Lecture 4: Common Agricultural Policy

1
Lecture 4 Common Agricultural Policy Based on
Sloman Chapter 3.4 and Chapter 8, Swann
2
CAP- The Common Agricultural policy

• Massively complex, massively expensive policy.
• Hard to understand without seeing how it
  developed.
• CAP started as simple price support policy in
  1962.
• Objective To stabilise prices
• AND provide income support for social reasons

3
Farm Size Distribution in EU(1987)

• Very skewed ownership
• biggest 7 per cent of farmers owned ½ of the
  land
• smallest 50 per cent of farmers owned only 7 per
  cent of the land.

Source Baldwin Wyplosz
4
Changes in Farm size 1970-1987
Source Baldwin Wyplosz
5
AGRICULTURE AND AGRICULTURAL POLICY

• Agriculture
• Many producers, all price takers
• Many consumers, all price takers
• free entry and exit
• As close to perfect competition as could imagine
• So why intervene in Agriculture sector?

6
AGRICULTURE AND AGRICULTURAL POLICY

• Why governments intervene in agriculture
• to reduce price fluctuations
• to raise farm incomes
• to protect rural communities
• to encourage greater self-sufficiency in food
• Causes of short-term price fluctuations
• fluctuations in demand instability
• fluctuations in the harvest

7
Suppose we have a crop which takes a year to grow
and is grown only once year,
P
e.g. Hops for Beer
SA
Suppose now that demand were to rise but supply
cannot respond immediately
P1
a
DA
Q1
O
Q
8
Suppose we have a crop which takes a year to grow
and is grown only once year,
P
e.g. Hops for Beer
SA
Suppose now that demand were to rise but supply
cannot respond immediately
P1
a
What will happen to Price?
DA
Q1
O
Q
9
Since supply is fixed, the price is determined by
the available supply at Q1.
P
SA
P2
So price rises to P2
P1
a
DB
DA
Q1
O
Q
10

• But next period farmers observe that the price of
  hops was very high
• So now they all want to grow hops
• At P2, what will the supply be?

11

P
SA
At P2, the following year supply increases to Q3
P2
P1
a
DB
DA
Q1
O
Q3
Q
12

P
SA
But now Supply exceeds demand so price must fall
to P3
P2
P3
P1
a
DB
DA
Q1
O
Q3
Q
13

P
SA
But next period farmers see lower price and
decide to supply less Q4
P2
P3
P1
a
DB
DA
Q1
O
Q3
Q4
Q
14

P
SA
Notice here that we are spiraling through time to
an equilibrium
P2
P3
This is a stable Cobweb
P1
a
DB
DA
Q1
O
Q3
Q4
Q
15
Suppose instead that the supply curve was very
flat.
P
SA
Now what will happen to Price?
P1
a
DA
Q1
O
Q
16
Suppose instead that the supply curve was very
flat.
P
SA
Now what will happen to Price?
P1
a
DA
Q1
O
Q
17
Since supply is fixed, again the price must rise
to P2
P
SA
P1
a
DB
DA
Q1
O
Q
18
Since supply is still fixed at Q1, again the
price must rise to P2
P
SA
P2
But next period farmers observe that the price of
hops was very high So now they all want to grow
hops
P1
a
DB
DA
Q1
O
Q
19

P
At P2, what will the supply be in this case?
SA
P2
P1
a
Now Supply Increases to Q5
DB
DA
Q1
O
Q
Q5
20

But again Supply exceeds demand so price must
fall to P5
P
SA
P2
P1
a
P5
DB
DA
Q1
O
Q
Q5
21

But at P5 next period farmers decide to supply Q6
P
SA
P2
P1
a
P5
DB
DA
Q1
O
Q
Q5
Q6
22

P6
But if only Q6 is supplied demand will exceed
supply and price will rise to P6
SA
P2
P1
a
P5
DB
DA
Q1
O
Q
Q5
Q6
23

But Now the price and quantity are gradually
spiraling away from equilibrium. This is an
unstable cobweb.
P6
SA
P2
P1
a
P5
DB
DA
Q1
O
Q
Q5
Q6
24
Summary of Cobweb Effects

