AP Microeconomics – Chapter 19 Outline I. Learning objectives—In this chapter students will learn: A. Why agricultural prices and farm income are unstable. B. Why there has been a huge employment exodus from agriculture to other U.S. industries over the past several decades. C. The rationale for farm subsidies and the economics and politics of price supports (price floors). D. Major criticisms of the price‐support system in agriculture. E. The main elements of existing federal farm policy. II. Economics of Agriculture A. The Short Run: Price and Income Instability 1. Demand for agricultural products is inelastic. The price elasticity of demand is low because there are few substitutes for agricultural products in general, and diminishing marginal utility occurs rapidly in wealthier societies. 2. Farm output fluctuates due to weather and the competitive nature of farming, so the individual farmer has little control over the amount of output. Coupled with an inelastic demand, this means that relatively small changes in output can lead to relatively large changes in farm prices and incomes. A bumper crop can result in a loss of revenue and income because of the inelasticity of demand (Figure 19.1). 3. Fluctuations in domestic demand can lead to sharp changes in farm incomes (Figure 19.2) but not farm production, because farmers’ fixed costs are high when compared with their variable costs. So even when the farmer experiences a loss, AP Microeconomics – Chapter 19 Outline he is better off working the land, because he will lose even more if he shuts down operations. 4. Most of the volatility of demand is caused by unstable foreign demand, due to changes in weather and crop conditions in countries that buy American agricultural exports. The increased importance of exports has increased the instability of farm incomes (Figure 19.3). AP Microeconomics – Chapter 19 Outline 5. Other factors influencing foreign demand for American crops include changes in foreign economic policies, changes in diplomatic relations, and changes in the international value of the dollar. Figure 19.4 shows the volatility in prices of select agricultural commodities. 6. CONSIDER THIS … Risky Business a. Instability of prices creates significant risk in agriculture (loan defaults), though farming of some crops is protected by government programs. b. For crops facing greater risk, farmers have adopted techniques to manage risk. i. Buying and selling farm output in futures markets. ii. Contracting with processors to lock in farm output prices. iii. Buying crop revenue insurance to guarantee a certain amount of revenue, even in the event of storm damage, drought, or similar natural events. iv. Leasing land to other operators for a fixed cash payment. v. Generating nonfarm income from off‐farm employment. B. The Long Run: A Declining Industry 1. Over time, technology has led to a rapidly increasing supply, because productivity in agriculture has grown twice as quickly as productivity in the nonfarm economy. Government‐sponsored research and education have been the source of much of the technological advance. 2. Demand has grown much more slowly than supply, because demand for agricultural products is relatively income inelastic; quantity demanded doesn’t rise proportionately as incomes rise. In addition, population growth has been too slow to allow demand to keep pace with increases in supply. AP Microeconomics – Chapter 19 Outline 3. Figure 19.5 is a graphical portrayal of the long‐run situation. Given the inelastic price and income demand for farm products, an increase in the supply of farm products relative to the demand for them has created persistent tendencies for farm incomes to fall relative to nonfarm incomes. 4. Low farm incomes have resulted in an outmigration of agricultural workers who worked on small, high‐cost farms, a consolidation of smaller farms, and the emergence of huge agribusiness producers. Table 19.1 shows changes in American farm employment, and Global Perspective 19.1 compares labor force participation in agriculture for selected countries. C. Historically, farm household incomes have been well below nonfarm households. By 2008, however, average farm household income greatly exceeded the average for all United States households ($78,803 vs. $68,424). AP Microeconomics – Chapter 19 Outline 1. The increase in farm household income was caused by outmigration, consolidation, rising farm productivity, and government subsidies. 2. Nonfarm income has also contributed significantly to farm household income. On average, only 11 percent of farm household income is derived from farming activities, but this figure is misleading; the average is low because of “residential farms.” “Commercial farms” (annual sales of $250,000 or more) derive most or all of their income from farming. III. Economics of Farm Policy A. The “farm program,” which began in the 1930s, involves six basic policies. 1. Subsidies to support prices, incomes, and output 2. Soil and water conservation 3. Agricultural research 4. Farm credit 5. Crop insurance 6. Subsidized sale of farm products in world markets B. Farmers and politicians view this primarily as a program to prop up prices and incomes. Global Perspective 19.2 reveals that agricultural subsidies are common. C. Rationale for Farm Subsidies 1. Many farmers earn relatively low incomes, even though their products are necessities of life. 2. The “family farm” is an American institution that should be preserved as a way of life. AP Microeconomics – Chapter 19 Outline 3. Farmers face hazards to production (floods, droughts, insects) that most industries do not face. 4. Farms are highly competitive, but their suppliers have considerable market power, which puts farmers at an unfair advantage. D. The parity concept was established by the Agricultural Adjustment Act of 1933. Parity suggests that the relationship between the prices received by farmers for their output and the prices they must pay for goods and services should remain constant. Comparing data from today to data from 1910‐1914 indicates that prices received by farmers must rise dramatically for farmers to achieve parity. Parity ratio = prices received by farmers / prices paid by farmers E. The concept of parity provides the rationale for government price floors (price supports) on farm products. Many price support programs have been tried, all with similar effects. 