Download aggregate demand, aggregate supply, and modern macroeconomics

Chapter 19
POLITICS AND ECONOMICS:
THE CASE OF
AGRICULTURAL MARKETS
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Today’s lecture will:
• Describe the competitive nature of
agricultural markets.
• Discuss the general rule of political
economy in a democracy.
• Explain the good/bad paradox in farming.
• Explain how a price support system works.
• Explain, using supply and demand curves,
•
the distributional consequences of four
alternative methods of price support.
Discuss real-world pressures politicians
face when designing agricultural policy.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-3
The Nature of Agricultural Markets
• Agricultural markets resemble perfectly
competitive markets:
 There are many independent sellers who are



generally price takers.
There are many buyers.
Products are interchangeable.
Prices can, and do, vary considerably.
• Agricultural markets are not perfectly
competitive:
 They are influenced by government programs.
 Farmers use their political clout to increase prices.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-4
The Good/Bad Paradox
in Agricultural
• Agriculture is characterized by the
•
good/bad paradox – the phenomenon of
doing poorly because you are doing well.
The good/bad paradox appears in several
ways.
 In the long-run, increased productivity has
decreased the number of farmers.
 In the short-run, farmers may be financially
worse off when there are good harvests.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-5
The Good/Bad Paradox
P
Initially total income at
P0 and Q0 is the area B.
S0
P0
S1
If the supply increases to S1,
price falls to P1 and quantity
increases to Q1. The increase
in income, C, is smaller than
the lost income A.
A
P1
B C
0
McGraw-Hill/Irwin
Q0 Q1
D
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-6
The Long-Run Decline of
Agriculture
• The U.S. used to be a highly
•
•
agricultural society, but now just over
2% of the labor force works in
agriculture.
Productivity has increased while
income has fallen.
Due to competition most of the
benefits of productivity have gone to
consumers in the form of lower prices.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-7
The Short-Run Cyclical
Problem Facing Farmers
• The short-run demand for most
•
•
agricultural products is inelastic.
Good harvests that increase supply lead
to declines in price that are relatively
greater than the increase in quantity. Total
farm revenue declines.
Agricultural production tends to be highly
unstable because it depends on weather
and luck.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-8
Ways Around the
Good/Bad Paradox
• Farmers organize and lobby the
government to establish programs that
limit supply or keep prices high.
 Price-stabilization programs are designed to
eliminate short-run fluctuations in prices,
while allowing prices to follow their long-run
trend.
 Price-support programs are designed to
maintain prices above market prices.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-9
The General Rule of
Political Economy
• The general rule of political economy states
•
•
that small groups that are significantly
affected by a government policy will lobby
more effectively than large groups that are
equally affected by that same policy.
Farmers are the small group that lobbies
effectively. Consumers are the large group.
The small group tends to lobby more
effectively for the policy that the large group
against it.
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19-10
Four Price-Support Options
• The government has four options to
maintain higher than equilibrium
prices:
 Regulatory force.
 Economic incentives to reduce supply.
 Subsidize the sale of the good.
 Buy up and store, give away, or destroy
the good.
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19-11
A Price Support System
P
S
P1
PE
Government establishes
a price support, P1,
which results in excess
supply, QS-QD.
E
Various government
methods must be used
to maintain P1.
D
0
McGraw-Hill/Irwin
QD QE
QS
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-12
Supporting the Price by
Regulatory Measures
• Government can use regulatory force to
•
prevent anyone from selling or buying at
a lower price.
How many farmers helped or hurt
depends on the elasticity of demand and
supply.
 When demand and supply are inelastic, the
number hurt is relatively small.
 When demand and supply are elastic, the
number hurt is large.
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19-13
The Need for Rationing
• A price floor requires rationing to distribute
•
•
•
the limited demand among the suppliers.
Keeping new farmers from entering the market
restricts supply.
Existing farmers are grandfathered – a law is
passed affecting the new farmers, but
exempting the existing farmers from the law.
Tariffs and quotas keep foreign producers out
of the market.
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19-14
Regulating Price Directly
At a price support of $5,
there is a surplus of Q2Q1 .
S
P
5.00
A
3.50
Farmers’ revenues increase
by A and decrease by B and
C.
D
C
B
D
0
McGraw-Hill/Irwin
Q1 Qe
Q2
Areas C and D are welfare
loss to society.
Q
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19-15
Providing Incentives to
Reduce Supply
At the support price of $5, there
will be a surplus of Q2-Q1.
S
$5.00
B
To reduce the quantity
supplied to Q1, the
government could pay
farmers $2.20 not to grow Q2Q1 wheat. The total cost to
taxpayers is area A.
