The Farm Problem Chapter 14

Destabilizing Forces The agriculture industry is one of the most competitive of all U.S. industries.

Competition in Agriculture Individual farmers have no market power. Market power – The ability to alter the market price of a good or service.

Competition in Agriculture Competition in agriculture is maintained by low barriers to entry. Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market.

Competition in Agriculture Because of low barriers to entry, economic profits don’t last long in agriculture. Economic profit – The difference between total revenues and total economic costs.

Technological Advance Since 1929, the farm labor force has shrunk by two-thirds, yet farm output has increased by 70 percent. Farm output per labor hour has grown even faster, having increased nearly 10 times since the early 1950s.

Inelastic Demand The price elasticity of food demand is low. Price elasticity of demand – The percentage change in quantity demanded divided by the percentage change in price.

Inelastic Demand With low price elasticity of demand, abrupt changes in farm output have a magnified effect on market prices.

Inelastic Demand 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.

Inelastic Demand Prices and farm income have fallen over time because U.S. food production has grown faster than the U.S. demand for food. In the absence of government price-support programs and foreign demand, farm prices would have fallen still further.

Abrupt Shifts of Supply Short-term swings in weather generate large supply shifts in both directions.

Short-Term Instability Price (dollars per bushel) Quantity (bushels per year) Weather-reduced supply Normal supply p2 Abundant harvest supply p1 p3 Demand

Response Lags Time lags between the production decision and the resultant harvest also contribute to price instability. If prices are high one year, farmers have an incentive to increase their rate of output.

Unstable Corn Prices

The First Farm Depression, 1920-40 The first farm depression occurred in two major steps: World War I ended and exports to Europe dropped drastically. The Great Depression.

Farm Prices, 1910 - 1940 1942 1914 1910 1918 1922 1926 1930 1934 1938 240 220 200 180 160 140 120 100 80 60 40 20

U.S. Farm Policy The U.S. Congress has responded to these agricultural problems with a variety of programs

Price Supports As early as 1926, Congress decreed that farm products should sell at a fair price. By fair, Congress meant higher than the market equilibrium.

Price Supports A price floor creates a market surplus. Market surplus – The amount by which the quantity supplied exceeds the quantity demanded at a given price; excess supply.

Price Supports The farm-nonfarm price relationships of 1909-14 were regarded by Congress as fair and came to be known as parity prices. Parity – The relative price of farm products in the period 1910-14.

Fair Prices and Market Surplus Quantity of Food (bushels per year) Price of Food (dollars per bushel) Market demand Market supply Surplus pf pe qd qs

Supply Restrictions The goal of parity pricing couldn’t be attained without altering market supply or demand.

Set-Asides Congress raised farm prices without creating a surplus by reducing the production of food. Congress did this by paying farmers for voluntary reductions in crop acreage.

Set-Asides These acreage set-asides shift the food supply curve to the left. Acreage set-aside – Land withdrawn from production as part of policy to increase crop prices.

Dairy Termination Program Between 1985 and 1987, the government paid dairy farmers to kill or export dairy cows to boost dairy prices.

Marketing Orders The federal government permits farm groups to limit output to keep farm prices artificially high.

Import Quotas The market supply of farm products is also limited by import restrictions. Import taxes limit the foreign supply of other farm products.

Demand Distortions While trying to limit the supply of farm products, the government also inflates the demand for selected farm products.

Government Stockpiles President Franklin Roosevelt created the Commodity Credit Corporation (CCC) in 1933. Farmers can borrow money from the CCC at loan rates set by Congress. Loan rate – The implicit price paid by the government for surplus crops taken as collateral for loans to farmers.

Government Stockpiles Whenever market prices are below CCC loan rates, the government ends up buying surplus crops.

Government Stockpiles The market surplus induced by price supports must be eliminated in one of three ways: Government purchases. Export sales. Restrictions on supply.

The Impact of Price Supports on the individual farmer Impact of price supports on the agricultural market Price or Cost (per unit) Quantity (units per period) Price (per unit) Quantity (units per period) MC Supply Surplus p2 p2 CCC loan rate p1 p1 Equilibrium price Market demand q1 q2 Q1

Cost Subsidies The market surplus induced by price supports is exacerbated by cost subsidies. For example, irrigation water is delivered to many farmers at substantially below the cost of delivering it. This difference amounts to a subsidy.

