Thursday, April 19, 2007

Escaping from Farm Programs

Since the 1920's, economists, policymakers and farmers have been at odds over the need for programs to deal with the tendency for output to increase faster than consumption and with the large variation in commodity output. For the most part, economists have argued for reliance on the free market and the competitive system to cure these problems. However, farmers have asserted that they were at a disadvantage in the market compared with other industries and needed help to get a fair deal. Policymakers listened to their farmer constituents and sold their ideas to consumers and taxpayers. They justified market interference on the basis that family farmers were the backbone of our society. They pointed to depressed farm incomes and suggested that our food security should be guarded. They argued that an income transfer to farmers was, thus, a good idea.

Policymakers and their farmer constituents designed intervention programs to raise total income for the sector and average incomes of commercial producers of program commodities above free market levels. The programs control prices, hold stocks, idle land and transfer income. As the various administrations have operated the programs they have provided annual price floors for program commodities. During most the past 65 years, these floors exceeded short run market clearing levels. Over the entire 65 year period, they have exceeded long run free market prices. Thus, the price floors have encouraged production which was larger than the market could clear. The excess over sales accumulated in government storage programs, and resulted in attempts to reduce production to avoid further accumulations. For producers of program commodities, incomes and asset values were higher than they would have been in the absence of the programs. Producers of program commodities became dependant on, or coupled to, income support programs.

The Food Security Act of 1985 (FSA) moved a step toward market orientation by allowing price floors and commodity prices to decline. Income support to producers of program commodities was maintained through direct payments based on program yield and program acreage. The income support was achieved at a substantial increase in budget cost because the direct payments replaced hidden transfers from consumers.

As a result of the increased budget cost, the variability and size of the program budget became a major policy issue. The purpose of the income transfer and effectiveness of the program in achieving income stability was questioned and was considerable debate over whether these income transfers should continue.

At issues as we move toward a new Farm Program is whether commodity producers deserve a larger than free market share of income? Does the government have a role in providing for market stability even if it does not provide an income transfer? Such questions will only find answers in Congress through legislation.

Since the beginning of commodity programs economists have rather consistently argued for market orientation in agriculture with prices free to signal the need for more or less resources committed to production. However, the lack of a clearly defined statement of the sources of market failure and lack of sound economic programs to address the fundamental problems has often blunted their arguments for program reform.

The following evaluates how a free agricultural market diverges from the economists'competitive norm and to suggests how Federal programs could ease long run price discovery in a market oriented system.

THE COMPETITIVE MARKET NORM

At the center of the agricultural policy issues is the underlying faith of our society in the value of the free market in allocating resources and returns. Economist rely on competitive markets as a norm or standard. The assumptions of competitive market theory are a scale against which they measure economic performance. They argue that only in cases of market failure would an economy be better off with Government intervention. Pressure to cut government interference and move to a free market stems from a belief that competitive markets are effective, efficient and equitable. That is, competitive markets will result in just the right use of resources to produce just the right quantity of a commodity. And, according to the competitive theory free trade results in countries producing according to their comparative advantage.

Most economists believe that it would be desirable for the market to pass the "appropriate" economic signals through from consumers to producers concerning the quantity of resources to use in the production of commodities and how much to produce. They seldom specify the type of signal, but most infer that prices are the appropriate mechanism. In a free and competitive market the market price adjusts to bring about an equilibrium between the quantity supplied and the quantity demanded. Price provides the signal for adjustments in production and consumption. This competitive theoretical framework assumes perfect knowledge and instantaneous adjustment to equilibrium for long run and short run positions. That is, there is no short run. Capital, labor and current expenditures adjust eliminating excess resources. And, no stocks are carried in the system.

DEPARTURE FROM FROM THE NORM

Although the competitive model is a useful tool for analysis, the market for farm commodities departs from the rigid assumptions of the perfect market model. Specifically, there is a lack of perfect knowledge; production and consumption do not adjust simultaneously; random shocks affect production; there is not a fixed relationship between units of input and units of output; and production is seasonal, but consumption is continuous. Although producers can plan for an expected output and estimate how that output might vary, they have no basis for determining how output will vary in any one year. Producers make planting decisions on the basis of an expected price and an expected set of cost relationships. These would permit them to earn a return over variable cost sufficient to cover some or all of fixed cost. However, it would be coincidence if expected cost and actual cost or expected price and actual price coincided.

