Economics: Problems in Agricultural Economics

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Consider the peculiar characteristics of a market where the demand is price inelastic. We've already seen that when the demand is price inelastic, there is a direct relationship between the price of the good and the total revenue that is earned in that market. Consider, however, in addition to this inelastic demand that supply is highly variable; that is, the supply curve shifts around a lot, say in response to changes in the weather. When you've got inelastic demand, plus shifts in the supply curve, you wind up with a situation where total revenue itself becomes highly variable, and this can become a problem, particularly if you're a farmer.
Most agricultural products have price inelastic demand; that is, people are going to buy their food products whether they're expensive, or whether they're cheap - you don't really have much choice. So if we take an agricultural market, this is the situation that characteristics it. What's more, not only is the demand for food price inelastic, it's also income inelastic as well. When you get richer, you don't tend to spend a lot more money on food; you'll spend your money on vacations, or health care, or automobiles, or something else instead. So things that shift the supply curve - say changes in productivity, technological advance, other stuff like that, that tend to make people wealthier - don't have a big effect on the demand curve for food. So shifts in the supply curve, then, cause the price of agricultural products to vary quite a bit. And with this variability in price, comes variability in total revenue, and that means variability in the income of farmers.
From the point of view of a farmer, this is a problem, and it's a cause for government intervention. We've had agricultural markets forever, and back well before there were well-functioning insurance markets, farmers faced this problem of price and income variability, so they encouraged governments to step in and implement policies that would stabilize income, or failing that, at least stabilize the price of their products. We have now in the United States a vast array of agricultural policies designed to deal with this problem, and that's why economists like to talk about agricultural markets when it comes to a discussion of government interference in the market - its causes and its consequences, both intended and unintended.
So let's look now at how an agricultural market works, and how particular government policies may end up actually making the situation worse. Consider, first of all, the demand for corn. When the price is high, the total revenue is going to be price times quantity - the area of this green box. If the price is low, on the other hand, we get a smaller total revenue - the area of the purple box. Because demand is inelastic, price and total revenue will move in the same direction.
Now let's consider what's happening in the market that causes the price to change. That's going to be caused by shifts in the supply curve. Farmers are going to make their plans based on some average supply curve, where the market would presumably through the bidding mechanism give us some average price and some average quantity. But the average thing almost never happens. You can have a bad year. A bad year means a year where weather is unfavorable - floods and draughts - which shifts in the supply curve. At any given price, you get less corn than the farmers expected to get. The odd and paradoxical thing is that a year that's bad for weather is actually a year that's good for total revenue. When farmers have a bad year, they actually end up making more money. It's almost like a monopolist that restricts the quantity so as to jack up the price. Well, competitive farmers can't collude like that, but if the weather forces a scarcity on them, it becomes an occasion for the bidding mechanism to provide a higher price and a bigger total revenue.
On the other hand, if the farmers had what we might call a good year, the supply curve shifts outwards. That is, a bumper crop, favorable weather, lots of corn - the market is flooded with food. However, this is bad for farmers, because the lower price winds up giving us a smaller total revenue in this market where the demand is inelastic. So the first paradox about agricultural markets is that a good year is bad for farmers, and a bad year is good for farmers if farmers are really concerned about their total revenue, or their earnings.
So what can we do about a situation like this? What can we do about a situation where shifts in the supply curve create price instability, and price instability creates instability in total revenue? Well, one thing that we could try to do is to stabilize the price. Suppose we decided that the price is going to be stabilized at some notion of average price of corn. That is, let's draw in here a supply curve that represents the average of the good years and the bad years, and let's look at what the price would be in a case that we had this outcome. So supply and demand crossing at this point gives us this, and we'll call this P*, which represents our average price. And I won't clutter the diagram by putting in the average quantity, but it's certainly going to be down here on the horizontal axis.
Well, of course, no year is truly average. So what's going to happen is that in a bad year, a year with bad weather, when the supply curve would shift inwards - so we have here a supply in the bad year, so I'll call this "bad" - we have a higher equilibrium price. But if the government is going to support the price - that is, keep the price at P* - what's going to happen in these years is we've got an excess demand. That is, farmers are only supplying this small quantity down here, but people who want corn flakes and corn meal and the agricultural product are going to want this larger quantity at the supported price.
So the government has to stand ready to provide enough corn to make up for the excess demand. Where is the government going to get the corn that it sells to keep the price constant? It's going to get it by buying corn in years of bumper crops. So in the years of the bumper crop - here is our supply curve in a good year - if the government keeps the price at P*, then the farmers are going to find that they're not able to sell corn at P* to all the people that they have corn for. In fact, the quantity supplied is going to be much larger than the quantity demanded - we have an excess supply of corn at a price of P*. So the government takes that excess supply, fills up its barns and silos, and stands ready to pay farmers this price - P* - which farmers can now count on.