The Impact of Cost Subsidies (dollars per bushel) Price or Cost Initial marginal cost Subsidized marginal cost p2 p1 q1 q2 q3 Quantity (bushels per year)

Direct Income Support The advantage of direct income supports is that they achieve the goal of income security without distortions of market prices and output.

Direct Income Support The principal form of direct income support are so-called deficiency payments. A deficiency payment is an income transfer paid to farmers for difference between target and support prices.

Direct Income Support In principle, direct income payments are a more efficient mechanism for subsidizing farm incomes. But many farmers would rather have price supports – “parity, not charity.”

The Second Farm Depression, 1980-86 Despite price supports, supply restrictions, cost subsidies, and income transfers, farm incomes have remained low and unstable, especially for small farms.

Net Farm Income, 1977 - 1997

The Cost Squeeze The cost squeeze was not due to abrupt price declines, but rather to steeply rising production costs. As a result, the profit of farmers fell abruptly.

Fuel Costs The cost squeeze on farm incomes started with an abrupt increase in fuel prices. OPEC raised crude oil prices by 50 percent in 1979.

Fertilizer Costs Fertilizers, being mostly manufactured from a petroleum base, went up in price along with fuel.

Interest Rates Most of farmers’ assets necessary for farming are often purchased on funds borrowed at variable rates. Therefore, when the interest rate skyrockets, the debt burden of farmers mounted.

Declining Land Values High interest rates and declining incomes reduced the value of farmers’ most important asset – their land.

Declining Land Values The value of land reflects its present and future income potential. High costs reduced potential income and high interest rates made future income less valuable.

Declining Exports In 1980, President Carter imposed an embargo on grain sales to the Soviet Union. Between 1980 and 1984, the international value of the dollar rose a staggering 50 percent.

Steps Toward Deregulation U.S. government farm policy was changed during the 1980s and 1990s.

The 1985 Farm Act Congress passed the Farm Security Act of 1985 in order to limit government purchases of surpluses. The support price of wheat was reduced. Deficiency payments were capped.

The 1990 Act By 1990, crop prices, farm incomes, and the farmland prices had all risen. Declining oil and fertilizer costs, and strong foreign demand for U.S. Farm products increased profits.

The 1990 Act The 1990 farm act continued the basic structure of farm subsidies. It increased the loan rates, effectively raising the price floor for farm products. Nevertheless it moved farming a small step closer to market realities.

1996: Freedom to Farm In 1996, the Federal Agricultural Improvement and Reform Act made two radical changes in farm policy Target prices and their associated deficiency payments were terminated. Many restrictions on acreage set-asides were eliminated.

1996: Freedom to Farm In the place of deficiency payments, farmers were offered “market transition payments.” Transition payments were targeted to stabilizing farm incomes rather than farm prices.

1996: Freedom to Farm Farmers no longer have to keep set-aside acreage completely idle or grow only specific commodities.

The Asian Crisis The Asian crisis that began in July 1997 was the principal cause of the farm economy turning sour again. U.S. farm exports fell sharply when the currencies of Thailand, Korea, Indonesia and Malaysia, and other Asian nations tumbled.

The Asian Crisis Abundant harvest in the United States, China, Europe, and elsewhere also depressed farm prices.

Renewed Subsidies When farm prices and incomes plunged during 1997 and 1998, farmers again demanded federal aid. Because it was an election year, they got a fast response.

The 2001 Farm Act The intent of the 1996 Farm Act was to wean farmers off the dole, making them more reliant on market forces. That isn’t how it worked out, however.

The 2001 Farm Act It was clear that farmers were prepared to rely only on good markets, not bad ones. Farmers got more permanent aid with the Farm Security Act of 2001.

Moral Hazard Farmers do not manage their risk as they would in an unregulated market because they have come to rely on government intervention. Moral hazard – An incentive to engage in undesirable behavior.

Moral Hazard 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.

Moral Hazard The challenge for farm policy in the economy tomorrow is to maximize production incentives and minimize moral hazards.

The Farm Problem End of Chapter 14