Chapter 4 Competitive Markets and Agriculture
What's in This Chapter and Why
This chapter further develops demand and supply analysis. The demand curve is interpreted as
giving both the quantity demanded for a given price and the demand price for a given quantity.
The latter is the maximum price that a consumer will pay for one more unit, stating the idea of
consumer surplus and efficiency analysis.
The supply curve is interpreted as giving both the quantity supplied for a given price and the
supply price for a given quantity. The latter is the minimum price a producer would accept in
return for one more unit, stating the idea of producer surplus. By presenting the supply curve as a
curve of minimum acceptable prices, we can more easily interpret it as the industry marginal cost
curve. Supply conditions are developed for a competitive industry without the necessity of a
thorough development of the theory of the firm. Both the demand and supply curves as long-run
curves are developed. In a one-semester issues course, some concepts must be sacrificed. We
believe that the theory of the firm and the distinction between short- and long-run supply are
concepts that can be de-emphasized. In Chapters 4 and 5, however, some of the important
distinctions between short- and long-run analysis are introduced.
The traditional analysis of changes in demand and supply compared with changes in quantity
demanded and supplied is followed by an analysis of equilibrium price and quantity. The terms
excess supply and excess demand are used rather than surplus and shortage so that the student
avoids confusion between surplus meaning excess supply and other meanings of surplus. All of the
demand and supply examples are discussed in the context of agriculture.
The rest of the chapter discusses agriculture programs. The purpose of agriculture programs is
discussed in the context of market analysis. The student is invited to consider whether agriculture
programs are designed to achieve the conventional goals of reducing farm poverty and saving the
family farm. Rent-seeking is presented as an alternative explanation for the existence of agriculture
programs.
Although we believe that agriculture and agriculture policy provide an excellent vehicle for
introducing demand, supply, and policy analysis, other vehicles may come more naturally to some
students. If the instructor wishes, this unit could stop at the section entitled "U. S. Agriculture."
Instructional Objectives
After completing this chapter, your students should know:
1. The distinction between a change in demand and a change in quantity demanded, and three
factors that cause the demand curve to change.
2. The distinction between a change in supply and a change in quantity supplied, and three factors
that cause the supply curve to change.
3. The effect of changes in demand and supply on equilibrium price and quantity exchanged.
4. The avowed purpose and the actual effects of U.S. agriculture programs.
5. The types of risks faced by farms and some ways to deal with these risks.
6. The effects of and distinctions among price support programs, target price programs, and
output constraint programs.
7. The concepts of economic and political rent-seeking and their importance.
Key Terms
These terms are introduced in this chapter:
Coefficient of the price elasticity of demand
Price elastic
Price inelastic
Unit elastic
Suggestions for Teaching
This is a key chapter in the book. A careful development of demand and supply prepares the
student for moving quickly through other parts of the book. In developing the material, we start
with arithmetic and tabular approaches, and build to a graphical approach as we progress through
the chapter and the book; however, we gradually wean the student from the former approaches and
use the graphical approach exclusively.
The discussion of agriculture policy can be enlivened by using current stories from such
sources as Business Week, the Economist, and The Wall Street Journal. Some instructors may
want to use the discussion of the relationship between agriculture policies and trade barriers to
emphasize the interdependence of national economies.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Browne, William P., Jerry R. Skees, Louis E. Swanson, Paul B. Thompson, and Laurian J.
Unnevehr. Sacred Cows and Hot Potatoes: Agrarian Myths in Agricultural Policy. Boulder,
CO: Westview Press, 1992.
2. Cletus C. Coughlin and Kenneth C. Carraro, "The Dubious Success of Export Subsidies for
Wheat," Federal Reserve Bank of St. Louis, Review 70 (November/December 1988), pp.
38-47.
3. Mark Drabenstott and Alan D. Barkema," U.S. Agriculture Charts a New Course for the
l990s," Federal Reserve Bank of Kansas City, Economic Review (January/February 1990), pp.
32-49.
4. Bruce Gardner, ed., U.S. Agricultural Policy: The 1985 Farm Legislation (Washington, D.C.:
American Enterprise Institute for Public Policy Research, 1985).