A
3.50
2.80
Farmers gain more revenue
than they lose.
D
0
McGraw-Hill/Irwin
Q1 Qe
Q2
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-16
Subsidizing the Sale of the Good
P
Suppliers produce Q2 and
sell this quantity for $5 per
bushel to the government.
S
$5.00
B
3.50
The government sells that
quantity for $1.75 to
consumers, whose benefit is
area A.
C
A
1.75
D
0
McGraw-Hill/Irwin
Qe
Suppliers are benefited by
area B. The cost to
taxpayers, however, is
areas A+B+C.
Q2 Q
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19-17
Buying Up and Storing
P
S
$5.00
B
At the support price of $5,
consumers buy Q1 and the
government buys Q2-Q1
from farmers at a cost of A.
3.50
A
D
0
McGraw-Hill/Irwin
Q 1 Qe
Q2
Consumers transfer the
area B to producers when
they pay $5 instead of
$3.50.
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-18
Which Group Prefers Which Option
• Regulation costs the government the least, but
it benefits farmers the least.
 Government is least likely to use this approach
because existing farmers are likely to push for price
supports.
• Economic incentives cost more than
regulation, but less than subsidies or buying
up and storing.
 Farmers benefit because they don’t have to grow a
crop, and they can use their land for other purposes.
McGraw-Hill/Irwin
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19-19
Which Group Prefers Which Option?
• Subsidies to keep prices low benefit both
consumers (who get low prices) and
farmers (who get high prices).
 Taxpayers are harmed because they must
finance the subsidy payments.
• Buying up and storing or destroying the
goods costs taxpayers more than
regulation and incentives, but less than
subsidies.
 The government is left with the surplus to
dispose of.
McGraw-Hill/Irwin
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19-20
Economics, Politics, and
Real-World Policies
• The two prevalent U.S. farm programs
have been:
 The land bank program – the government
supports prices by giving farmers economic
incentives to reduce supply.
 The nonrecourse loan program – the
government “buys” goods in the form of
collateral on defaulting loans.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-21
Factors That Complicate Policy
• Interest groups (farmers, taxpayers,
•
and consumers) examine only the
part of the issue that directly affects
them.
Governments in many of our trading
partners, especially Japan and the
European Union, subsidize farming
in their countries.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-22
Conclusion
• Agriculture is just one example the
•
interrelationship between economics and
politics.
Other examples of how individuals act as
self-interested maximizers are:
 A military draft
 Government support of the arts
 Government support of education
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-23
Summary
• Agricultural markets have many qualities of
purely competitive markets:
 Sellers are price takers.
 There are many buyers.
 Products are interchangeable.
 Prices vary considerably.
• Agricultural markets are not purely competitive
•
because of significant government
intervention.
The good/bad paradox is the result of inelastic
demand. Total revenue decreases when supply
increases.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-24
Summary
• Because farmers are a small, easily
•
identifiable group, and because farm
states get larger representation relative to
population in the Senate, the farm lobby
is very effective in influencing policy.
A price support program works by
government maintaining higher than
equilibrium prices through regulations,
incentives, subsidies, and buying up and
storing or destroying.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-25
Summary
• Regulation costs the government the
•
•
•
least, but benefits farmers the least.
Incentives cost the government and
taxpayers more than regulation, but less
than subsidies or buying up and storing.
Subsidies benefit consumers and
farmers the most, but cost taxpayers the
most.
Buying up and storing gives the
government a surplus to deal with.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-26
Summary
• Two prevalent farm programs in the U.S. are:
 The land bank program – the government gives

farmers economic incentives to reduce supply.
The nonrecourse loan program – government buys
goods in the form of collateral on defaulting loans.
• Agricultural policy is affected by interest
groups (consumers, taxpayers, and farmers)
and international issues (farm policies of our
trading partners).
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
19-27
Review Question 19-1 What are the similarities and differences
between competitive markets and agricultural markets?
Agricultural markets are purely competitive in that there are many
buyers and sellers, sellers are price takers, products are
interchangeable, and prices vary considerably. Agricultural
markets differ from purely competitive markets because of
government intervention, usually in the form of price supports.
Review Question 19-2 Explain the good/bad paradox in agriculture.
The demand for agricultural products is inelastic. In the short run,
a good harvest increases supply, which decreases price. Since
demand is inelastic, the decrease in price results in a decrease in
total revenue, farm income. In the long-run, increases in
productivity increase supply and decrease price. With inelastic
demand, the decrease in price causes a decrease in total revenue.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.