Government Intervention in Agriculture

GovernmentIntervention in

Agriculture

Chapter 11

Topics of DiscussionDefining the Farm ProblemForms of government interventionPrice and income support mechanisms Phasing out of supply managementDomestic demand expansionImportance of export demand

Net Farm Income With and WithoutDirect Government Payments

Bil. ($2005)

NFI with Govt. Payments

NFI without Govt. Payments

Pre FAIR ActsFAIR Act

2002Bill

More market driven ag.policy under FAIR Act

(1996 Farm Bill)

Government Payments as a %of Net Farm Income

The Farm ProblemMany agricultural commodities exhibit

inelastic consumer demandIndividual farmers lack market power

In contrast to some input suppliersInterest sensitivity

Capital intensive operationsProduction creditCapital purchases

International trade important marketTends to be more volatile

Asset fixity and excess capacity5

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 priceResults in price falling

relatively more than the market clearing quantityQ

$ D S1S2

The Farm Problem

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 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 S1S2

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

The Farm Problem

The Farm ProblemFarms and ranchers in the aggregate

exhibit conditions of perfect competitionLarge number of producersProducing a homogenous product (i.e., corn,

soybeans, wheat, etc)No one farmer has sufficient market power

to influence the market equilibrium priceIf a single producer suffers a disastrous year in

terms of yield, he alone will suffer as market price is not impacted

The Farm ProblemAgricultural sector is one of the most

highly capitalized sector in the U.S. economyMore 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 ProblemQuarterly Agricultural Interest Rates (%), 7th District

20.0OperatingReal Estate

The Farm ProblemHigh interest rates in the U.S. economy

increases the value of the dollar in foreign currency marketsMore 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 marketsFor many agricultural commodities excess

supply relative to domestic marketReduced export demand → Downward

pressure on commodity prices15

The Farm Problem

%U.S. Corn and Soybean Exports as a % of Production

Soybeans

The Farm Problem

U.S. Exports and Imports as a Percent of Total U.S. Milk Solids Production

Dairy Exports

Dairy Imports

% of Dairy Solids

Dramatic DropIn Milk Prices

The Farm Problem

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q22002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Dairy Exports as % of Production

Dry Whey

Butter

The Farm Problem

Asset fixity refers to the difficulty farmers have in disposing of capital equipment when downsizing or shutting down the business Tractors, combines, silos, etc When commodity prices are low and

farmers are downsizing the value of these assets may be quite low relative to purchase price Could owe more on purchase loan than

asset is worth in the used market

The Farm ProblemExcess 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

84.4 86.4

U.S. Corn and Soybean Stocks as a % of Production

The Farm ProblemCombined 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

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 curve will shift up → Market prices will improve

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 Debate concerning the 2012 Farm Bill is

already starting26

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

NutritionConservationCrop InsuranceCommoditiesOther

Note: Nutrition includes food stamps, women infants and children (WIC) andother food assistance programs

Allocation of U.S.D.A Expenditures

S1→original supply curvePolicies 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

$ D S2 S1

Q2 Q10

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 government

purchasing surplus commodities Dairy product price support program (DPPSP)

Another alternative is to support farm incomes through direct transfers USDA-RMA and subsidization of crop

insurance premiums30

Dairy Product Price Support Program

Program established in 1949CCC offers to purchase nonperishable

dairy products at a specified (intervention) price and in a specified formCheeseButterNon-fat dry milk

No-limit on amount that can be sold to the CCC

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 priceNow purchase price of products are

explicitly set by newest Farm Bill

Public policy issuesEffectiveness in establishing a realistic and

adequate milk price floorDistortion in allocation of milk and relative

product prices to products not being demanded by the open market

Impact on U.S. dairy trade Keeps the price of some commodities artificially

high and hurts our ability to export these goods.

Budget Costs of Dairy Price Supports

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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 → increases demand from foreign customers36

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

$ D S2 S1

Q2 Q10

Another alternative is to ↑ demand for U.S. agricultural products in foreign markets by reducing export priceThe Federal gov’t can subsidize

purchase of U.S. agricultural commodities

Example: The Dairy Export Incentive Program (DEIP)

Government Intervention in AgricultureDairy 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

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 MechanismCommodity 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

$ DMKT

The Loan Rate MechanismWheat 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