5. Public Agenda Foundation, The Farm Crisis: Who's in Trouble, How to Respond, National
Issues Forum (Dubuque, Ia.: Kendall/Hunt Publishing Company, 1989).
6. Richard T. Rogers, "Broilers: Differentiating a Commodity," in Larry L. Duetsch, ed., Industry
Studies (Englewood Cliffs, N.J.: Prentice Hall, 1993), pp. 3-32.
7. Daniel B. Suits, "Agriculture," Chapter 1 in Walter Adams, ed., The Structure of American
Industry, 8th ed. (New York: Macmillan, 1990), pp. 1-40.
Outline
I. DEMAND AND SUPPLY ANALYSIS
A. General Definitions and Comments
1. The law of demand states that consumers will purchase more of a good at lower prices
and less of a good at higher prices.
2. The law of supply states that producers will sell less of a good at lower prices and
more of a good at higher prices.
3. Equilibrium exists when there is no reason for a situation to change.
a. When equilibrium exists, the quantity people plan to buy is equal to the quantity
that producers plan to sell.
b. The laws of demand and supply cause the market to move to equilibrium.
B. Other Demand Factors
1. Changes in demand factors other than price of the good will result in a change in
demand.
a. An increase in demand is depicted as a rightward shift of the demand curve.
b. An increase in demand means that consumers plan to purchase more of the good at
each possible price.
c. A decrease in demand is depicted as a leftward shift of the demand curve
d. A decrease in demand means that consumers plan to purchase less of the good at
each possible price.
2. The price of related goods is one of the other factors affecting demand.
a. Related goods are classified as either substitutes or complements.
1. A good that is used in the place of another good is a substitute.
a. An increase in the price of a good will increase demand for its substitute,
while a decrease in the price of a good will decrease demand for its
substitute.
2. A good that is used with another good is a complement.
a. An increase in the price of a good will decrease demand for its
complement while a decrease in the price of a good will increase demand
for its complement.
3. Income is another factor that can affect demand.
a. If a good is a normal good, increases in income will result in an increase in
demand while decreases in income will decrease demand.
b. If a good is an inferior good, increases in income will result in a decrease in
demand while decreases in income will increase demand.
Consumer preferences obviously can affect demand.
C. Other Supply Factors
1. Changes in other supply factors will result in a change in supply.
a. An increase in supply is depicted as a rightward shift of the supply curve.
b. An increase in supply means that producers plan to sell more of the good at each
possible price.
c. A decrease in supply is depicted as a leftward shift of the supply curve.
d. A decrease in supply means that producers plan to sell less of the good at each
possible price.
2. Other factors affecting supply include technology, the prices of inputs, and the prices
of alternative goods that could be produced.
a. An advance in technology, a decrease in the prices of inputs, or a decrease in the
prices of alternative goods that could be produced will result in an increase in
supply.
b. A deterioration of technology, an increase in the prices of inputs, or an increase in
the prices of alternative goods that could be produced will result in a decrease in
supply.
II. HOW CHANGES IN DEMAND AND SUPPLY AFFECT EQUILIBRIUM PRICE AND
QUANTITY
A. Change in Demand
1. A change in demand will cause equilibrium price and output to change in the same
direction.
a. A decrease in demand will cause a reduction in the equilibrium price and quantity
of a good.
1. The decrease in demand causes excess supply to develop at the initial price.
a. Excess supply will cause price to fall, and as price falls producers are
willing to supply less of the good, thereby decreasing output.
b. An increase in demand will cause an increase in the equilibrium price and quantity
of a good.
1. The increase in demand causes excess demand to develop at the initial price.
a. Excess demand will cause the price to rise, and as price rises producers
are willing to sell more, thereby increasing output.
B. Change in Supply
1. A change in supply will cause equilibrium price and output to change in opposite
directions.
a. An increase in supply will cause a reduction in the equilibrium price and an
increase in the equilibrium quantity of a good.
1. The increase in supply creates an excess supply at the initial price.
a. Excess supply causes the price to fall and quantity demanded to increase.
b. A decrease in supply will cause an increase in the equilibrium price and a decrease
in the equilibrium quantity of a good.
1. The decrease in supply creates an excess demand at the initial price.
a. Excess demand causes the price to rise and quantity demanded to
decrease.
