Markets and
Agricultural Policy
Chapter 3
US Agricultural Sector
Data for 2010
 1% population employed in agriculture
 Enough production for the US plus exports (10% of total)
 Annual subsidies of $10-15 billion to support the industry
Goal of subsidies? Eliminate poverty
Poor Farmers?
 Median farm income 10% higher than median national income
 Average farm income 25% higher than average national income
 This has been true ever since 1996
 Farming is not that risky: a non-farm business is six times more likely to fail
WHY SUBSIDIES?
Farm Classification
Commercial family and non-family farms: 11% population, 82.4% crops, 84.7% livestock
Farm Classification
<$100,000 sales: 83% farm population, 8.4% crops, 8.7% livestock
>$1,000,000 sales: 2.3% farm population, 42.6% crops, 61.7% livestock
Who is getting the subsidies?
Distribution of Subsidies
• Largest recipient of subsidies: commercial family and
nonfamily farmers (11% population, 82.4% crops, 84.7%
livestock)
• Case of Stuttgart, Arcansas
1649 recipients
$87.5 million a year between 1995 and 2006
255 farms received >$500,000, but 51 farms received >$1,000,000
between 2005 and 2010
Small farmers receive little or no subsidies
Subsidies: Adverse Consequences
• Overproduction  Lower prices for the farmers
• Increased farm land values  support buyout of small family farms
• Congress pays 40 million acres of cropland from production
• Market distortions: lack of allocative and technical efficiency
Subsidies: Adverse Consequences
• 2005-2007: direct payments to US farmers averaged $17
billion a year
• Most of these payments go to rich and wealthy farmers
• TOTAL SUPPORT to farmers is three times the direct
payments
Tariffs
Price controls
Government Support to Agriculture
• Interferes with farmers’ production decisions
• Increases food costs
• Provides large subsidies to the wealthy
• Does little to help the poor
• Income redistribution from an average citizen to the privileged
group, the farmers
National Security Argument
Widely spread fallacy: support farmers because without them this
country will have to import all of its food, which is dangerous for
security reasons.
US: farms declined in number for most of 20th century, but they still
supply enough food for the US market because they are more
productive.
Removal of support makes inefficient, high-cost farmers leave.
New Zealand: only 3% of total farm receipts is farm support.
Compare to US 18%, Europe 33%, Korea at 63%
Demand and Supply Analysis
• Equilibrium is a stable state given by the intersection of supply
and demand, provided all other factors do not change
• If all or some other factors change, the equilibrium will
change as well
• When equilibrium changes, we analyze comparative statics
Complements and Substitutes
Definition. A good consumed in place of another good is called a
substitute to that good.
Example. Suppose milk and cheese are substitutes, and the price of
cheese drops.
1) The maximum value placed by consumers on each gallon of milk
decreases
2) The number of gallons of milk producers are willing to supply at
each price declines
Example: Milk and Cheese
Milk and Cheese: Decrease in Demand
 Gallon #6 is valued at $1.25 rather than
$1.75
 At the price of $1.75, producers are willing to
supply 4 rather than 6 gallons
 Definition. A situation in which, at each
price, consumers plan to purchase less of a
good, is called a decrease in demand.
 Graphically, a decrease in demand is
depicted by a downward or a leftward shift of
the demand curve
Substitutes: Practice
Which pair of goods below is composed of substitutes?
a)
b)
c)
d)
Computers and software
Automobiles and tires
Left and right shoes
Pepsi and Coke
Complements
Definition. A good used with another good is called a
complement to that good.
Example. Cheese and hamburger, airplane body and wings
If the price of cheese decreases, hamburgers become more
desirable, and demand for hamburgers increases.
Complements and Substitutes: Demand
An increase in the price of a substitute results in
an increase in demand for the other substitute
(demand shifts rightward.)
An increase in the price of a complement results in
a decrease in demand for another complement
(demand shifts leftward.)
Demand Factors: Income
 With higher income,
quantity demanded
at each price is
higher
 Increase in income
results in an
increase in
demand for a
normal good
 Decrease in income
results in a
decrease in
demand for an
inferior good
Normal and Inferior Goods
Definition. A good that consumers purchase more of when their
income rises is called a normal good.
Definition. A good that consumers purchase less of when their
income rises is called an inferior good.
Increase in Demand for a Normal Good
Income rises
Inferior and Normal Goods: Subjective
Example. Consider ramen noodles.
A poor family is likely to increase its purchases of ramen noodles if its
income goes up a little bit. Ramen is a normal good.
As this family is getting wealthier, it might switch to healthier and more
expensive foods, reducing its consumption of ramen, which is now an
inferior good.
Distinction between normal and inferior goods is subjective in that it
wholly depends on consumer preferences.
Other Demand Factors
• Number of consumers
• Consumer preferences
• Expectations
Supply Factors
• Everything that affects production costs
Technology
Prices of inputs
Prices of goods that can be produced instead of this good
Decrease and Increase in Supply
Definition. A situation in which, at each price, producers plan to sell
more of a good is called an increase in supply.
Definition. A situation in which, at each price, producers plan to sell
less of a good is called a decrease in supply.
