside requirements  Farmers must remove a certain % of cropland from production  Condition for receiving program benefits  Used for a majority for most major food and feed grains to reduce surplus production such as corn and wheat Crop-specific %’s determined in part by expected ratio of ending stocks to total use

The Set-Aside Mechanism Major Problem Farmers will set-aside their poorest land first and crop the remaining acres more intensely  Results in larger supply and lower prices than desired by policy-makers 1995 Farm Bill eliminated the ability of USDA to require set-asides

The Set-Aside Mechanism What are the market-level impacts?  S MKT, market supply curve prior to acreage restrictions  E 1 is initial equilibrium at P F,Q F  Assume the Federal gov’t wants to support farm price at level P G Q $ D S MKT PFPF QFQF 0 PGPG QGQG QSQS E1E1

The Set-Aside Mechanism Assume that X% of land must be idled  Resulting supply curve, S MKT*  Achieve desired point Welfare effects  Farmers give up areas 2 +3 but gain area 6  On net, farmers gain as area 6 > areas (2 + 3)  Consumers lose sum of areas 4, 5 and 6  Net loss to society =sum of areas 3+4 Q $ D S MKT PFPF QFQF 0 E1E1 PGPG QGQG QSQS S MKT* E2E2 Why is SMKT* curved?

The Set-Aside Mechanism Unlike CCC purchases, the set-aside program does not encourage production as under loan-rate program Q $ D S MKT PFPF QFQF 0 E1E1 PGPG QGQG QSQS S MKT* E2E2

The Set-Aside Mechanism Q $ D S Firm PFPF qFqF 0 PGPG qGqG S Firm* At the firm level the set- aside program causes output to be reduced from q F to q G Welfare Impacts (PS)  Before policy =  After policy =  Gain = 4 – 2 – 3  Whether gain is positive or negative depends on  Supply elasticities  Demand elasticities  Amount of shift of S Page 208

The Target Price Mechanism Another method for assisting with the maintenance of farm income has been the use of target price deficiency payments The Federal government sets a predefined target price for particular crops  Payment/bushel is based on the difference between the target price and the market price or loan rate, whichever is higher Page 209

Target Price Deficiency Payment Mechanism Deficiency payment = Q M x (TP – max(MP, LR)) shown as the blue shaded area TP = Target Price MP = Market price LR = Loan Rate Deficiency payment = Q M x (TP – max(MP, LR)) shown as the blue shaded area TP = Target Price MP = Market price LR = Loan Rate

Recent Approaches to Supporting Farm Prices and Income

Policy The 1996 FAIR Act many of previously reviewed mechanisms  Loan rate mechanism remained  Set-aside program eliminated  Deficiency mechanisms eliminated Participating farmers receive fixed contract payments that were phased out over time Farmers were “free” to plant whatever crops they desire and still receive contract payments. No longer had a variable safety net should crop prices drop due to weak export demand. Pages

The 2002 Farm Bill Began in 2002 and expired in 2007 Retained loan rate mechanism Retained a fixed payment mechanism introduced under FAIR Act in 1996 Added a new counter-cyclical mechanism Updating base acres and program yields Risk management tools such as enhanced crop insurance coverage Pages

Milk Income Loss Contract Program Milk Income Loss Contract (MILC) Program  Target price deficiency payment program but for dairy  Direct payments to dairy farmers when milk price falls below a specified level  First enacted under the 2002 Farm Bill  Since 2002, $3.9 Bil payed to U.S. dairy producers Individual farm payments are limited by an annual production cap  Program unpopular in regions with large herds

Milk Income Loss Contract Program

Countercyclical Payments Established via 2002 Farm Bill  Applied to a number of grain crops Countercyclical Payment: The payment ($/bu) = TP – EP  EP = effective price = max(12 month avg market price, LR + DP) where DP is a direct payment rate  DP is based on commodity base acres not what you plant that year Page 210

Countercyclical Payments D S LR PF TP Q Payment acres cannot exceed planted acres The maximum countercyclical payment = sum of areas 3 and 4 Page 210

Some Demand Side Options

Domestic Demand Expansion Increased farm income can be obtained through domestic demand expansion  → Shifting out farm products demand curve in the U.S.  Profits increase by area P F P G E 2 E 1 Page 210 D1D1 S PFPF QFQF D2D2 PGPG QGQG E1E1 E2E2

Domestic Demand Expansion Producer surplus impacts  PS before shift = 1  PS after shift =  PS Gain = > 0 Consumer surplus impacts  CS before shift =  CS after shift =  CS Gain = 4 – 2 0?  Societal surplus = > 0 Page 213 D1D1 S PFPF QFQF D2D2 PGPG QGQG E1E1 E2E

Domestic Demand Expansion How can domestic demand be shifted out and therefore result in higher equilibrium prices and quantities?  School feeding and other nutrition service programs (i.e., Food Stamps, WIC)  Advertising and promotional programs  The gov’t can subsidize the development of uses for farm products  i.e., state and Federal subsidies in the use of ethanol as a gasoline extender Page 213

Export Demand Expansion Many agricultural commodities are highly dependent on foreign markets for purchases  For agriculture as whole > 20% of the value of total production is exported  The importance of export market varies by commodity Page 213 Commodity 07/08 07/0808/0909/1010/11 Corn Wheat Soybeans Note: Exports originate from both current and stocks. The above gives some sense of importance of foreign markets Exports as % of Current Production

Export Demand Expansion Remember that domestic demand for many agricultural products are inelastic Export Demand tends to be more elastic than domestic demand At a given price, domestic demand + export demand = total demand Page 213 DD S Q DD P DD TD E1E1 Q DD

Export Demand Expansion P 0 = price where export demand = 0 E 1 represents equilibrium with no export demand E 2 represents equilibrium with export demand Price and quantity both increase Page 213 DD S Q DD P DD TD EoEo E1E1 E2E2 Q DD P TD PoPo

Export Demand Expansion What the welfare impacts of having trade? Producer Surplus  Before trade = 1  After trade =  Gain = Domestic Consumer Surplus  Before trade =  After trade = 5  Loss = 2 Foreign Consumer Surplus at E 2 = 4 Page 213 DD S Q DD P DD TD EoEo E1E1 E2E2 Q DD P TD PoPo

Summary USDA has tried to support prices and incomes by acquiring/storing excess supply at desired price USDA supply side approaches to supporting farm prices and incomes included set-aside rates and deficiency payments FAIR Act decoupled supports from planting decisions; resulted in large supplemental payments during period. New bill restored safety net with counter-cyclical payments Demand side approaches designed to promote domestic and/or export demand

Chapter 18 focuses on why nations trade ….