C. Changes in Demand and Supply
1. If demand and supply change in opposite directions, then the change in the equilibrium
price can be determined, but the change in the equilibrium output cannot.
a. A decrease in demand and an increase in supply will cause a fall in equilibrium
price, but the effect on equilibrium quantity cannot be determined.
1. For any quantity, consumers now place a lower value on the good, and
producers are willing to accept a lower price; therefore, price will fall. The
effect on output will depend on the relative size of the two changes.
b. An increase in demand and a decrease in supply will cause an increase in
equilibrium price, but the effect on equilibrium quantity cannot be determined.
1. For any quantity, consumers now place a higher value on the good, and
producers must have a higher price in order to supply the good; therefore, price
will increase. The effect on output will depend on the relative size of the two
changes.
2. If demand and supply change in the same direction, the change in the equilibrium
output can be determined, but the change in the equilibrium price cannot.
a. If both demand and supply increase, there will be an increase in the equilibrium
output, but the effect on price cannot be determined.
1. If both demand and supply increase, consumers wish to buy more and firms
wish to supply more so output will increase. However, since consumers place
a higher value on each unit, but producers are willing to supply each unit at a
lower price, the effect on price will depend on the relative size of the two
changes.
b. If both demand and supply decrease, there will be a decrease in the equilibrium
output, but the effect on price cannot be determined.
1. If both demand and supply decrease, consumers wish to buy less and firms
wish to supply less, so output will fall. However, since consumers place a
lower value on each unit, but producers are willing to supply each unit only at
higher prices, the effect on price will depend on the relative size of the two
changes.
III. U.S. AGRICULTURE
A. Economic and Historical Characteristics
1. The percentage of workers in agriculture has fallen since 1800, and the number has
fallen since the 1920s.
a. The downsizing of agriculture employment has been accompanied by large
reductions in the number of farms.
2. Advances in technology are largely responsible for the downsizing of agriculture.
a. Technological advances have significantly increased the supply of agriculture
products.
b. Demand for agriculture products has not kept pace with the increases in supply.
1. Population has not grown at a fast enough rate to keep pace with the increase
in supply.
2. Income has increased, but it has not resulted in a proportionate increase in
demand for agriculture products.
3. The farm population is better off both relatively and absolutely than in previous time
periods.
a. Changes in technology and decreases in the price of agriculture output has
decreased the demand for labor in agriculture.
b. Tremendous growth of opportunities have resulted in large decreases in the supply
of labor in agriculture.
c. Because the decreases in supply have outweighed the decreases in demand, wages
in agriculture have increased.
B. Competitive Markets and Economic Profits
1. Two important elements of agricultural markets are risk and competition.
2. Farmers face individual risk.
a. There is a long lag between the decision to produce and the harvesting of crops or
selling of livestock.
b. Changes in market conditions, bad weather, or disease can cause the operation to
go under.
3. Farmers face market risk.
a. Because both the supply and demand of agriculture products is not very sensitive
to changes in price, supply increases can result in large reductions in revenue.
1. If there is an increase in supply, there will be a large drop in price and farmers'
revenue will decrease.
a. Revenues fall because the drop in price outweighs the increase in
quantity bought by consumers.
b. Changes in weather can cause frequent changes in the supply of agricultural
products, thereby leading to the instability of farm income.
4. Farmers face intense competition in the market.
a. If farmers introduce a new crop, they may reap economic profits due to the risk
associated with bringing a new product to market.
b. Over time, the economic profits will be competed away as new suppliers enter the
market.
1. The economic profits are competed away because of the decrease in price that
accompanies increases in supply and because marginal cost increases as output
is expanded.
5. Government has attempted to decrease risk by regulation, by reducing price and
income risk, and by providing disaster relief.
a. Economic analysis shows that government intervention in these areas is
unnecessary.
1. Farmers can reduce risk by purchasing crop insurance, diversifying crops, and
using commodity market techniques.
IV. U.S. FARM POLICY
A. The most visible and costly farm programs have been those designed to increase the price
that farmers receive for various agricultural commodities. The basic idea is that the
government guarantees a minimum price for the product. The government might
1. establish a minimum price-a price floor-and take appropriate action to maintain that
price.
2. use regulation to control supply and thus support the price.
3. pay the farmer a deficiency payment, which is the difference between the market price
and some guaranteed price.
