WELFARE ECONOMICS & COST/BENEFIT ANALYSIS:

Illustrated through an economic analysis of farm support policies

The Point of this Section of Notes?

UK Farm Policy History I: (see here for a longer but still abreviated version of UK farm policy history)

The UK supported the farm sector between 1947 and 1973 with Deficiency Payments - annual payments from the Government Exchequer to farmers, making up the difference between actual market prices and guaranteed prices on the total quantities sold by farmers. Guaranteed prices were set annually by the government in consultation with the NFU (in the Annual Price Review) and reflected judgements about the costs of production and fair prices for farmers.

This near universal tendency for developed countries to support and protect their agricultural sectors arises because of the inevitable consequence of economic development - that fewer people can earn a full time living from agriculture - coupled with the unavoidable pressures of democratic control, which legitimise support for the deserving less-well off (the small and poorer farmers) - since agricultural adjustment tends to be slow and painful - with those with few or no alternatives being stuck in farming rather than following their more able or more mbile peers into other occupations.

In 1973, the UK joined the European Community and the Common Agricultural Policy. The CAP used a different system to support farmers - it effectively taxed imports of farm products from outside the EU (and also subsidised exports from the EU) which raises the internal domestic EU price above the ruling world market price (see Buckwell, Ch. 7, Ritson and Harvey (eds), 1997). Thus, on entry to the CAP, in 1973, UK market prices were increased and the deficiency payment system was scraped.

The debate prior to UK entry about whether or not to join emphasised the effects of EC membership on food prices (they would go up for the consumer) and on the benefits to farmers (where it was anticipated that EC supported prices would be higher than the guaranteed prices).

Analysis:

How can one try and organise this debate so as to get an idea of the potential gains and losses from entry? Answer: by using some very straightforward economics. Consider a simple and stylised diagram of (as a major part of the agri-food system) the UK cereals market. Under the Deficiency Payment system, this market can be represented as follows: (Figure 1).

If these curves are reasonable representations of the real world, then the consequence of the DP policy is to increase the total returns to cereal farmers over and above what they would get without the policy Reference: Ritson & Harvey (ed), 1997, The Common Agricultural Policy, 2nd. edn. CAB International, Chapters 7, 8, 17 & 18 .

Suppose that the Supply and Demand curves (showing the response of Producers and Consumers respectively to cereal price changes, ceteris paribus - nothing else changing) are as shown by S and D. Here, the guaranteed price is Gp/tonne. The world price, at which consumers can buy foodstuffs, is Wpa/tonne. The supply under the policy is Sg m. tonnes, encouraged by the support price of Gp per tonne, while the quantity consumed is Dw, at price Wpa per tonne. The EUXd curve is the EU's excess demand curve, shifted by the effect of the subsidy to EUXd(g). The RoWXs show the excess demand curve for the rest of the world, so Wp is the equilibrium world price in the absence of any policy.

Figure 1 Economics of the Deficiency Payment System (large country):

- Importer Case. [UK 1947 - 1973] [DP is subsidy of Gp-Wp on every tonne (Sg tonnes)]

Why do Producers gain R?
Total revenues without the policy are £(Wp x Sw).  With the policy, total revenues are £(Gp x Sg), but it costs more to produce Sg than it does to produce Sw tonnes. How much more?
As supplies are increased from Sw to Sg, so the cost of producing each extra tonne rises from Wp to Gp - this is what the supply curve tells us.  So, the total cost of producing the extra tonnes between Sw and Sg are represented by areas F plus c.
Hence, the additional margins earned by the producers (at least according to this logic (but see below) as a consequence of the policy is given by the difference between the total revenue with the policy and total revenue without the policy, minus the extra costs of producing the extra quantity - which is area R. So R is the gain in Producers Surplus as a consequence of the policy
Why do consumers gain Tx1+Tx2+G? Because they pay a lower price and also consume more than without the policy - the value of the additional quantity consumed is the small triangle between the two price lines (Wp and Wpa) and below the demand curve, since the demand curve shows the willingness to pay.
Taxpayers costs of this subsidy is Tx1+Tx2+c+R, since this is the cost of the deficiency payment making good the difference between the actual market price (Wpa) and the guaranteed price (Gp) times the quantity produced (Sg).
Overall Society Gain or Loss? the sum of the gains and losses to each group (consumers, producers and taxpayers) = G-c
Notice that, so long as G is greater than c, the EU (large country) gains more than it loses from this policy - but the greater the subsidy, the greater is c, but the smaller G will tend to become, as imports are gradually eliminated (as Gp is increased) - so there is an idea of an optimal subsidy, which maximises the net social gain.
But this possible gain to the EU is at the expense of the rest of the world - which loses G+Lr, by the same logic. - the subsidy in the EU generates a gain of G which is offset by the equivalent loss of G to the rest of the world, which also loses because its export prices are depressed.
In effect, this welfare loss or gain is a measure of the amount by which National Income is lower than it otherwise would be because of the policy, ignoring (because this is a partial analysis) the second round, indirect or multiplier effects of the policy.