$ DSMKT

ExcessSupply

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

The Loan Rate MechanismThe 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

Government purchases QG − QDQ

$ DMKT

DMKT+CCCQ

Gov’t purchase

The Loan Rate MechanismTotal taxpayer cost of

purchases to achieve the target price would be PG x (QG – QD)= Area QDABQG

$ DMKT

DMKT+CCCQ

The CCC stores the surplus QG-QD at taxpayer expenseThis approach has the unwanted

effect of increasing supply from (QF to QG) in a sector already plagued by surplus production

$ DMKT

DMKT+CCCQ Consumer surplus declines from area 3+4+6 to area 6 Consumer welfare

decreases by area 3+4Producer surplus

increases from area 1+2 to area 1+2+3+4+5 There is a welfare

gain of area 3+4+5Total economic surplus

increases by area 5

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

The Set-Aside MechanismSignificant 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 MechanismSet-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 MechanismMajor 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 MechanismWhat are the market-level

impacts? SMKT, market supply curve

prior to acreage restrictions E1 is initial equilibrium at

Assume the Federal gov’t wants to support farm price at level PG

$ DSMKT

The Set-Aside MechanismAssume that X% of land

must be idled Resulting supply curve,

Achieve desired pointWelfare 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

$ DSMKT

Why is SMKT* curved?

The Set-Aside MechanismUnlike CCC purchases,

the set-aside program does not encourage production as under loan-rate program

$ DSMKT

The Set-Aside Mechanism

$ DSFirm

SFirm*

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

The Target Price MechanismAnother 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

Target Price Deficiency Payment Mechanism

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

Recent Approachesto Supporting

Farm Prices and Income

1996-2002 PolicyThe 1996 FAIR Act many of previously reviewed

mechanismsLoan rate mechanism remainedSet-aside program eliminatedDeficiency 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 212-21459

The 2002 Farm BillBegan in 2002 and expired in 2007Retained loan rate mechanism Retained a fixed payment mechanism

introduced under FAIR Act in 1996Added a new counter-cyclical mechanism Updating base acres and program yieldsRisk management tools such as enhanced

crop insurance coverage

Pages 212-21360

Milk Income Loss Contract Program

Milk Income Loss Contract (MILC) ProgramTarget price deficiency payment program but

for dairy (fluid milk)Direct payments to dairy farmers when milk

price falls below a specified levelFirst enacted under the 2002 Farm BillSince 2002, more than $3.9 Bil paid to U.S.

dairy producersIndividual farm payments are limited by an

annual production capProgram unpopular in regions with large herds

Milk Income Loss Contract Program

Countercyclical PaymentsEstablished via 2002 Farm Bill

Applied to a number of grain cropsCountercyclical Payment: The payment

($/bu) = TP – EPEP = 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

Countercyclical Payments

Payment acres cannot exceed planted acres

The maximum countercyclical payment = sum of areas 3 and 4

Some Demand Side Options

Domestic Demand ExpansionIncreased farm income

can be obtained through domestic demand expansion → Shifting out farm

products demand curve in the U.S.

Profits increase by area PFPGE2E1

Domestic Demand Expansion

Producer surplus impacts PS before shift = Area 1 PS after shift = Areas (1 + 2 +

3) PS Gain = Areas (2 + 3> > 0

Consumer surplus impacts CS before shift = Areas(2 + 5) CS after shift = Areas (4 + 5 CS Gain = (Areas (4 – 2) > 0?

Societal surplus increase = Area 3 + Area 4 > 0

Domestic Demand ExpansionHow 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 programsThe 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

Export Demand ExpansionMany 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

Commodity 07/08 08/09 09/10 10/11Corn 18.3 15.6 14.7 14.7

Wheat 61.5 40.1 39.1 44.8Soybeans 41.6 43.3 43.5 41.5

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 ExpansionRemember 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 (DD) + export demand = total demand (TD) Page 213

Export Demand ExpansionP0 = price where

export demand = 0E1 represents

equilibrium with no export demand

E2 represents equilibrium with export demand

Price and quantity both increase

Export Demand Expansion What the welfare impacts

of having trade? Producer Surplus

Before trade = Area 1 After trade = Areas(1 +

2 + 3) Gain = Areas(2 + 3)

Domestic Consumer Surplus Before trade = Areas( 2

+ 5) After trade = Area(5) Loss = Area(2)

Foreign Consumer Surplus at E2 = Area 4 Page 213

SummaryUSDA has tried to support prices and incomes by

acquiring/storing excess supply at desired priceUSDA 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 1999-2001 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 ….

Government Intervention in Agriculture

agricultural economics

pearson higher education

upper saddle river

total farm revenue

farm bill3introduction

inelastic demand

supply curve

net farm incomepage

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