• With a demand SHIFT and supply fixed yearly, a
  sudden rise in demand will see a big increase in
  income.
• The lagged response next year can generate
  cyclical fluctuations in prices over the next few
  years.
• When Q goes up and P fall, income PxQ can also
  fluctuate.
• Not all cobwebs are stable

25
Supply Side Shock
P
SRSA
SRSE
LRS is the long-run supply curve. SRSE is the
expected supply this year.
LRS
PA
e
PE
SRSA is the actual supply this year. e.g. Bad
harvest
D
QA
QE
O
Q
26
Supply Side Shock
P
SRSA
SRSE
So price rises, what about income? PEeQEOab is
expected income
LRS
PA
c
e
PE
ac actual income Overall depends on size of c
relative to b
a
b
D
QA
QE
O
Q
27
Supply Side Shock
P
SRSA
SRSE
PA
If demand is more inelastic, cgtb and income rises.
LRS
c
e
PE
ac actual income Overall depends on size of c
relative to b
a
b
D
QA
QE
O
Q
28
Supply Side Shock
P
SRSE
SRSA
But if it is a good crop and demand is inelastic,
LRS
c lt b and income falls So variability in incomes
leads to pressure for government intervention
e
PE
b
PA
a
c
D
QE
O
Q
QA
29
REASONS FOR INTERVENTION

• Causes of short-term price (and income?)
  fluctuations
• fluctuations in demand
• fluctuations in the harvest (supply)
• Causes of declining farm incomes
• low income elasticity of demand
• increases in supply

30
Decline in farm incomes over time 1
P
S1
P1
D1
Q1
Q
O
31
Decline in farm incomes over time 1
P
S1
An improvement in farm efficiency!
S2
P1
But with inelastic demand, income will fall as
before
P2
D1
Q1
Q2
Q
O
32
Decline in farm incomes over time 2
P
S1
How might farmers gain? Need an increase in
demand due to rising income in other sectors.
S2
But if demand does not move out much there may be
no income gain
P1
P2
D2
D1
Q2
Q1
Q
O
33
Decline in farm incomes over time 3
P
If income elasticity of demand is low, the D
curve only moves out a little and there may be no
income gain
S1
S2
P1
P2
D2
D1
Q1
Q2
Q
O
34
Evidence on Income elasticities of demand for
various foodstuffs
Source Sloman from National Food Survey 2000
(National Statistics, 2001), extracted from
Tables 6.1, 6.3, 6.4 and 6.5
Note NEGATIVE values imply these are inferior
goods so demand falls as income rises
35
RECAP on REASONS FOR INTERVENTION in Competitive
market

• Causes of short-term price fluctuations
• fluctuations in demand
• fluctuations in the harvest (supply)
• Causes of declining farm incomes
• increases in supply
• low or negative income elasticity of demand

36
AGRICULTURE AND AGRICULTURAL POLICY

• Types of government intervention in agriculture
• buffer stocks
• subsidies
• high fixed prices
• reducing supply
• structural policies

37
Buffer stocks to stabilise prices
P
Existed in all six original member states
Pg
D
Q1
Q
O
38
Buffer stocks to stabilise prices 1
P
Sa1
Pg
Bought into buffer stock
D
Qs1
Q1
Q
O
39
Buffer stocks to stabilise prices 2
P
Sa2
Pg
Released from buffer stock
D
Qs2
Q1
Q
O
40
Buffer stocks to stabilise prices 3
P
Sa2
But income still fluctuating, now worse
Pg
Extra income in good times
Income in Bad Times
Normal
D
Qs2
Q1
Q
O
41
AGRICULTURE AND AGRICULTURAL POLICY

• Buffer stocks
• buffer stocks to stabilise prices
• buffer stocks to stabilise farm incomes

