US and EU Agricultural Policy: Divergence or Convergence?

Abstract

The 2008 US Farm Bill has many similar features to the 2002 US Farm Bill where key provisions such as the target price and loan rate remain. On the other hand, the European Union is following a path of more decoupled payments, especially given the reforms in 2003 and afterward. However, many of the elements of either farm program may no longer be of significance if high commodity prices remain, many of which are above US target prices. High prices have caused many countries to lower tariff and nontariff barriers. In the context of high prices, the welfare costs of both the US and EU policies have been greatly reduced. However, especially for the European Union, there remains a large income transfer from the treasury to farmers since, under decoupling, farmers are given annual payments at least through 2013. Given the single farm payment scheme of the European Union, farmers are allowed to respond to high prices and, in addition, collect a subsidy from the treasury under the rubric of decoupling. Producers have collected double rents: from the market and the government.

Appendices

Appendix 1: Ethanol and Market Distortions

Appendix 1, Fig. 3.10 depicts the US corn market where S is the supply schedule and D _T is total demand. Given the loan rate under the 2002 Farm Security and Rural Investment (FSRI) Act of 2002, farmers receive a price of p _LR for each bushel of corn produced, yielding a total production of q _s bushels. Given a domestic demand curve D _d and an export demand curve of D _e, the total demand curve is D _T. These demand curves result in a market clearing price of p ₀. With this market clearing price, q _d is consumed domestically and q _e is exported. At this equilibrium, the loan deficiency payments paid to farmers based on the level of production is represented by the area p _LR abp ₀. In addition, farmers receive a countercyclical payment based on their historical level of production (q _k, typically 85% of historical yields) and the target price (p _TP). Graphically, this payment is depicted by the area p _TP cdp _LR. The net cost of the subsidy program from the US perspective is aefgb, of which efgb is a gain to importers (the “slippage” effect).

Fig. 3.10

Ethanol effects: direct and indirect subsidies

In this original equilibrium, we assume that the market clearing price (p ₀) is less than the choke price for the derived demand curve for corn used to produce ethanol (D _ET). Thus, given the total demand curve of D _T + D _ET, no ethanol is produced. Next, we assume that increases in the price of gasoline shift the derived demand for corn used to produce ethanol outward to D _ETʹ. This changes the shape of the total demand curve to D _T + D _ETʹ. This rightward shift in the derived demand for corn from ethanol producers is sufficient to raise the equilibrium price of corn to the loan rate, eliminating the loan deficiency payments to farmers. Thus, there are no direct subsidies based on production, but there are indirect subsidies to corn producers via ethanol tax credits.

Consider further the demand for corn derived from ethanol production. Starting from D _ETʹ (which assumes a fixed oil price), a sufficiently large increase in corn prices (above p ₂) chokes off the demand for corn to produce ethanol. This point represents the corner solution in Appendix 1, Fig. 3.10. However, if one assumes an increase in oil prices for a given price of corn, the derived demand curve for corn shifts to the right. It is important to note that from a theoretical perspective, the demand for corn for ethanol production could be positive without a tax credit, which is discussed later. At least two factors affect ethanol production, namely, the favorable oil to corn price ratio and a tax credit for ethanol production.

In the first case, we assume that producers are not impacted by ethanol demand even though corn prices rise. This is because the loan deficiency payments no longer exist (and the countercyclical payments remain unchanged). Also, an important result is derived from the observation that market clearing prices rise from p ₀ to p _LR, causing both domestic and export demand to fall for those components making up demand D _T. (The demand for corn for ethanol is q _s – q _sʹ.) Domestic consumers now pay a higher price for corn and related products, given demand D _d. Likewise, foreign importers pay a higher price for the corn they import.

The market for corn-given demand D _T + D _ETʹ might look like a “free market” except for the subsidies provided to the ethanol sector. From a distributional standpoint, (1) producers are unaffected from ethanol demand, (2) domestic consumers lose p _LR hgp ₀, (3) foreign importers lose hibg, (4) the government saves loan deficiency payments p _TP cdp _LR, (5) the consumers of ethanol gain jia, and (6) there are government cuts from the indirect subsidy on ethanol production.

To calculate the “net effect” of ethanol, one needs to consider (1) the net welfare gain of aefgb, (2) the consumer gain from the introduction of ethanol of jia, and (3) the cost of the indirect ethanol subsidy. The first two components are positive, while the last one is negative. Ethanol subsidies replace direct subsidies. The price impact due to ethanol affects consumers. The direct effect from ethanol is a rise in the price of corn. Production costs are now covered so direct subsidies are no longer binding.

To further show the interrelationship between ethanol production and government payments to corn farmers, we assume that the derived demand for corn used to produce ethanol shifts farther outward to D _T ^it. This increased derived demand causes the total demand for corn to shift outward to D _T + D _ET ^it, increasing the market equilibrium price to p ₁ and the equilibrium quantity to q _t. Comparing this equilibrium with the equilibrium at the loan rate, producers gain p ₁ lap _LR. However, part of this gain (p ₁ kdp _LR) is offset by reductions in the countercyclical payments to farmers. Thus, the net producer gain is kdal. This shift results in an economic loss to domestic consumers of p ₁ mhp _LR and a loss to foreign consumers of mndh. Completing the model, the economic gain for ethanol producers is the area onl.

If the demand for ethanol shifts even farther to the right than D _ET ^it, all government payments (including countercyclical payments) are eliminated. Thus, there a direct linkage between tax credit to ethanol and farm program payments.

Appendix 2: Coupled Versus Decoupled Subsidies: The Case of Cotton

In the following theoretical discussion, we emphasize that the price impact of US cotton policy critically depends on the choice of which cotton price to use in the analysis, since the positioning of the supply and demand structure is dependent on the particular price. In Appendix 2, Fig. 3.11, S is the US supply curve under a coupled framework, while S' is the US supply curve under a coupled framework that includes water subsidies. Likewise, S ₀ is the supply curve under decoupling and S'₀ is the supply curve under decoupling that includes water subsidies. Domestic demand is D _d, and total demand is D _D. Given a specific domestic supply–price elasticity and production point q*, one can either use the target price P _s to derive the intercept and slope of the subsidized supply curve (that leads to the coupled subsidized supply curve S') or the loan rate P _l to derive the decoupled supply curve S ₀ (and the decoupled subsidized supply curve S'₀). Under the decoupled model, the subsidized supply curve changes from S' to S'₀ by shifting downward and rotating clockwise. Essentially, the initial free-trade equilibrium price P _f, derived from the intersection of the coupled unsubsidized supply curve S and the total demand curve T _D, moves downward along the total demand curve to establish a smaller decoupled free-trade price P _f' and free-trade quantity q. Schmitz et al. (2006) perform sensitivity analyses for the coupled model by rotating the coupled subsidized supply curve S ₀ around point o in Appendix 2, Fig. 3.11, using different elasticities. They also perform sensitivity analyses for the decoupled model by rotating the decoupled subsidized supply curve S'₀ around point z using different elasticities.

Fig. 3.11

A decoupled policy

Appendix 3: US and EU Producer Supports

Fig. 3.12

US producer supports: 1990–2004 (US$ millions). Source: OECD (2005)

Fig. 3.13

EU producer supports: 1990–2004 (ECU million). Source: OECD (2005)

Appendix 4: National Ceilings