1. Surplus output occurs as consumers reduce the quantity purchased at the higher support price, and sellers produce a greater quantity than at the lower market equilibrium price. 3. Farmers gain from price supports as their gross revenues increase (Figure 19.6). 3. Consumers lose because they must pay the higher price and receive less; this difference especially affects the poor, who spend a larger percentage of their AP Microeconomics – Chapter 19 Outline income on food. In some cases, the difference between world market prices and support prices can be great. For example, the domestic price of sugar is 32 percent higher than the world market price, and a quart of milk is double the price it would be without government programs. 4. Resources are overallocated to agriculture, which represents allocative inefficiency. The competitive market would produce less output at a lower price. 5. Price supports cause other social losses. a. Taxpayers pay higher taxes to finance the government’s purchase and storage of the surplus. b. Government’s intervention entails administrative costs. c. “Rent‐seeking” activity by farm groups involves considerable sums to sustain political support for price supports and other programs to enhance farm incomes. 6. Environmental costs result from the extra production. a. Farmers use more fertilizer and pesticides, and farmers are less likely to rotate crops. b. More land is cultivated, including “marginal” land that is susceptible to erosion, and wetlands that support wildlife habitat. 7. International costs result from farm price supports. a. Inefficient use of resources extends worldwide, as the United States limits imports of more efficient foreign products in favor of less‐efficient domestic production. b. Surpluses are “dumped” on world markets, depressing world market prices for these products. F. How do the government and farmers cope with surpluses that occur with price supports? 1. Restricting supply: “Set aside” or acreage allotment programs require farmers to limit planting in exchange for the supported prices. “Soil bank” programs pay farmers not to grow any crops, but conserve land for a period of time. 2. Bolstering demand: Finding new uses for agricultural products, such as gasohol and biodiesel, is one way to raise demand. Domestic demand is augmented through programs like food stamps for low‐income families, while foreign demand is increased via the Food for Peace program, which helps less developed countries to buy our surplus farm products. 3. CONSIDER THIS … Putting Corn in Your Gas Tank a. Government promotion of ethanol production serves a dual purpose of reducing dependence on foreign oil and increasing demand for domestically produced corn. b. The increased demand for domestic corn increased the price of corn 50 percent between 2005 and 2007. AP Microeconomics – Chapter 19 Outline c. As farmers shifted production to corn, they produced lesser amounts of soybeans and other crops, increasing the prices of those crops. And because corn is used so heavily for feed, prices of beef, pork, and chicken also increased. d. The increased demand for resources to produce corn, including seed, fertilizer, farmland, and especially water, caused increases in prices for these resources. IV. Criticisms and Politics A. Decades of experience with government price support programs suggested that the goals and techniques of farm policy needed to be reexamined and revised. In 1996, Congress ended the price support programs for several farm commodities. B. Economists reject the parity concept because it assumes that relative prices should not change. If that were true, we should subsidize producers of high tech goods because of the price declines they have faced. C. Agricultural subsidies were designed to treat the symptoms—not the causes—of farm problems. The root cause of the problem is a misallocation of resources; there are too many farmers, relative to the rest of the economy. D. Price support and subsidy programs generated the most benefit for large farmers who needed it least; poor farmers produced too little output to gain much from the programs. In addition, while farmers that owned their land benefited from increased land values, farmers renting land did not benefit. But the wealthy nonfarm landlords, people not actively engaged in farming, did reap the benefits of higher land values. E. Policies contradicted other policy goals. Subsidized research was aimed at increasing farm productivity, while farmers took land out of production to reduce supply. Price supports for crops caused increased feed costs for ranchers and higher meat prices for consumers. Tobacco farmers were subsidized, while the costs of medical care soared higher. Import quotas on sugar conflicted with our free trade policies. F. Public choice theory can help explain the contradictions in farm policy (Chapter 17). 1. Rent‐seeking behavior occurs when a group (a union, a firm in an industry, or farmers producing a particular crop) uses political means to transfer income or wealth to itself at the expense of another group or society as a whole. 