42
Recall Elasticity Formula
If elasticity equals 1 it means the percentage
increase in quantity is the same as the
percentage fall in prices
So if the percentage price and income change is
the same then income stays the same
43
Buffer stocks to stabilise incomes
P
a
P1
D
Q
O
44
Buffer stocks to stabilise incomes
P
Ped -1
a
P1
Y
D
Q
O
45
Buffer stocks to stabilise incomes 1
P
Sa1
Sa2
a
P1
Y
D
Q2
Q1
Q
O
46
Buffer stocks to stabilise incomes
P
Sa1
Sa2
a
P1
Y
P2
D
Q2
Q1
Q
O
47
Buffer stocks to stabilise incomes
P
Sa1
Sa2
Bought into buffer stock
a
P1
b
P2
Y
c
P2
D
Q2
Q2
Q1
Q
O
48
Buffer stocks to stabilise incomes 2
P
Sa1
Sa3
a
P1
Y
D
Q3
Q1
Q
O
49
Buffer stocks to stabilise incomes
P
Sa1
Sa3
P3
a
P1
Y
D
Q3
Q1
Q
O
50
Buffer stocks to stabilise incomes
P
Sa1
Sa3
Released from buffer stock
P3
e
d
P3
a
P1
Y
D
Q3
Q3
Q1
Q
O
51
AGRICULTURE AND AGRICULTURAL POLICY

• Subsidies
• effects on price and output
• the incidence of a subsidy
• Subsidy is an amount paid for every unit
  produced. It reduces the cost to the farmer of
  supplying the good and moves the supply curve
  down and out.

52
Effect of subsidies on foodstuffs in which the
country is self-sufficient 1
P
S
Pe
D
Qe
Q
O
53
Effect of subsidies on foodstuffs in which the
country is self-sufficient
P
S
S subsidy
Pe
D
Qe
Q
O
54
Effect of subsidies on foodstuffs in which the
country is self-sufficient
P
Note at Pe farmers willing to supply Q2,
S
S subsidy
But then Supply exceeds demand
Pe
P1
so price must fall to P1
D
Q1
Qe
Q2
Q
O
55
Effect of subsidies on foodstuffs in which the
country is self-sufficient 2
P
S
S subsidy
Pg
Pe
Subsidy
P1
D
Q1
Qe
Q
O
56
Effect of subsidies on foodstuffs in which the
country is self-sufficient
P
S
S subsidy
Pg

• Note two parts to the subsidy in this example
• Getting higher price Pg
• But also selling more, S1
• Depends on epD

Pe
Subsidy
P1
D
Q1
Qe
Q
O
57
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
Pw
Sworld
D
Q
O
58
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
Pw
Sworld
D
Qd
QS1
Q
O
Imports
59
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
S subsidy
Pw
Sworld
D
Qd
QS1
Q
O
60
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
S subsidy
Pw
Sworld
D
Qd
QS1
Q
QS2
O
Imports
61
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
S subsidy
Pg
Pw
Sworld
D
Qd
QS1
Q
QS2
O
62
Effect of subsidies on foodstuffs which are
partly imported
P
SEU
S subsidy
Pg
Pw
Sworld
D
Qd
QS1
Q
QS2
O
63
Problems of Oversupply

• EU switches from net food import to exporter in
  most products.

Source Baldwin Wyplosz
64
EU citizen Attitudes to the CAP

• Support among those questioned for direct support
  to farmers was on average 62
• 42 - in the number of respondents who felt that
  the CAP ensured that agricultural produce was
  safe to eat
• Lack of information continues to be a problem
  -'Don't know' answers in the poll ranged from 24
  - 35.

65
EU citizen attitudes to the OBJECTIVES of the CAP
Question New EU 15
Should the EU use its agricultural policy to.. Yes Yes
ensure that agricultural products are healthy and safe? 88 90
favour and improve life in the countryside? 88 77
ensure stable and adequate incomes for farmers? 86 77
promote the respect of the environment? 84 87
help farmers to adapt their production to consumers' expectations? 84 80
protect medium or small sized farms? 83 81
defend farmers' interests in their dealings with intermediaries and distributors ? 81 69
make European agriculture more competitive on world markets? 80 77
encourage the diversification of agricultural products and activities? 80 73
reduce development disparities between regions? 80 72
protect European agricultural products? 78 73
favour methods of organic production? 69 72