B. Price Floors
1. A price floor is an example of a price support.
a. A price floor sets a minimum price for a commodity; market price is not allowed
to fall below the price floor.
2. Price floors for commodities have several consequences.
a. The price floor creates an excess supply of the commodity.
1. Government purchases this excess supply in the form of a nonrecourse loan.
b. The price floor increases the revenues of farmers because they sell more of the
commodity at a higher price.
c. Price floors mean that consumers spend more for the commodity.
1. More is spent because the price support causes price to be greater than the
equilibrium price and because government must raise taxes to purchase and
store the excess supply of the commodity.
d. In order to prevent increases in the excess supply of the commodity created by the
supports, government must restrict the flow of imports.
C. Output Constraints
1. In order to decrease either excess supply or deficiency payments, government may
enact a program of output constraints.
2. Output constraints require or induce farmers to limit their production.
3. Output constraints appeal to politicians because they shift part of the burden of
supporting farmers from taxpayers to consumers without causing excess supply.
4. Farmers take their less productive land out of production and use the remaining
acreage more intensively.
D. Target Prices and Deficiency Payments
1. Instead of enacting price supports, government enacts target prices for some
agricultural products.
a. A target price is simply a guaranteed price for a product.
2. Target prices have several consequences.
a. As with the price support system, farmers sell more output and receive more
revenue.
b. Unlike price supports, there is no surplus associated with the target price.
1. A potential surplus does develop, but it is sold on the market at a price below
the market equilibrium price.
c. Government must pay farmers the difference between the target price and the price
for which the product is sold by making a deficiency payment.
1. The money for this deficiency payment comes from the taxpayer.
d. Domestic buyers pay less for the product than they do under a system of price
supports.
D. Rent Seeking
1. There are different types of rent-seeking.
a. Political rent-seeking is activity undertaken to gain an economic advantage through
government action.
b. Economic rent-seeking is activity undertaken to gain an economic advantage by
producing new, better products or by producing at a lower cost and selling for a
lower price.
2. Even though farm policies have undesirable consequences, they continue because of
the political rent-seeking activities of individuals.
3. A small group of committed individuals, say dairy farmers, who have a big stake in a
certain political action have a good chance of obtaining the desired action.
a. The cost of the action is spread over a large group so that no single individual
bears a cost large enough to attempt to defeat the action.
b. The benefit of the action is spread over a small group of individuals so that each
one will work to ensure the action's passage.
Answers to Review Questions
1. What factors will lead to a change in demand? If the good in question is a normal good,
briefly explain how each factor will affect demand.
A change in demand means that consumers are willing to buy either more or less of a good or
service at each possible price. The factors which will lead to a change in demand are changes
in income, the price of related goods, the tastes and preferences of consumers, and the number
of consumers. If the good is a normal good, one would expect increases (decreases) in income
to be associated with increases (decreases) in demand. If the price of a complement, a good
used jointly with another good, rises (falls), one would expect demand to decrease (increase).
If the price of a substitute, a good that satisfies a similar need or desire, rises (falls), one would
expect an increase (decrease) in demand. If consumers decide they like a good more (less) than
in the past, one would expect an increase (decrease) in demand. Finally, if the number of
buyers rises (falls), one would expect an increase (decrease) in demand.
2. Use your knowledge of demand to answer each of the following questions.
a. How would a freeze in Florida affect the demand for oranges?
b. The price of coffee falls. How is the demand for coffee affected?
c. Income falls. How will this affect the demand for beans, an inferior good?
d. How will a fall in the price of peanut butter affect the demand for jelly?
e. The media reports that red apples are sprayed with a substance that allegedly causes
cancer. What would be the likely effect of this news on the demand for apples?
f. How would an East Coast hurricane affect the demand and supply of lumber in the
affected area?
a. A freeze in Florida would cause a decrease in the supply of oranges. This decrease in
supply would lead to an increase in the price of oranges, and hence an increase in the price
of orange juice. As the price of orange juice rises, there will be a decrease in quantity
demanded.
b. As the price of coffee falls, there will be an increase in quantity demanded.
c. As income falls, there will be an increase in the demand for beans.
d. Since peanut butter and jelly are complements, a fall in the price of peanut butter will lead
to an increase in the demand for jelly.
e. If the public is made aware that apples are being sprayed with a cancer-causing agent, their
preferences for apples will fall and their will be a decrease in the demand for apples.
f.
