© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Farm Problem Chapter 29

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n This chapter explores the following questions: l Why do farmers need any subsidies? l How do government subsidies affect farm output, prices, and income? l Who pays for farm subsidies?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Destabilizing Forces n The agriculture industry is one of the most competitive of all U.S. industries.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Competition in Agriculture n Individual farmers have no market power. l Market power – The ability to alter the market price of a good or service.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Competition in Agriculture n Competition in agriculture is maintained by low barriers to entry. l Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Competition in Agriculture n Because of low barriers to entry, economic profits don’t last long in agriculture. l Economic profit – The difference between total revenues and total economic costs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Competition in Agriculture n Given the competitive structure of U.S. agriculture, individual farmers tend to behave like perfect competitors.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Technological Advance n Since 1929, the farm labor force has shrunk by two-thirds, yet farm output has increased by 60 percent.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Technological Advance n Farm output per labor hour has grown even faster, having increased nearly 10 times since the early 1950s.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n The price elasticity of food demand is low. l Price elasticity of demand – The percentage change in quantity demanded divided by the percentage change in price.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n The income elasticity of food demand is also low. – Income Elasticity of Demand – The percentage change in quantity demanded divided by the percentage change in income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n With low price elasticity of demand, abrupt changes in farm output have a magnified effect on market prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n The income elasticity of food demand is also low.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n In the long run, the increasing ability of U.S. agriculture to produce food coupled with the very slow growth of U.S. demand for food meant prices and farm income have fallen over time.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inelastic Demand n In the absence of government price- support programs and foreign demand, farm prices would have fallen still further.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Abrupt Shifts of Supply n Short-term swings in weather generate large supply shifts in both directions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Response Lags n Time lags between the production decision and the resultant harvest also contribute to price instability.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Response Lags n If prices are high one year, farmers have an incentive to increase their rate of output. n Supply cannot respond quickly. n No additional food supplies will be available until a new crop or herd grows.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Short-Term Instability 0 Price (dollars per bushel) Quantity (bushels per year) Weather-reduced supply Normal supply Abundant harvest supply Demand p2p2 p1p1 p3p3

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The First Farm Depression, n The first farm depression occurred in two major steps: l World War I ended and exports to Europe dropped drastically. l The Great Depression.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Unstable Corn Prices $

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Farm Prices,

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin U.S. Farm Policy n The U.S. Congress has responded to these agricultural problems with a variety of programs

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Supports n As early as 1926, Congress decreed that farm products should sell at a fair price. n By fair, Congress meant higher than the market equilibrium.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Supports n A price floor creates a market surplus. l Market surplus – The amount by which the quantity supplied exceeds the quantity demanded at a given price; excess supply.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Supports n The farm-nonfarm price relationships of were regarded by Congress as fair and came to be known as parity prices. l Parity – The relative price of farm products in the period

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 0 Quantity of Food (bushels per year) Price of Food (dollars per bushel) Fair Prices and Market Surplus Market demand Market supply Surplus pfpf pepe qdqd qsqs

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Supply Restrictions n The goal of parity pricing couldn’t be attained without altering market supply or demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Set-Asides n Congress raised farm prices without creating a surplus by reducing the production of food. n Congress did this by paying farmers for voluntary reductions in crop acreage.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Set-Asides n These acreage set-asides shift the food supply curve to the left. l Acreage set-aside – Land withdrawn from production as part of policy to increase crop prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Dairy Termination Program n Between 1985 and 1987, the government paid dairy farmers to kill or export dairy cows to boost dairy prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Marketing Orders n The federal government permits farm groups to limit output to keep farm prices artificially high.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Import Quotas n The market supply of farm products is also limited by import restrictions. n Import taxes limit the foreign supply of other farm products.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Demand Distortions n While trying to limit the supply of farm products, the government also inflates the demand for selected farm products.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Government Stockpiles n In 1933, an executive order by President Franklin Roosevelt created the Commodity Credit Corporation (CCC).

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Government Stockpiles n Farmers can borrow money from the CCC at loan rates set by Congress. l Loan rate – The implicit price paid by the government for surplus crops taken as collateral for loans to farmers.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Government Stockpiles n Whenever market prices are below CCC loan rates, the government ends up buying surplus crops.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Government Stockpiles n The market surplus induced by price supports must be eliminated in one of three ways: l Government purchases. l Export sales. l Restrictions on supply.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 0 Price (per unit) Quantity (units per period) 0 Price or Cost (per unit) Quantity (units per period) The Impact of Price Supports MC p2p2 p1p1 q1q1 q2q2 Impact on the individual farmer Q1Q1 p2p2 p1p1 Supply Surplus CCC loan rate Equilibrium price Market demand Impact on the agricultural market

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost Subsidies n The market surplus induced by price supports is exacerbated by cost subsidies. l For example, irrigation water is delivered to many farmers at substantially below the cost of delivering it. l This difference amounts to a subsidy.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Impact of Cost Subsidies Price or Cost (dollars per bushel) Initial marginal cost Subsidized marginal cost p2p2 p1p1 q1q1 q2q2 q3q3 0 Quantity (bushels per year)

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Direct Income Support n The advantage of direct income supports is that they achieve the goal of income security without distortions of market prices and output.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Direct Income Support n The principal form of direct income support are so-called deficiency payments. n A deficiency payment is an income transfer paid to farmers for difference between target and support prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Direct Income Support n In principle, direct income payments are a more efficient mechanism for subsidizing farm incomes. n But many farmers would rather have price supports – “parity, not charity.”

