Government Intervention in Agriculture Slides are from:

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

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

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

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

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 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 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 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 Another alternative is to support farm incomes through direct transfers

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 domestic 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 agricultural products in foreign markets by reducing export price  Export subsidies  Export tax reductions

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

The Loan Rate Mechanism Commodity Loan Rate: Sets minimum prices for farmers that participate in the program  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 Government wants 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 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 Government 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 Government 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

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

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 Government 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 Govermnent 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

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

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