Government Intervention in Agriculture

1. GovernmentIntervention in Agriculture Chapter 11

2. 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

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

4. 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

5. The Farm Problem • 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 Market Equilibrium $ D S1 S2 P1 P2 ΔP Q Q1 Q2 Page 199 ΔQ

6. The Farm Problem • What happens to total farm revenue when you have an inelastic demand and an increase in supply? • Total revenue under original equilibrium was area 0P1AQ1 • Total revenue under the new equilibrium is 0P2BQ2 • We know that total revenue to this sector has ↓, (i.e., 0P2BQ2< 0P1AQ1) • How do we know this? $ D S1 S2 A P1 P2 B ΔP Q 0 Q1 Q2 ΔQ Page 199

7. The Farm Problem • In contrast, with a relatively elastic demand curve, D2 • Shift in supply will result in price P3 instead of P2 • Shift in supply will result in quantity Q3 rather than Q2 • Compared to inelastic demand, a larger impact on quantity and less of an impact on price • What happens to total revenue? $ D1 S1 S2 P1 P3 P2 D2 Q Q1 Q2 Q3 Page 199

8. The Farm Problem • 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

9. 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

10. The Farm Problem

11. 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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. Government Intervention in Agriculture $ D S2 • S1→original supply curve • Policies restricting resource use shifts curve to S2 • Market equilibrium moves from E1 to E2 • Total revenue • Original: OP1E1Q1 • After move: OP2E2Q2 • Does total revenue increase? • Depends on demand elasticity S1 P2 E2 P1 E1 Q 0 Q2 Q1

20. 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

21. 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

22. Government Intervention in Agriculture $ D S2 • 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 S1 P2 E2 P1 E1 Q 0 Q2 Q1

23. 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)

24. 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

25. 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

26. 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

27. 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

28. 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

29. Budget Costs of Dairy Price Supports

31. The Loan Rate Mechanism $ DMKT • 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 SMKT PF E Q 0 QF

32. The Loan Rate Mechanism $ D • Wheat market • PF, QF: market clearing price and quantity • USDAwants to support prices at PG > PF • Quantity demanded = QD • Quantity supplied = QG • Excess Supply of QG - QD SMKT Excess Supply PG PF E Q 0 QG QF QD

33. 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, PG • 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

34. The Loan Rate Mechanism • The goal is to shift demand from D to D+CCCQ • → ↑ price from PF to PG • Consumer demand ↓ from QF to QD due to higher price DMKT+CCCQ $ DMKT SMKT PG PF E Q 0 QG QF QD

35. The Loan Rate Mechanism • Total taxpayer cost of purchases to achieve the target price would be PG x (QG – QD) • = Area QDABQG DMKT+CCCQ $ DMKT SMKT A PG B PF E Q 0 QG QF QD

36. The Loan Rate Mechanism • The CCC store the surplus QG-QD at taxpayer expense • This approach has the unwanted effect of increasing supply from (QF to QG) in a sector already plagued by surplus production

37. The Loan Rate Mechanism DMKT+CCCQ • Consumer surplus declines from area 3+4+6 to area 6 • There welfare decreasesby area 3+4 • Producer surplus increases from area 1+2 to area 1+2+3+4+5 • There is a welfare gain of area 3+4+5 • Total economic surplus increases by area 5 $ DMKT SMKT 6 PG 5 4 3 PF E 2 1 Q 0 QG QF QD

38. The Loan Rate Mechanism • The individual firm under free market conditions will produce quantity qF at price PF • Profit = area 1 • CCC purchases → the price ↑ to PG • Participating farmers ↑ production from qF to qG • Profits ↑ by the area 2 • Total profit = areas 1 + 2 $ SFIRM PG 2 PF E 1 Q 0 qG qF

39. 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

40. 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

41. 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

42. The Set-Aside Mechanism • What are the market-level impacts? • SMKT, market supply curve prior to acreage restrictions • E1 is initial equilibrium at PF,QF • Assume the Federal gov’t wants to support farm price at level PG $ D SMKT PG PF E1 Q 0 QS QF QG

43. The Set-Aside Mechanism • Assume that X% of land must be idled • Resulting supply curve, SMKT* • 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 Why is SMKT* curved? D $ SMKT* SMKT 7 E2 PG 6 4 5 E1 3 PF 2 1 Q 0 QF QS QG

44. The Set-Aside Mechanism • Unlike CCC purchases, the set-aside program does not encourage production as under loan-rate program D $ SMKT* SMKT 7 E2 PG 6 4 5 E1 3 PF 2 1 Q 0 QF QS QG

45. The Set-Aside Mechanism • At the firm level the set-aside program causes output to be reduced from qF to qG • Welfare Impacts (PS) • Before policy = 1 + 2 + 3 • After policy = 1 + 4 • Gain = 4 – 2 – 3 • Whether gain is positive or negative depends on • Supply elasticities • Demand elasticities • Amount of shift of S D $ SFirm* SFirm PG 4 3 PF 2 1 Q 0 qF qG Page 208

46. 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

47. Target Price Deficiency Payment Mechanism Deficiency payment = QMx (TP – max(MP, LR)) shown as the blue shaded area TP = Target Price MP = Market price LR = Loan Rate Page 209

48. Recent Approachesto SupportingFarm Prices and Income

49. 1996-2002 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 andstill receive contract payments. • No longer had a variable safety net should crop prices drop due to weak export demand. Pages 212-214

50. 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 212-213