1. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. POLITICS AND ECONOMICS: THE CASE OF AGRICULTURAL MARKETS POLITICS AND ECONOMICS: THE CASE OF AGRICULTURAL MARKETS Chapter 19

2. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-2 Today’s lecture will: Describe the competitive nature of agricultural markets. Discuss the general rule of political economy in a democracy. Explain the good/bad paradox in farming. Explain how a price support system works. Explain, using supply and demand curves, the distributional consequences of four alternative methods of price support. Discuss real-world pressures politicians face when designing agricultural policy.

3. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-3 The Nature of Agricultural Markets Agricultural markets resemble perfectly competitive markets:  There are many independent sellers who are generally price takers.  There are many buyers.  Products are interchangeable.  Prices can, and do, vary considerably. Agricultural markets are not perfectly competitive:  They are influenced by government programs.  Farmers use their political clout to increase prices.

4. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-4 The Good/Bad Paradox in Agricultural Agriculture is characterized by the good/bad paradox – the phenomenon of doing poorly because you are doing well. The good/bad paradox appears in several ways.  In the long-run, increased productivity has decreased the number of farmers.  In the short-run, farmers may be financially worse off when there are good harvests.

5. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-5 The Good/Bad Paradox S0S0 B A C S1S1 Q0Q0 P0P0 Q1Q1 P1P1 P Q 0 D Initially total income at P 0 and Q 0 is the area B. If the supply increases to S 1, price falls to P 1 and quantity increases to Q 1. The increase in income, C, is smaller than the lost income A.

6. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-6 The Long-Run Decline of Agriculture The U.S. used to be a highly agricultural society, but now just over 2% of the labor force works in agriculture. Productivity has increased while income has fallen. Due to competition most of the benefits of productivity have gone to consumers in the form of lower prices.

7. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-7 The Short-Run Cyclical Problem Facing Farmers The short-run demand for most agricultural products is inelastic. Good harvests that increase supply lead to declines in price that are relatively greater than the increase in quantity. Total farm revenue declines. Agricultural production tends to be highly unstable because it depends on weather and luck.

8. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-8 Ways Around the Good/Bad Paradox Farmers organize and lobby the government to establish programs that limit supply or keep prices high.  Price-stabilization programs are designed to eliminate short-run fluctuations in prices, while allowing prices to follow their long-run trend.  Price-support programs are designed to maintain prices above market prices.

9. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-9 The General Rule of Political Economy The general rule of political economy states that small groups that are significantly affected by a government policy will lobby more effectively than large groups that are equally affected by that same policy. Farmers are the small group that lobbies effectively. Consumers are the large group. The small group tends to lobby more effectively for the policy that the large group against it.

10. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-10 Four Price-Support Options The government has four options to maintain higher than equilibrium prices:  Regulatory force.  Economic incentives to reduce supply.  Subsidize the sale of the good.  Buy up and store, give away, or destroy the good.

11. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-11 A Price Support System S E D QEQE PEPE QSQS QDQD P1P1 P Q0 Various government methods must be used to maintain P 1. Government establishes a price support, P 1, which results in excess supply, Q S -Q D.

12. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-12 Supporting the Price by Regulatory Measures Government can use regulatory force to prevent anyone from selling or buying at a lower price. How many farmers helped or hurt depends on the elasticity of demand and supply.  When demand and supply are inelastic, the number hurt is relatively small.  When demand and supply are elastic, the number hurt is large.

13. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-13 The Need for Rationing A price floor requires rationing to distribute the limited demand among the suppliers. Keeping new farmers from entering the market restricts supply. Existing farmers are grandfathered – a law is passed affecting the new farmers, but exempting the existing farmers from the law. Tariffs and quotas keep foreign producers out of the market.

14. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-14 D A B Regulating Price Directly C D S Q1Q1 Q2Q2 P 3.50 5.00 0 Q QeQe At a price support of $5, there is a surplus of Q 2 - Q 1. Farmers’ revenues increase by A and decrease by B and C. Areas C and D are welfare loss to society.

15. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-15 Providing Incentives to Reduce Supply A B P $5.00 0 3.50 2.80 Q Q1Q1 QeQe Q2Q2 D S At the support price of $5, there will be a surplus of Q 2 -Q 1. To reduce the quantity supplied to Q 1, the government could pay farmers $2.20 not to grow Q 2 - Q 1 wheat. The total cost to taxpayers is area A. Farmers gain more revenue than they lose.

16. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-16 Q2Q2 Subsidizing the Sale of the Good A C B P $5.00 0 1.75 Q D S 3.50 QeQe Suppliers produce Q 2 and sell this quantity for $5 per bushel to the government. The government sells that quantity for $1.75 to consumers, whose benefit is area A. Suppliers are benefited by area B. The cost to taxpayers, however, is areas A+B+C.

17. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-17 Buying Up and Storing B A Q1Q1 Q2Q2 $5.00 P Q 0 QeQe 3.50 D S At the support price of $5, consumers buy Q 1 and the government buys Q 2 -Q 1 from farmers at a cost of A. Consumers transfer the area B to producers when they pay $5 instead of $3.50.

18. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-18 Which Group Prefers Which Option Regulation costs the government the least, but it benefits farmers the least.  Government is least likely to use this approach because existing farmers are likely to push for price supports. Economic incentives cost more than regulation, but less than subsidies or buying up and storing.  Farmers benefit because they don’t have to grow a crop, and they can use their land for other purposes.

19. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-19 Which Group Prefers Which Option? Subsidies to keep prices low benefit both consumers (who get low prices) and farmers (who get high prices).  Taxpayers are harmed because they must finance the subsidy payments. Buying up and storing or destroying the goods costs taxpayers more than regulation and incentives, but less than subsidies.  The government is left with the surplus to dispose of.

20. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-20 Economics, Politics, and Real-World Policies The two prevalent U.S. farm programs have been:  The land bank program – the government supports prices by giving farmers economic incentives to reduce supply.  The nonrecourse loan program – the government “buys” goods in the form of collateral on defaulting loans.

21. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-21 Factors That Complicate Policy Interest groups (farmers, taxpayers, and consumers) examine only the part of the issue that directly affects them. Governments in many of our trading partners, especially Japan and the European Union, subsidize farming in their countries.

22. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-22Conclusion Agriculture is just one example the interrelationship between economics and politics. Other examples of how individuals act as self-interested maximizers are:  A military draft  Government support of the arts  Government support of education

23. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-23Summary Agricultural markets have many qualities of purely competitive markets:  Sellers are price takers.  There are many buyers.  Products are interchangeable.  Prices vary considerably. Agricultural markets are not purely competitive because of significant government intervention. The good/bad paradox is the result of inelastic demand. Total revenue decreases when supply increases.

24. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-24Summary Because farmers are a small, easily identifiable group, and because farm states get larger representation relative to population in the Senate, the farm lobby is very effective in influencing policy. A price support program works by government maintaining higher than equilibrium prices through regulations, incentives, subsidies, and buying up and storing or destroying.

25. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-25Summary Regulation costs the government the least, but benefits farmers the least. Incentives cost the government and taxpayers more than regulation, but less than subsidies or buying up and storing. Subsidies benefit consumers and farmers the most, but cost taxpayers the most. Buying up and storing gives the government a surplus to deal with.

26. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-26Summary Two prevalent farm programs in the U.S. are:  The land bank program – the government gives farmers economic incentives to reduce supply.  The nonrecourse loan program – government buys goods in the form of collateral on defaulting loans. Agricultural policy is affected by interest groups (consumers, taxpayers, and farmers) and international issues (farm policies of our trading partners).

27. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 19-27 Review Question 19-1 What are the similarities and differences between competitive markets and agricultural markets? Agricultural markets are purely competitive in that there are many buyers and sellers, sellers are price takers, products are interchangeable, and prices vary considerably. Agricultural markets differ from purely competitive markets because of government intervention, usually in the form of price supports. Review Question 19-2 Explain the good/bad paradox in agriculture. The demand for agricultural products is inelastic. In the short run, a good harvest increases supply, which decreases price. Since demand is inelastic, the decrease in price results in a decrease in total revenue, farm income. In the long-run, increases in productivity increase supply and decrease price. With inelastic demand, the decrease in price causes a decrease in total revenue.