Example. Advances in technology increase supply: new technology
makes wheat grow fast with lower amount of fertilizer.
Cheaper fertilizers also increase supply.
Higher wages decrease supply since they increase production costs.
Increase in Supply
Decrease in Supply
 More expensive fertilizers
 Labor laws that increase
minimum wage
 Related crops. Suppose the
relative price of corn went up
compared to the price of
wheat. The opportunity cost
of growing wheat is now
higher, which decreases
supply of wheat.
Changes in Equilibrium
Market equilibrium may change in three situations:
1) Demand changes
2) Supply changes
3) Both demand and supply change
Demand Changes and Equilibrium
 Suppose cheese is found to damage health
because of the dietary fat it contains
 Consumers’ valuation of cheese decreases
 Demand decreases: at each price consumers
purchase less cheese
 At the initial equilibrium price P0 excess supply
develops
 Under excess supply, prices go down
 New equilibrium is established at P1: no excess
supply again
 Equilibrium quantity falls from Q1 to Q0: production
resources get reallocated to other sectors
Automatic Resource Reallocation
• Consumer preferences change: cheese now less valuable
• Milk less valuable as well, so workers in cheese- and milkproducing sectors find jobs in (are reallocated to) other sectors
• Land used to graze cows reallocated to, say, growing wheat
• Resource reallocation is motivated by changes in relative prices
and is done automatically in a market economy versus command
economy.
Supply Changes and Equilibrium
 Workers in cheese industry receive lower wages
 Production costs of cheese are lower, which
increases supply
 At previous equilibrium price P0 there is excess
supply, which makes prices fall
 However, output increases now compared to
decrease in demand
Supply Changes and Resource Reallocation
Lower wages decrease opportunity costs of producing cheese
Producers want to sell more at the same price, but they fail if they don’t decrease
the price
New equilibrium: lower price, no excess supply, higher quantity
Consumers substitute cheaper cheese for other foods
Resources get reallocated towards cheese production
Resource reallocation is automatic in a free market economy
Change in Demand AND Supply
 Increase in supply and decrease in
demand
 Prices decrease
 Quantities increase or decrease
depending on the relative size of supply
and demand shifts
 When demand and supply move
together, there is ambiguity with
respect to quantity or the price
US Farms: Economics and History
• Technological progress
Supply increase
• Income growth
Illustrate with diagram
Demand increase
• Combined effect
Drop in prices
Increase in quantity
Supply effect strongly dominates demand effect since population and
income do not grow as fast as technology progresses
US Farming Labor
 Farmers leave agriculture due to large drops in
farm products prices
 Same number of workers can produce more
agricultural output
 Demand price for farming labor decreased as well
 Combined effect
 Increased farming wages
 Decrease in the number of farmers
 Labor supply effect dominates (productivity
effect)
Agriculture: Reallocation of Labor
• High-cost farmland taken out of agriculture
Infertile land
Adverse weather
High opportunity costs of farming instead of, say, selling to a
shopping-mall developer
• Farm labor reallocated away from agriculture
Remaining farm labor more productive
Remaining farm labor earns higher wages
Cultural pains (family farming traditions)
Transitional pains (difficult to find a job in a non-farming sector)
Farms: Risk
• Long lag between planting and harvesting
• Large borrowings at the start of growing season to buy land or plant crops, build inventory
stock
• Farmers’ decisions are made on the basis of expectations about factors such as weather
• Weather is largely unpredictable
• Once planted, the farmers cannot influence output
• Demand for agricultural products is not responsive to price changes either: physical
reasons
Agricultural supply and demand respond little to price changes: they are rather STEEP
Risk: Unexpected Increase in Supply
 Suppose weather is much better than predicted,
resulting in an increase in supply
 Expected revenue: 0 P0 R0 Q0
 Actual revenue: P1 R1 Q1 Q0
 Change in revenue:
 Farmers sell more: Q1>Q0
 Farmers receive a lower price: P1<P0
 The price effect dominates
 Farmers’ revenues decline
 The price effect dominates because demand is
unresponsive to changes in supply
Risk: Unexpected Reduction in Demand
• Agricultural supply is not responsive to changes in prices
• A reduction in demand may cause a sharp drop in farm
prices and farm income
• Great Depression: agricultural prices fell more than other
prices
• Foreign competition may partially replace domestic demand
Practice: Q34
Competition
Definition. A market environment with (1) a large number of buyers and
sellers and (2) free entry of new producers is called a competitive market.
Note. Economists also add the assumption of product homogeneity (no
varieties) and of perfect information both on the part of buyers and sellers.
Large number of buyers and sellers implies no one is too large to be
important: no one can influence the market price
Free entry implies that profitable industries attract new producers until
profits are competed away
Competition: an Example
• In the very short run, supply curve is vertical because
producers cannot adjust their production levels during a
very short period of time
• Initially, the marginal cost of production is C0, supply is
S0 in the very short run, and demand is D0.
• The market equilibrium will be at P0, producers earn
economic profits equal to P0-C0.
• Definition. A rate of earning in excess of the minimum
necessary to attract economic resources into a particular
use.