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Second Farm Depression, n Despite price supports, supply restrictions, cost subsidies, and income transfers, farm incomes have remained low and unstable, especially for small farms.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Cost Squeeze n The cost squeeze was not due to abrupt price declines, but rather to steeply rising production costs. n As a result, the profit of farmers fell abruptly.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Net Farm Income,

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fuel Costs n The cost squeeze on farm incomes started with an abrupt increase in fuel prices. n OPEC raised crude oil prices by 50 percent in 1979.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fertilizer Costs n Fertilizers, being mostly manufactured from a petroleum base, went up in price along with fuel.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Interest Rates n Most of farmers’ assets necessary for farming are often purchased on funds borrowed at variable rates. n Therefore, when the interest rate skyrockets, the debt burden of farmers mounted.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Declining Land Values n High interest rates and declining incomes reduced the value of farmers’ most important asset – their land.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Declining Land Values n The value of land reflects its present and future income potential. n High costs reduced potential income and high interest rates made future income less valuable.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Declining Exports n In 1980, President Carter imposed an embargo on grain sales to the Soviet Union.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Declining Exports n Between 1980 and 1984, the international value of the dollar rose a staggering 50 percent. n This made it more expensive for foreigners to buy American farm output.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Farmers on the Dole n U.S. government farm policy was changed during the 1980s and 1990s.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1985 Farm Act n Congress passed the Farm Security Act of 1985 in order to limit government purchases of surpluses. l The support price of wheat was reduced. l Deficiency payments were capped.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1990 Act n By 1990, crop prices, farm incomes, and the price of farmland had all risen primarily due to an expansion of the American economy.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1990 Act n Declining oil and fertilizer costs, and strong foreign demand for U.S. Farm products increased profits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1990 Act n The 1990 farm act essentially continued the basic structure of farm subsidies and actually increased the loan rates, effectively raising the price floor for farm products.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1990 Act n The net effect of the 1990 legislation was to move farming a small step closer to market realities.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 1990 Act n More acreage was freed from government regulation, target prices were set closer to market prices and more market surpluses were sold rather than stored in government warehouses.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 1996: Freedom to Farm n In 1996, the Federal Agricultural Improvement and Reform Act made two radical changes in farm policy

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 1996: Freedom to Farm n Target prices and their associated deficiency payments were terminated. n In their places, farmers were offered “market transition payments.”

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 1996: Freedom to Farm n Transition payments were targeted to stabilizing farm incomes rather than farm prices. n In 2002, all such income support will end, leaving the farmers the “freedom to farm.”

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 1996: Freedom to Farm n The 1996 Act also eliminated many restrictions on acreage set-asides. n Farmers no longer have to keep set-aside acreage completely idle or grow only specific commodities.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Asian Crisis n The Asian crisis that began in July 1997 was the principal cause of the farm economy turning sour again.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Asian Crisis n When the currencies of Thailand, Korea, Indonesia and Malaysia, and other Asian nations tumbled, U.S. farm exports fell sharply.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Asian Crisis n Abundant harvest in the United States, China, Europe, and elsewhere also depressed farm prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Renewed Subsidies n When farm prices and incomes plunged during 1997 and 1998, farmers again demanded federal aid. n Because it was an election year, they got a fast response.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Hazards of Government Help n Congress increased market transition payments by 50 percent. n Congress also authorized the early payment of $5 billion in farm aid not due until 1999.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 2001 Farm Act n The intent of the 1996 Farm Act was to wean farmers off the dole, making them more reliant on market forces.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The 2001 Farm Act n That isn’t how it worked out, however. n It was clear that farmers were prepared to rely only on good markets, not bad ones. n Farmers got more permanent aid with the Farm Security Act of 2001.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Moral Hazard n Farmers do not manage their risk as they would in an unregulated market because they have come to rely on government intervention. l Moral hazard – An incentive to engage in undesirable behavior.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Moral Hazard n With government subsidies, farmers are not as likely to purchase crop insurance, or hedge the value of their crops by selling forward contracts on their crops.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Moral Hazard n The challenge for farm policy in the economy tomorrow is to maximize production incentives and minimize moral hazards.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Farm Problem End of Chapter 29