As rebuilding took place after the hurricane, the demand for lumber would increase. The
hurricane could destroy existing stocks of lumber in the affected area. If this occurred, the
supply of lumber would temporarily decrease.
3. Briefly describe the difference between a change in quantity supplied and a change in
supply. What will cause each of these changes to occur?
A change in quantity supplied means that sellers will be willing to sell more (less) of a good at
a new price. For example, if price rises, the seller will be willing to sell more of the product at
the new higher price. A change in supply means that sellers will be willing to sell more (less)
of a good at all possible prices. For example, before an increase in supply, sellers were willing
to sell 10 pizza slices at a price of $1.00 per slice. Now they are willing to sell 15 pizza slices
at this same price. Change in quantity supplied is illustrated by a movement along the supply
curve while change in supply is illustrated by a shift of the supply curve.
A change in quantity supplied is caused by a change in the price of the good. A change in
supply is caused by a change in the cost of inputs, production technology, or the price of
related goods.
4. Use a graph of supply and demand to illustrate each of the following.
a. Equilibrium price and quantity.
b. An increase in demand and its effect on the equilibrium values.
c. A decrease in supply and its effect on the equilibrium values.
d. A relatively small decrease in demand and a relatively large increase in supply and
their effect on the equilibrium values.
a. Equilibrium is given by the intersection of demand and supply. In the above graph,
equilibrium is at point A. P0 and Q0 are the equilibrium price and quantity.
Price per Unit (Dollars)
S0
A
P0
D0
Q0
Quantity per W eek
Price per Unit (Dollars)
S
B
P1
0
A
P0
D
1
D
Q0
0
Quantity per Week
Q1
b. An increase in demand is illustrated by a rightward shift of the demand curve to D1. The
new equilibrium point is point B, and the new equilibrium price and quantity exchanged
have risen to P1 and Q1, respectively.
c. A decrease in supply is reflected as a leftward shift in the supply curve to S1. The new
equilibrium point is point B. The new equilibrium price has risen to P1 while the new
equilibrium quantity exchanged has fallen to Q1.
Price per Unit (Dollars)
S1
P1
P0
S0
B
A
D0
Q1
Q0
Quantity per Week
Price per Unit (Dollars)
S
0
S
1
A
P0
B
P1
D
D
Q0
Q
0
1
Quantity per Week
1
d. The decrease in demand is represented by the leftward shift in the demand curve to D1.
The increase in supply is represented by the rightward shift in the supply curve to S1. The
new equilibrium point is point B. The new equilibrium price has decreased to P1 while the
new equilibrium quantity exchanged has risen to Q1.
5. Explain in words and use graphs of demand and supply to illustrate what happens to the
price and quantity exchanged of each of the following:
a. new cars, if automobile workers receive a 20 percent increase in wages.
b. compact disc recordings of rock music, if the teenage population increases.
c. bread, if wheat fertilizer prices increase.
d. fur coats, if conservation laws restrict the number of fur-bearing animals that can be
harvested.
e. hamburgers, if strict environmental regulations reduce the profitability of raising
cattle and consumers become more worried about the consumption of animal fats.
a. If automobile workers receive a 20 percent increase in wages, there will be an increase in
the cost of producing automobiles. As a result, supply will decrease from S0 to S1.
Equilibrium will move from point A to point B. Price will increase from P0 to P1.
Quantity exchanged will decrease from Q0 to Q1.
Price per Unit (Dollars)
S
S
0
B
P1
P
1
A
0
D
Q1
0
Cars per Week
Q0
b. If the teenage population increases, there will be an increase in demand for compact
disc recordings of rock music from D0 to D1. Equilibrium will move from point A to
point B. Equilibrium price will increase from P0 to P1. Equilibrium quantity exchanged
will increase from Q0 to Q1.
Price per Unit (Dollars)
S
P1
P0
0
B
A
D1
D
0
Q0
Q
CDs per Week
1
c. An increase in the price of fertilizer will increase the price of wheat. This means that an
input used in the production of bread will increase. As a result, there will be a decrease in
the supply of bread. Equilibrium will move from point A to point B. Equilibrium price
will increase from P0 to P1. Equilibrium quantity exchanged will decrease from Q0 to Q1.