• Profits act as a signal to the other potential kiwi
producers who enter the market so that the very short
run supply shifts to the right, S1, and the price goes
down to P1 where it is equal to the marginal cost
C1=P1
• Economic profits = 0 at P1, and entry stops
Normal Rate of Return
• Marginal costs include normal rate of return
Definition. The minimum rate of return on investment necessary to
keep resources in a particular industry is called normal rate of return.
Example. Suppose the rate of return on investment in agriculture is
4%, but a bank deposit gives you 5%. Where would you invest your
money? Therefore, the normal rate of return in agriculture must be at
least 5%.
Normal rates of return will be higher in a riskier industry to
compensate for the risk.
Why Entry Causes Marginal Costs Rise?
• New farmers and new land may not be well suited to kiwi
production
• The opportunity costs of kiwi production increases because
land and labor of increasingly inferior quality is being used by
the new entrants
• Opportunity costs are the true economic costs of production,
which for one unit are equal to the marginal cost
Dealing with the Risk
• Buy crop insurance to protect against the weather
• Diversify: grow different types of crops for different types of
weather, or different species entirely
• Commodity market techniques: futures and options
• Market participants may assume other participants’ risk for a
price, e.g. poultry farmers cooperating with large processors
Price Controls
To help the farmers receive a higher price for their products, the
government institutes price controls:
1) Price floors: a legal minimum on a price
2) Regulate supply: limit supply
3) Deficiency payment: pay farmers the difference between
market price and guaranteed price
Price Floor
Definition. A minimum price set by government below which the
market price is not allowed to go is called a price floor.
 Price floor P1 is above the market price P0
 At price floor P1 there is excess supply Q2-Q1
 At P1, only Q1 bushels are purchased by consumers
 The excess supply Q2-Q1 must be purchased by the
government
 In reality, the government often uses the mechanism of a
non-recourse loan
Non-Recourse Loans
• Excess supply is used as collateral to the loan made by the
government to the farmer.
• Suppose you are a farmer, and at P1 your excess supply is 100
bushels that you cannot sell since P1 is too high
• The government lends you 100xP1 USD
1. Market price is >P1, you sell 100 bushels at a price higher than P1 so you
repay the loan
2. Market price is below the price floor of P1, you default on the loan, and the
government takes away the collateral of 100 bushels
Who Pays for the Price Floors?
•
This is what
consumers pay in taxes
so the government can
spend it to buy excess
supply
• Farmers’ revenue is
0P1R1Q2
Where Does the Excess Supply Go?
• Not all excess supply can be absorbed by demand in lean years
• Dumping everything on the domestic market will result in plummeting prices,
making domestic farmers unhappy
• Dumping the surplus in world markets will likely violate trade agreements
• Storing surplus is costly
• Some might be sold at subsidized prices to developing countries
• Some surplus can be given away in school lunch and commodity distribution
programs
Output Constraints
Storing the surplus corn is costly
and politically problematic
Require farmers to limit their
production: shift supply to S1
where there is no excess supply
Since demand is unresponsive to
price, farmers’ revenues grow:
lose A, but they gain a larger B
Hidden costs: consumers pay
higher prices for corn
Output Constraints: Effects
• Goal: reduce corn production by 10%
• Means: take 10% of land out of production
• Result: production decreases by less than 10% because:
1. Less fertile land is taken out of production
2. Use more fertilizers and labor on remaining 90%
3. The opportunity cost of corn is higher since more inputs are used per acre of land
• Paying farmers not to use land is politically embarrassing  target prices,
deficiency payments
Target Prices
Definition. A guaranteed price for a product is called target price.
Note. The product is sold at a market price, but the government
pays the difference between target and market price.
Target Prices
 Price floor is P1
 Farmers produce Q2 at P1
 Once Q2 gets to the market, the price falls
to P2
 At P2, there is no excess supply
 The government pays for each bushel the
difference P1-P2
 Target prices subsidize foreign buyers
without seeming to do so
Price Floors and Targets: Summary
• Price-floor system extracts subsidies from consumers for farmers
Consumers pay higher prices for farm products
Consumers pay taxes for the government to buy excess supply
• Target price system harms consumers
Deficiency payments come from consumers taxes
Two political problems
o Size of subsidy is apparent to taxpayers
o Farmers are receiving of government transfer payments—welfare payments
Practice: Q45
Political and Economic Rent Seeking
Definition. Attempt by certain individuals or groups to encourage
government activity that will result in an economic advantage for them is
called political rent seeking.
Political rent seeking may be the reason why agricultural policies exist
while imposing large costs on consumers. This is in contrast to economic
rent seeking.
Definition. Attempt by people to gain an economic advantage through
production of new or better products or through production of products at a
lower cost is called economic rent seeking.
Benefits and Costs Concentration
• Farmers are 2% of total population: why are they politically powerful?
• Benefits are concentrated to a handful of farmers, so the opportunity
costs for inaction are high enough to induce lobbying
• Costs are spread around a large number of consumers so an increase
in the price of wheat will not make an average family much worse off
• Logrolling: members of Congress trading votes to pass legislation of
interest to each other. Legislators from sugar-producing states vote to
support wheat farmers, and the other way round.