Probability theory offers no assistance in bringing expectations together with reality. It merely consists of the mathematics of the distribution of possibilities for situations which can not be empirically identified. (1) Thus, the quantity shock that occurs because of yield and weather variability is a non trivial condition. We can know the likely hood of a particular shock, but we have no information at planting time on whether that shock will occur in a particular year. Although nothing else changes, weather will bring about a mismatch between expected and actual yield and therefore expected and actual prices. Because the market allocates actual supply among demands rather than allocating expected supply among expected demands, determining the existence of fundamental shifts in demand or supply caused by economic forces requires several production periods.

Although many argue that market orientation will strengthen agricultural markets, some evidence shows that fitting agricultural production more closely to the competitive norm may not be good for the agriculture in either the short run or long run. McCalla and Carter argue that "... if production agriculture is a competitive island surrounded by varying degrees of concentration in markets, then deducing conclusions about the advantage of a return to a free market from theoretical constructs may not be valid"(3). However, consequences of government price fixing include (1) a heavy burden on the public treasury, (2) higher taxes, (3) higher cost of living, and (4) over stimulation of production for the protected commodity. In spite of these problems, agriculture programs from 1933 to 1985 have by one means or another established a floor price for program commodities by acquiring stocks and limiting production or marketings to set prices. A persistent problem remained through the existance of the programs. Policymakers could not establish a floor price belowr the long run market price and they therefore had difficulty clearing out stocks from farmer or Government held reserves. This is not surprising because income support through price supports, with out relying on the public treasury, requires that demand be inelastic and prices must be higher than the long run average free market price.

Although the legislators and program managers usually assumed the problem to be a chronic excess production problem that resulted in a low income problem, they relied on weather related production variability to extract them from the long run problem of stock accumulation. The stock accumulation was the result of excess production created by the price support effort. However, production variability is an ineffective procedure for emptying out storage bins, unless large acreage reduction programs restrict production to a level short of expected demand.

Using price as the trigger variable to initiate a Government action prevents the price from serving as a true measure of the need for production in future periods. Fixed current prices do not provide a sound base for forming expectations concerning future prices. Fixed prices also distort market allocation of the current year's crop and truncation of the expected price distribution on the lower end causes the expected price faced by the consumer to be higher than the price floor.

CONTINUING MARKET AND POLICY FAILURE

D. Gale Johnson, in an evaluation of agricultural policy, said "The policies of the 1950's were concerned with attempting to protect agriculture from changing conditions."... "The policies of the 1960's were reasonably effective in aiding agriculture to adjust to the inevitable resource transfers and the relative contraction of the farm sector."(2) In the Johnson context, policies of the 1980's tended to protect the sector from changing conditions rather than allow the sector to make the inevitable resource transfers.

Speaking to the subject of policy failure, Johnson has said: "If my analysis of the flexibility of resource allocation in agriculture is approximately correct, small errors in program formulation will very soon result in substantial cost to taxpayers, and possibly in difficulties in maintaining our pre-eminent position as a great agricultural exporter." In other words, it is relatively easy to create significant excess capacity in agriculture. if prices or payments are inconsistent with the underlying demand and supply situation. When agricultural output is greater than the demand, at politically acceptable levels of prices, a long time and large income transfers are required to eliminate the excess productive capacity and avoid major shocks to the production sector.

Price floors above long run market price levels are a major cause of excess production, but removal of such floors will not result in a stable market for agricultural commodities. Changing technology will result in a continuing expansion of production with a given set of resources. Producers have no means of retaining the benefits of cost reductions and real prices will trend downward as output increases faster than the combined effects of population and income shift demand.