2. The special‐interest effect involves promoting a policy whereby a small group of farmers realizes large benefits, while the individual taxpayer’s and consumer’s costs are largely hidden and relatively small. 3. Logrolling occurs to get representatives from rural states to vote on urban issues (urban support of farm price supports in return for rural support of food stamp programs). 4. Large agribusinesses that sell chemicals and machinery to farms, as well as Department of Agriculture employees, also lobbied for the continuation of the programs. G. The politics of farm subsidies has changed in recent years. AP Microeconomics – Chapter 19 Outline 1. The farm population continues to decline and is now less than 2 percent of the population (v. 25 percent in the 1930s, when many of these programs were established). 2. Urban congressional representatives have been critically examining the effects of farm policies on consumers’ grocery bills. 3. More farmers resent the federal government intrusion into their decision‐making. H. World Trade Considerations 1. The United States has taken the lead in reducing trade barriers on agricultural products. 2. Nations of the European Union and many other nations continue to provide agricultural price supports. They then try to sell their domestic surpluses on the world markets. 3. These trade barriers hinder American farmers from selling in these countries, and the subsidized exports depress world agricultural prices. 4. These policies distort both world agricultural trade and the international allocation of agricultural resources, because agricultural subsidies shift production away from what would occur based on comparative advantage. a. Artificially high prices in industrially advanced nations encourage more farm output than would otherwise occur. b. Farmers in developing countries then face artificially low prices for their exports, discouraging output. 5. In 1994, the world’s trading nations agreed to reduce farm price support programs and barriers on imported farm products. V. Recent Farm Policies A. Freedom to Farm Act (1996) 1. Ended price supports and acreage allotments for wheat, corn, barley, oats, sorghum, rye, cotton and rice, thus allowing farmers to respond to changing crop prices. 2. Provided guaranteed annual transition payments to farmers through 2002; these payments were based upon the subsidies formerly received by the farmer and not on crop prices or the farmer’s current income. 3. In 1998‐1999 when commodity prices severely declined, the government provided emergency relief payments. B. The Food, Conservation, and Energy Act (2008) 1. Continues the “freedom to plant” and direct‐payment approaches, but adds an automatic system of emergency aid, and extends the direct‐payment system to cover peanuts, soybeans, and other oilseeds. 2. This Act provides three forms of commodity subsidies: AP Microeconomics – Chapter 19 Outline a. Direct Payments—Cash payments are fixed and based on past production and prices; they are a permanent transfer payment from the government. Farmers are protected from price and output fluctuations and can choose how much to plant in a given season. b. Countercyclical Payments—Payments that protect farmers from crop price fluctuations. If prices fall below a target price, farmers receive an additional payment—even if the farmer is not currently growing that crop—essentially implementing another form of price support. c. Marketing Loans—Government‐provided loans that further protect farmers against price fluctuations. If crop prices equal or exceed the “loan price” (a minimum crop price specified in the loan agreement), the farmer repays the loan with interest. If the price is below the loan price, the farmer can forfeit the crop to the lender to satisfy repayment of the loan. VI. LAST WORD: The Sugar Program: A Sweet Deal A. Price supports for American sugar producers have increased domestic sugar prices 32 percent above the world price, for an estimated cost to consumers of $1.5 billion to $1.9 billion per year. The effect is regressive because poor households spend a larger percentage of their income on food than do high‐income households. Also, sugar growers receive benefits that are estimated to be twice the nation’s average family income. In one recent year, a single producer received $30 million in benefits, while many sugar producers receive more than $1 million each year. B. Import quotas have been imposed to keep low‐priced foreign sugar out of the domestic market, so that price supports can be maintained. In 1975, 30 percent of American sugar was imported; today about 20 percent comes from abroad. C. Important foreign markets in less developed countries have been harmed. The decline in potential sugar revenue has hurt the Philippines, Brazil, and a number of Central American countries. 1. Decline in export revenues hurts their ability to repay foreign debt. 2. The sugar that could have been sold in the United States is dumped on world markets, where the world price is then further depressed. 4. The United States could become an exporting country, further lowering world prices and increasing competition for the sugar producers of the developing world. D. The General Accounting Office estimates that American sugar producers receive a benefit of $1 billion annually while the sugar program costs consumers $1.5 billion to $1.9 billion. This efficiency loss has resulted from an overallocation of resources to the production and processing of domestic sugar. E. Price supports have caused a shifting of resources to less efficient American producers, away from more efficient, low‐cost foreign producers.