SO HOW DID UK ENTRY INTO THE EC CHANGE THIS PICTURE?

Old CAP (Pre 1992)


A TAX (known as a VARIABLE IMPORT LEVY) is charged on all imports of cereals into the community to increase the price of imports from Wp - the world price, at which importers to the EC are willing to sell the product to EC buyers - to Tp - the Threshold Price set by the Council of Ministers for the EC market.

So long as the EC remains an importer, buyers cannot satisfy all their demand from the local market and are obliged to import. Since we assume that the product is homogeneous, that is - there is no distinction between imports and local product - the domestic market price will be set by the available imports at price Tp. Thus, no one in their right mind would sell local domestic cereals for less than Tp - there are no available additional supplies from abroad at less than this price

[Note: The tax is called a variable levy because the actual amount of the tax per tonne varies as world prices change to keep the Threshold price constant.]

Market Prices in the EC would be Tp, NOT Wp - the consumer would pay more (and thus consume less), but the Taxpayer would now GAIN the proceeds of the Import Tax (levy) rather than have to pay out for DPs.

FOR ANALYTICAL PURPOSES, SUPPOSE THAT Tp IS SET AT THE SAME LEVEL AS Gp (it wasnt in practice - Tp was expected to be higher than Gp). We can see the effects of the EC Import Levy policy on our market diagram - Figure 2.

Figure 2 Economics of the CAP (Old Style) Levy Effects:

With Tp = Gp in Fig.1, PRODUCER effects are as before (Gain [R])
CONSUMERS Lose [R+c+V+m], because:
a) they pay [R+c+V] more for quantity Dt than without the policy, hence losing [R+c+V];
b) they also lose quantity Dw - Dt, which they now are not willing to purchase because of the higher price. This quantity (Dw - Dt) has a total value to consumers of [F'+m] - remember that the demand curve shows willingness to payfor the product - willing to pay Wp for quantity Dw, but a higher price of Tp for quantity Dt.
However, consumers save F* on their spending compared with no policy, which they can now spend on other goods.
So they lose a net of m on the reduction in consumption.
So overall consumers loss is = [R+c+V+m] - called the Consumers' Surplus Loss of the policy
TAXPAYERS now Gain [V1 + V2] instead of losing £[R+c]
Overall, EU Society (farmers, consumers and taxpayers) Lose/Gain: {[c+m] - V2} which raises the possibility of an optimal tariff - where the gain of V2 offsets the loss of [c+m]
The rest of the world loses Lr + V2 (again the gain of V2 to the EU is at the direct expense of the rest of the world).
The overall loss generated by the import tariff is greater (other things being equal) than the equivalent producer subsidy.

First Question;  Given some reasonable estimates of the shapes and slopes (elasticities) of supply and demand, and knowledge of the relative positions (sizes) of Tp, Wp, (EU and world prices), and of Sg and Dt (the currently observed quantities produced and consumed) - How big is this net welfare loss and the component transfers between producers, consumers and taxpayers likely to be?
Second Question: Farmers gain R under both policy alternatives. But what is this gain in practice?
It is, in essence, the increase in the Gross Margin of the industry, defined as the increase in Revenues minus the associated increase in Costs of Production. This can be taken here as equivalent to the increase in the Gross Product of the industry - its contribution to the Economys national income. This increase in gross margin or gross product accrues to the owners of the fixed factors in the industry - land, labour, capital and management. - See Ritson & Harvey, 1997, Chapters 7 & 8, especially, for this.

Third Question: So what happens in the industry when the policy generates or increases R?

So: What has been the History of EU Farm Support?  This can be measured by the Producers Subsidy Equivalent (PSE), as estimated annually by the OECD.

Figure 3: The EU PSE (as % of total farm receipts): ( as estimated by the OECD):

Note: The PSE is actually a measure of areas R + c in each of the diagrams above, here estimated for 16 commodities over the whole of the European Union, expressed as a % of total farm receipts (Tp*Sg). It is, essentially, an estimate of the difference between internal domestic EU prices and the relevant world price (called the reference price by the OECD) times the total quantities produced in the EU. In addition, other government spending in support of farming (such as under the Guidance part of the European Agricultural Guarantee and Guidance Fund) is also included in the support measure.
The total support figure is the expressed as a percentage of the total revenues of the industry (domestic price times quantity produced plus any other direct payments from the government). The variations in the percentage figure shown here largely reflect variations in world prices, either in dollar terms and/or through variations in exchange rates between the EU and the rest of the world.
Evidence the paper on the Future of Agriculture and Rural Development provides (in the opening section of an otherwise rather long paper) the evidence of the recent history of UK farm incomes in real terms (eliminating the effects of inflation). It is clear from this picture that farm incomes, as the residual of the industrys Gross Product after actual capital, land and labour costs have been met, have not been rising in real terms for the sector as a whole, in spite of the rising level of support under the CAP (at least until 1994).
 