So we stabilize the price of corn, farmers know what they can count on, and, unfortunately, we've got barns full of corn in some years, and the government involved in distributing corn in other years. "How did the government get in the food distribution business?" you might ask. Well, on top of that, we've got another problem, which is P* is a policy variable, and there's going to be disagreement about exactly where this average supply curve is, and in time, the farmers' lobby is going to work to push P* up, because that adds to their profits - which means that, on average, there are going to be more years where the government has to buy corn than there are going to be years when the government sells corn. In time, the government is going to accumulate surpluses chronically.
Now we've got a bunch of corn sitting around and we don't know what to do with it. We could give it away in the United States, but that would push down the price of corn and complicate our farmers' problem. What we do then is we export it; we send it to some other market, like Africa, and we can even send it there as food relief. That sounds great and humanitarian until you consider the fact that all of this free food flooding into Africa distorts incentives in those agricultural markets. Farmers counting on free food from the U.S. and Europe aren't inclined to plant food themselves, because they know they can't make a profit for it, because their price is going to be low because of all of this free food aid. And then, anytime the free food aid is disrupted, there isn't food there to feed the local population, and famines can result. So our attempts to get rid of these chronic surpluses by dumping them in other markets creates problems for other countries - countries where the needs may be more desperate.
So let's suppose then we don't go with a flat-out price support - a guaranteed price for farmers - but instead we try to restrict the quantity supplied so as to keep the price higher. How can we restrict supply when we've got thousands and thousands of competitive farmers out there each trying to make a profit by selling more food? It's kind of like the problem OPEC has of controlling oil producers. Well, one possibility would be set-aside programs, where we tell farmers you can only plant corn on so many acres, and the farmers agree that this is a condition of their support from the government - that they have to go along. Well, if they do, they're just going to take their least productive land out of agriculture, and hypercultivate the most productive land. That is, they're going to use a lot more labor, a lot more fertilizer, to try to grow more corn on limited parcels of ground.
Well, this just raises the cost of producing any given quantity of corn, because we're forcing farmers to substitute away from land, and instead to use more expensive labor and fertilizer that they wouldn't use if it weren't for this government policy. So set-aside programs introduce another distortion, which are inefficient techniques of production. Another possibility besides set-aside programs are marketing arrangements, where farmers agree only to bring so much corn to market each year; that is, they agree to collude and shift the supply curve in so as to keep prices up.
Well, these agreements are subject to all kinds of cheating; people are going to look for other ways of selling their products on the side, so they're kind of hard to enforce. But even if they were perfectly enforced, that means there's going to be a lot of waste, because if the amount that farmers are allowed to sell is limited to this amount right here - QH - which gives us the high price, then in a year of a bumper crop, we've got a lot of oranges and corn and other stuff that we just simply have to destroy, because otherwise it would be floating around in the market, depressing the price. So these marketing agreements can be very wasteful, unless farmers want to get into the business of storing their products, which may or may not be feasible.
A final way of dealing with the problem that farmers face is to directly support their incomes, and this is what the economists would say to begin with. The problem is, farmers' incomes are too variable. If we want to help the farmers, then let's stabilize their incomes. Well, the economists' first solution would be to have these farmers buy insurance; the insurance market can solve this problem. But short of that solution, if the government is going to provide some kind of insurance substitute, then it should give farmers money to supplement their incomes in years when prices are low, and tax the farmers to cover the cost of this program in years where prices are unexpectedly high. And this is the basic idea behind the Federal Agricultural Improvement and Reform Act of 1996. This act is designed to get the government out of the business of price supports and running storage programs, and instead to provide income for farmers to help them stabilize the difference between years when output is low and prices are high - and farmer incomes are typically good - and years when bumper crops push prices down and provide farmers with less income.
So although we can be critical of the act - I mean, there are some provisions that economists would say are not promoting efficiency - it is a step in the right direction by getting the government out of the business of tinkering with prices, and putting it in the business of redistribution of wealth, which is something that the government can do in a society where we want to protect the incomes of people who are otherwise at the mercy of the weather. So agricultural markets are a great example of the government interfering to try to make the world work better. But, as is usually the case, there are unintended consequences of each of these government policies, and the unintended consequences, in many cases, wind up creating more problems than the problems they were originally designed to solve. The moral of the story is: If you've got a distortion in the market, try to find the policy that's crafted so as to directly address that distortion, without introducing new ones.
Understanding Markets
Agriculture Economics
Examining Problems in Agricultural Economics Page [3 of 3]