Price per Unit (Dollars)
S
P1
1
S
0
B
A
P0
D
Q1
0
Bread per Week
Q0
d. If conservation laws restrict the harvest of animals that can be used in the production of fur
coats, this will decrease the supply of fur. As the supply of fur falls, its price will increase.
An increase in the price of fur will increase the cost of producing fur coats. The supply of
coats will fall from S0 to S1. Equilibrium will move from point A to point B. Price will
increase from P0 to P1. Quantity exchanged will decrease from Q0 to Q1.
Price per Unit (Dollars)
S
P1
1
S
0
B
A
P0
D
Q1
Q0
0
Fur Coats per Week
e. The stricter regulations will decrease the supply of cattle while the change in consumer
tastes and preferences will decrease the demand for cattle. These two changes will
decrease the quantity of cattle exchanged in the market. However, the price of cattle could
either increase or decrease. The change in price will depend on the relative size of the
changes in supply and demand. For example, the first diagram below shows a relatively
large decrease in demand and a relatively small decrease in supply.
Price per Unit (Dollars)
S1
S0
P0
P1
A
B
D0
D1
Q1
Q0
Quantity per W eek
Supply and demand are initially S0 and D0, respectively. Equilibrium is at point A. With
the changes in demand and supply, equilibrium moves to point B where the new demand
curve, D1, intersects the new supply curve, S1. Price falls to P1 while quantity exchanged
falls to Q1. In this case, price falls because the decrease in demand (which works to lower
price) outweighs the decrease in supply (which works to raise price).
In the following diagram, the decrease in supply is relatively large while the decrease in
demand is relatively small. In this case, price increases instead of falling.
Price per Unit (Dollars)
S1
S0
P1
P0
B
A
D0
D1
Q1
Q0 Quantity per W eek
Supply and demand are initially S0 and D0, respectively. Equilibrium is at point A. With
the changes in demand and supply, equilibrium moves to point B where the new demand
curve, D1, intersects the new supply curve, S1. Price increases to P1 while quantity
exchanged falls to Q1. In this case, price increases because the decrease in supply (which
works to raise price) outweighs the decrease in demand (which works to lower price).
Price per Unit (Dollars)
S1
P
S0
1
D0
0
Q1
Q3
Q2
Pounds per Week
6. Cite and briefly describe some specific examples of the government's farm policy.
Explain how the effects of price supports and of target prices differ.
One example of farm policy has been the price support program. Under this program
government works to ensure that farmers receive a specific price for the goods they produce.
Any goods not sold to the consumer at the support price are bought by the government. The
following graph of the demand for and supply of cheese illustrates the basics of this program.
Price per Unit (Dollars)
S0
P1
P0
D0
Q1
Q0
Q2
Pounds per Week
As can be seen the equilibrium price and quantity are P0 and Q0 respectively. Now suppose
government sets a price of P1. The quantity of cheese demanded falls to Q1 while the quantity
of cheese supplied rises to Q2. This results in a surplus of Q1 - Q2. Government purchases the
surplus from farmers at the support price of P1. Under this program, farmers are made better
off because they sell more output at a higher price.
Consumers, on the other hand, are made worse off because they now purchase less of the
product for a higher price. They must also provide government the money, through the
payment of taxes, to both purchase and store the surplus.
In an attempt to deal with the surplus created by the price supports, government has enacted
output restraints. The purpose of these restraints is to shift the supply curve to the left, thereby
causing the surplus to fall (from Q1 - Q2 to Q1 - Q3 in the following diagram). This means that
the support price can be maintained with smaller government purchases. Such programs
generally have a smaller effect than planned because farmers take their least productive inputs
out of production. Hence, a 10 percent decrease in inputs does not necessarily lead to a 10
percent decrease in output.
A final program enacted by government is that of a target price. In this case, government
guarantees farmers a certain price for their product, the target price. However, government
does not support this price or buy any surplus. Instead farmers, on the basis of the target price,
determine how much to produce. They then sell this output at the price the market will bear.
Again, graphical analysis helps to illustrate this program.