 

History II: CAP & UK: 1973 - 1992 

Figure 4: CAP in the 80s as an Exporter

EU taxpayers are now losing as the EU is an exporter, since the taxpayer is required to subsidise each unit of exports (Sg - Dg) by the difference between Tp and Wp, so the total subsidy bill is now [a + S + b + Sx], where the effect of the EU's exports in depressing world price is now to add to the tax cost of the export subsidy, which increases the domestic cost of the policy to the EU.
This puts internal pressure on the CAP for reform -> stabilisers, prudent prices, maximum guaranteed quantities, voluntary set-asides etc. and, eventually, quotas in the dairy sector (in 1984) to restrict supplies to be less than Sg, and MacSharry reforms in cereals, 1992 (See Ritson & Harvey, 1997.
The cost ot the rest of the world is exactly the same as this additional tax cost to the EU

Unlimited support for the farm sector increases the transfers from the consumer and taxpayer from [R + c] in the previous figures to [G + a + S + Sx] here: PSEs increase as domestic (EU) output expands and S shift right. - with the largest farmers gaining most (at least in the short term) so income distributions between the rich and poor within farming get worse, increasing pressure on the CAP from the more numerous poor and small farmers.

The Rest of the World, especially the major exporting countries (US, Canada, Australia, NZ, Argentina, Brazil etc.) find their markets now challenged and polluted by subsidised EU exports, and can be expected to complain and seek redress.

EU finds that the more it exports with subsidies, the lower world prices are - excess supplies on the world market are bound to drive world prices downwards, so export subsidy per unit (and in total) tend to increase, exacerbating the taxpayer pressure on the policy.

Meanwhile, the pressures on farm incomes are continuing, leading to a rapid decline in the number of people engaged in agriculture, so political force of farm sector declines (though slowly because people have long and fond memories of their farm ancestry)

Pressures lead to GATT Uruguay Round, 1986 start, and 1992 CAP MacSharry reforms

And to Agenda 2000. - response of the EU to the challenge of Central and Eastern European (CEE Countries) Enlargment

And to the Doha Round of International negotiations on farm policy under the WTO.

Further Questions -

For some outline answers to these questions, see here.

For further comment and analysis of farm policy, see, for example, the DEFRA and European Commission (DGVI) web sites.
See, also, the full report of an 'expert group', chaired by Prof. Allan Buckwell, Wye College (author of chapter 6 of the Ritson & Harvey text) on the future of Common Agricultural and Rural Policy
You should also be aware of the UK House of Commons Select Committee Report on Agenda 2000 and agriculture, 1998
See, also, the current statement (Dec, 1999) of the MAFF on A New Direction for (British) Agriculture - pdf file, 16 pages - and look at the discussion documents associated with this paper on the  DEFRA website  Also, if interested in the UK especially, see the Curry Commission report - Jan. 2002. (on DEFRA Web Site) 152 pages of closely reasoned argument as to why production support is both obsolete and counter-productive, with detailed suggestions as to what to put in its place.  One major omission from this document is the lack of any clear distinction between:

Otherwise, the report appears mostly sensible from an economist's point of view, and reasonably sensitive to the present condition of the industry - though not sufficiently to get the NFU's support.
For a one page outline of my arguments about future support for farming in the EU see Viewpoint:  How necessary is government support and regulation for Agriculture?, EuroChoices, premier edition, Spring, 2001. p 59. (joint publication of the AES and EAAE)
You may also be interested in some thoughts on the difficulties of reforming farm policies (a paper submitted to the IAAE Conference, 2003), which discusses these issues.
 
See here for an outline discussion of the conditions necessary for policy reform (from an OECD workshop on environmentally harmful subsidies, November, 2003.)

See my research website for more recent commentary and analysis of the current CAP reform opportunities, especially: An agenda for Review - forthcoming EuroChoices, Spring, 2006.  See, also, a memo from CRE (Prof Neil Ward about the rural development (Pillar 2) part of CAP policy in repsonse to the UK (Defra and Treasury) "Vision" for the CAP.
 

Major Assumptions necessary for this Welfare Analysis (Cost/Benefit Analysis)

Most of these are rehearsed in Chapter 8 of The Common Agricultural Policy and the World Economy, Ritson and Harvey (eds.), CABI, Wallingford, 1997.
The critical assumption is that money (£ notes) can be used to accurately measure welfare gains and losses. The necessary assumption is that £1 means the same for everyone concerned (in technical terms, that the marginal utility of money is both constant and equal to 1 for everyone concerned). This is  clearly an heroic asumption - and presumes that the distribution of gains and losses amongst individuals and groups makes no difference to policy choice.  It stems from the notion that the efficient allocation of scarce resources amongst uses and ends can be analysed independently of the distribution of these effects.  In practice, this is seldom, if ever, the case.

However, some estimates of the distribution of these gains and losses amongst groups can be made, and the values of these gains and losses could be adjusted according to some (whose?) social judgements about how deserving or not each group is.


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