In addition, a lack of homogeneity in the costs of production and marketing, resulting from differences in size, management, technology and location, will produce continuing excess capacity disequilibrium. Loss of resources from the sector will occur regardless of the form of policy. Because costs vary among firms, any price level below the average variable cost of the highest cost firm will in the result in the inevitable resource adjustment. Some firms will leave the sector while others continue to earn returns above of their variable and, perhaps, total production cost. Unlike industrial assets under excess capacity situations, land retains it's basic productivity. Frequently the assets of the exiting firms are recombined with those of the more profitable firms and production expands or cost decline or both. With no change in demand, or with demand shifting more slowly than supply, price will decline forcing additional firms to exit. However, production does not, necessarily, fall, because continuing consolidation of assets will occur. In the very long run, with firms exiting the sector a homogeneity of sorts may be achieved, permitting an equilibrium. Or, as concentration continues an oligopolistic system will be developed which permits some control of output at a level allowing the least competitive firm to remain in production because allocation of market shares has occurred.

ADJUSTING TO THE MARKET

Past price support policies caused more resource employment in crop production than the level needed to meet domestic and export demand at current prices. Stocks have accumulated. Removing excess capacity from the sector requires that real prices for output and real earnings must fall to force disinvestment from the sector.

Allowing real earnings to fall to the point that forces many of resources out of the sector is a painful treatment of the problem. In 1922, Henry A. Wallace, discussing the problem of heavy production against slack demand and addressing the possibility of market intervention said: "... in the long run every economic evil creates its own cure. If prices of farm products continue sufficiently long enough below cost of production, there will eventually be forced into bankruptcy enough farmers so that there will be no longer a disastrous surplus. At the same time there will be readjustments of land values, wages, etc., which will lower the production costs. "Henry A. Wallace, (4). However, avoiding the adjustment is impossible on a long term basis and easing the adjustment process becomes complex. Expansion of demand (shifting demand) at a fast enough rate to keep prices from falling seems economically and perhaps biologically impossible. Arbitrarily establishing a rigid price floor or a target price results in price certainty and provides the wrong information about future profitability. Tying price floors to current production costs results in distortion of returns in a manner that escalates future costs. This results in higher support levels in the future, higher production costs and an upward ratchet effect on support prices.

On the other hand, allowing the market to set prices without accounting for random disturbances from weather distorts the longer run economic signals. Prices changes from changes in demand or changes in technology and output are the economically determined signals that we wish to have transmitted.

WORKABLE OPTIONS

The critical aspect of any market oriented system is that the programs should not directly set prices and induce greater disequilibrium conditions. Providing protection against random shocks to the system need not distort long-term market signals if the shocks are due entirely to weather and yield quantity triggers rather than price triggers are used to initiate stock acquisition and dispersal. Also, stock acquisition must be limited to the yield increment.

Preventing the dynamic effects of the heterogeneous structure from driving prices down is difficult to achieve without inducing greater excess production. However, the most likely feasible solution may be some type of resource diversion (long term acreage diversion program) that diverts resources from production without fixing prices. With prices free to move according to true demand and supply shifts the cost of resource diversion program would be diminished.

CONCLUSIONS

Without price fixing programs, the agricultural sector would continue to experience a high degree of quantity and price variability from yield shocks. Also, the sector would continue to experience price disequilibrium, because of heterogeneity, even after the excess capacity induced by current programs is removed.

To achieve improved long run price discovery flexibility in prices is essential. To treat chronic excess capacity through Federal programs resources must leave the sector through positive adjustment programs and prices must adjust to economic stimuli. Prices must react to rationalize the market if income declines as a result of a change in the business cycle or if demand shifts as a result of a change in foreign exchange rates.

Programs that attempt to provide for price stability must use quantity changes as triggers and prices must be free to move with long run supply and demand conditions.

REFERENCES

1. Boulding, Kenneth E., "Normative Science and Public Policy", Economic Analysis and Public Policy, ed. Day, Richard H., Iowa State Press, Ames, Iowa, 1982

2. Johnson, D. Gale; "Food Production and Marketing: A Review of Economic Developments in Agriculture"; Food and Agriculture Policy; American Enterprise Institute for Public Policy; Washington D.C., March 10-11, 1977

3. McCalla, Alex F. and Carter, Harold O. "Alternative Agricultural and Food Policy Directions for the U.S. with Emphasis on a Market-Oriented Approach.

4. Wallace, Henry A., "Adjusting Production to Demand Benefits Both Farmers and the Public", Ames, Iowa, Dec. 28, 1922

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