Price per Unit (Dollars)
S
0
P1
P2
D
Q
1
Q2
0
Bushels of Wheat
Suppose government sets a target price on wheat of P1. At a price of P1, farmers will produce Q2
bushels of wheat. Households are willing to pay only P2, for Q2 bushels of wheat (found by
starting at Q2, reading up to the demand curve, and then across to the price axis). Government
then makes a deficiency payment to farmers equal to the difference between the target price and
the market price multiplied by the amount of wheat the farmer sells.
There are several differences between a price support and a target price program. First, there
are no surpluses associated with target prices. Second, there is no problem associated with
government subsidizing farmers' exports. Finally, under a target price program, buyers are able
to buy a product for less (in fact the price paid is less than the production price of the product)
than they could with price supports. In other words, the target price program subsidizes
domestic buyers.
Both programs are similar in that they extract subsidies from consumers for farmers. Under a
price support, these subsidies are extracted through both the higher price paid for the product
and the taxes used to purchase and store the surplus. Under a target price, these subsidies are
extracted only through the tax payment needed to make the deficiency payment to farmers.
Note: In actuality the target price is not so different from a price support system. With the
target price, there is a potential surplus. It simply does not develop because price is allowed to
fall. The output and the price received by the farmer are the same under both systems.
7. Suppose the government announced that it was going to treat the agricultural industry
the same way that it treats the retail industry. That is, it will eliminate all price support
programs and all deficiency payment programs. What would be the effect on farm
poverty? On the number of farmers? On food production? On food prices?
If government were to eliminate all price supports and deficiency payments, it might result in
some increase in farm poverty. The initial increase might be relatively small because the
largest payments go to farmers who are relatively wealthy and own relatively large farms.
There might be some additional increase as these large farmers, who were accustomed to
tailoring production to these higher prices, adjusted to the rigors of the market system.
If the government were to eliminate its monetary support of farmers, there would likely be a
decrease in the number of farmers. This monetary support allows farmers to sell more output
at a higher price, thereby increasing their profits. As the profits fell, some farmers would find
other alternatives more attractive and leave the agricultural industry.
Because of government support, there is currently an excess supply of many farm products. As
the price of the products fell to the equilibrium price, we would expect to see a decrease in the
quantity supplied. This decrease would continue until the excess supply (both actual and
potential) disappeared.
The effect on food prices would be mixed. In cases where price supports are used, the food
prices would fall. These supports cause price to be above the equilibrium, and force consumers
to pay a market price above the equilibrium price. In cases where target prices are used, food
prices would increase. In this instance, government is subsidizing domestic buyers. This
increase in price does not necessarily mean that consumers would be made worse off. Since
government is no longer making deficiency payments to farmers, this should allow taxes to be
lowered.
8. Explain the risks involved with farming. Explain why government programs are not
necessary for farmers to deal with these risks.
There are several risks involved with farming. One type of risk is an individual risk. For
example, at the beginning of a year, farmers must decide how to allocate inputs in light of
expected prices and profits. There is a long time lag between the decision to produce and the
actual harvest. Thus, farmers cannot be sure they will have any output to sell. A crop or herd
can be destroyed by weather, pestilence, or disease.
Farmers also face market risk. The quantity demanded and quantity supplied of farm products
are fairly insensitive to changes in output prices. This means a change in supply can result in a
large change in price. This will ultimately lead to large fluctuations in farm income. For
example, suppose farmers have an exceptionally good harvest of wheat. This increase in
supply will result in a large decrease in the price farmers receive for wheat. Their incomes will
fall because the drop in price will far outweigh any increase in consumption by consumers due
to the lower price.
The intense competition faced by farmers complicates the individual and market risks.
Suppose some farmers introduce a new crop to the market. If consumers like this product,
these farmers will initially earn an economic profit. This profit is their reward for bearing the
risk associated with introducing a new crop. Other farmers note the profit being earned, and
more resources are devoted to producing the new crop. As a result, supply increases. This
drives down price. Eventually, the economic profits are eliminated. (Note: rising marginal
costs that occur as supply expands also work to eliminate the economic profit.)
Farmers have argued that the risk and competition they face provide a basis for government
regulation in the agriculture industry. Some individuals go so far as to argue that regulations
are necessary to ensure that adequate food supplies are available. This argument is false.
Regulation in the broiler and livestock industries are minimal. Despite the absence of
regulations, these industries provide a dependable and inexpensive source of protein.
Orange production in California is strictly regulated. These regulations work to raise the price
of California oranges relative to oranges produced in other areas. This increase in price
encourages California orange growers to increase production. In addition, the increase in price
makes oranges produced in other areas relatively more attractive. Thus, the regulations cause
an increase in the supply of California oranges. At the same time, the demand for these
oranges falls. They cannot sell as much fruit. Oranges are left rotting on the trees. Thus, as
long as other producers are prevented from entering the market, regulations designed to protect
the California orange grower are ineffective in the long run.
In addition to the above problem, regulations distort prices. Because of the regulations, prices
do not adjust. Prices inform consumers about the relative scarcity of products. As products
become more scarce, their relative price rises. As products become more plentiful, their
relative price falls. Consumers adjust their spending patterns accordingly. Regulations prevent
this from occurring.
Disaster relief is designed to protect farmers from devastating weather changes. However, this
relief encourages behavior that leads to disaster. Farmers often do not buy crop insurance
because they know the federal government will bail them out if disaster strikes. Farmers also
farm in areas prone to flooding because they know in the event of a flood, they will receive
disaster relief. Instead of relying on the federal government, farmers could reduce risk
themselves by buying crop insurance and by diversifying.
9. Some people argue that no reason exists today for government to be so heavily involved
with agriculture. These people argue that agricultural programs exist to satisfy political
constituencies. Given that only 2 percent of the U. S. population is in agriculture, how
does agriculture get so much political support?
Government support of agriculture is the result of political rent seeking, individuals seeking an
economic advantage through government action. The benefits of government support are
concentrated on a few individuals. Because each individual can reap a relatively large benefit,
they are willing to spend a great deal of time and effort to ensure that government passes the
desired proposal. The cost of this proposal may be quite large; however, this cost is spread
over a substantial number of people. This means that any single individual bears only a small
cost if the proposal passes. Because the cost is so small, the individuals bearing the cost take
no action to stop the proposal. Thus, a small group of committed people with a large stake in
political action are likely to obtain the desired results from government because the costs of the
action are spread over a large group. No single person in the large group bears a large enough
cost to attempt to defeat the proposed action. Thus, the action is passed.
10. Use InfoTrac or some other means to research a particular government programs that
benefits a specific agricultural crop. Explain how the analysis in this chapter help you to
understand this program.
Choices of articles and answers will vary.
11. Based on the box titled “OECD Farm Policy,” compare New Zealand's farm programs
with those of the United States.
Traditionally, government has been heavily involved in supporting agriculture in the United
States. Farm support in New Zealand is much less. For example, the dollar support per farmer
in the United States is approximately $20,000. In New Zealand, dollar support per farmer is
zero! The per capita cost of these transfers is $1,400 for a family of four in the United States
and $320 for a family of four in New Zealand.
Unlike the United States (until recently) New Zealand has all but eliminated government
protection for agriculture. Most government expenditures for agriculture come in the form of
research, disease control, and pest control. Payments based on production are basically
nonexistent. New Zealand has also moved away from providing relief payments for climatic
disasters. As a result, New Zealand farmers, unlike their U.S. counterparts, have had
incentives to undertake risk management.
12. Explain the “all-or-nothing” fallacy. (See the Box on OECD Farm Policy.) Can you
think of other examples?
In the context of agriculture, the “all-or-nothing” fallacy is the implicit assumption that if some
farms or farmers are going out of business all farmers are in danger of going out of business.
According to this argument, food is necessary to survival. Farmers produce food. If they go
out of business, the country will have to rely on a foreign country to provide it with basic
necessities. As a result, the country will lose its independence. This argument often leads to
cries for protection of agriculture against foreign competition.
There are numerous examples of the “all-or-nothing” fallacy. They are used in industries from
agriculture to national defense. Students will likely discuss several different examples.
13. Economic News Online-- http://www.swcollege.com/bef/econ_news.html. Go to this site
and choose the Equilibrium category under Fundamentals and choose an EconNews story
that interests you. Read the full summary and answer the questions posed.
Choices of articles and answers will vary.