Agricultural Stability and Farm Programs

Concepts, Evidence, And Implications

Daniel A. Sumner, Daniel A. Sumner

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429713378
• Edition: 1
• Topic: Droit
• Subtopic: Droit rural

This book attempts to contribute to a fuller understanding of perennial issues underlying farm problems and agricultural policies in the United States thus contributing to better projections of policy effects, to better forecasts of policy changes, and perhaps to better policy for agriculture.

1
Instability and Risk as Rationales for Farm Programs

Robert J. Meyers and James F. Oehmke

Abstract

It is often argued that fanners face extraordinary instability and risk and that this causes eccoaaic inefficiency in agriculture. One implication is that in principle, farm programs can counteract instability and risk, thus inpxwing economic efficiency. But despite all of the attention given to stabilization and risk reduction policies for agriculture, there remains a great deal of confusion over the mechanisms through which instability and risk can lead to economic inefficiency.

The objective of this paper is to outline systematically the ways in which instability and risk can lead to inefficient resource use in agriculture, and hence hew stabilization and risk reduction policies may improve economic efficiency. We recognize explicitly that for instability and risk to be sources of economic inefficiency in agriculture, they must lead to sane farm of market failure. In the paper, we examine three sources of market failure: disequilibrium, incomplete forward markets, and incomplete contingency markets. We claim that these are the only sources of market failure directly associated with instability and risk.

The conclusion is that government Intervention In agriculture can, In principle, correct for these market failures but that In practice the potential efficiency gains may be small and are very difficult to realize.

Introduction

It is often argued that farmers face extraordinary. instability and risk and that this causes economic inefficiency in agriculture (Schultz, 1945; Johnson, 1947; Hazell and Scandizzo, 1975; Anderson, Dillon and Hardaker, 1977). In principle, farm programs can counteract instability and risk, thus improving economic efficiency. Indeed, this argument is often used to rationalize the existence of farm programs. But despite all of the attention given to stabilization and risk reduction policies for agriculture, there remains a great deal of confusion over how instability and risk can lead to economic inefficiency.

The objective of this paper is to outline systematically the ways in which instability and risk can lead to inefficient resource use in agriculture, and hence how stabilization and risk reduction policies may improve economic efficiency. We recognize explicitly that for instability and risk to be sources of economic inefficiency, they must lead to some form of market failure. In the paper, we examine three ways in which instability and risk can lead to market failure: disequilibrium, incomplete forward markets, and incomplete contingency markets. We claim these are the only sources of market failure directly associated with instability and risk.¹ The conclusion of the paper is that farm programs can, in principle, correct for these market failures but that in practice the potential efficiency gains may be small and are very difficult to realize.

The next three sections contain an overview of the three market failures mentioned above. This is followed by a discussion of whether governments have incentives to correct these market failures when they are found to exist. The paper then concludes with comments on key issues concerning the role of stabilization and risk reduction policies in agriculture.

Disequilibrium Rationales for Farm Programs

Disequilibrium occurs when prices fail to adjust to differences between quantity demanded and quantity supplied. Thus, markets in disequilibrium are quantity rationed and fail to clear. Furthermore, since resources and commodities are allocated by a rationing mechanism rather than a flexible price system, disequilibrium distorts the ideal market system and leads to economic inefficiency. Thus disequilibrium may require corrective action from an efficiency-minded government.

Instability in the agricultural sector has been linked directly to the existence of disequilibrium. For example, Schultz (1945) argued that the migration of resources between agriculture and the rest of the economy is inhibited by "rigidities" (disequilibria) in factor markets. In particular he argued that the labor market in the nonagricultural sector is quantity rationed. As a result, any shock or disturbance to the economy cannot be accommodated by a migration of labor from agriculture to industry because of implicit quantity rationing at the rigid nonagricultural wage. Instead, the adjustment has to be borne by agricultural prices and factor returns. Thus, prices are more volatile than they need to be, indicating disequilibria in factor markets.

In modern form, the disequilibrium rationale for government regulation of agriculture is called the fixed-price flex-price model. The idea is that agricultural markets adjust to shocks almost instantaneously but that there are disequilibria in nonagricultural markets which cause nonagricultural prices to be rigid and exhibit "price stickness"(Bosworth and Lawrence, 1982; Frankel, 1984). Markets with sticky prices are quantity rationed and cannot adjust rapidly to changing economic conditions, thus placing the burden of adjustment on the agricultural markets and their flexible prices. In this case, agricultural markets are called auction or flex-price markets, whereas nonagricultural markets are called customer or fixed-price markets (Okun, 1975).

The existence of both flex-price and fixed-price markets leads to a phenomenon called "overshooting," in which adjustment of agricultural prices to economic shocks is so great that these prices fluctuate beyond their equilibrium levels (Dornbusch, 1976; Rausser et al., 1986). The reason for overshooting is the inability of fixed-price markets to bear any of the adjustment. Thus disequilibrium leads to instability in agriculture, and government intervention may improve efficiency (Rausser, 1985; Frankel, 1986).

Disequilibrium rationales for government regulation of agriculture make the crucial assumption that price instability results from disequilibrium behavior. As a result, standard welfare propositions do not apply and one is left free to argue that any regulation designed to stabilize agriculture close to its "equilibrium path" is clearly justified. Proponents of intervention are thus released from the burden of justifying intervention on the basis of a traditional form of market failure, such as an externality or a public good. Instability is defined to be market failure, stability becomes an end desired for its own sake, and stabilization begins to take on a life of its own as a separate policy objective. This is exactly what has happened with discussions on stabilization of U.S. farm programs.

Disequilibrium rationales for government intervention have been criticized strongly on theoretical grounds (Sargent and Wallace, 1976; R. Lucas, 1977, 1979). These authors argue that economic models ought not to violate the principle that markets clear because the disequilibrium assumption avoids the fundamental question of why people would choose not to engage in mutually advantageous trade. Put another way, disequilibrium models do not have adequate microeconomic foundations because the cause of the disequilibrium remains unexplained.

Policy analysis based on models that lack adequate microeconomic foundations can lead to serious errors and give an incorrect ranking of policy alternatives (R. Lucas, 1976). Evaluating policies usually involves the difficult task of determining how people will act in situations that have never actually been observed. To do this successfully, one must know not only how past decisions were made but also how decisions will change as a result of hypothetical changes in policy. But when markets fail to clear, the change in behavior will depend not only on the change in policy but also on whatever quantity rationing is going on. Thus when disequilibrium is an unexplained postulate rather than the outcome of an explicit behavioral model, behavioral responses to policy changes cannot be accounted for and the task of policy analysis becomes difficult or even impossible.

The response to these criticisms has been a growing literature on the microfoundations of disequilibrium models. This literature generally cites three reasons why manufactured or consumer goods prices are sticky: noncompetitive market structures, high costs of changing prices, and the prevalence of long-term, fixed-nominal-wage labor contracts in the manufacturing sector.

Price rigidities result from noncompetitive market structures when price signals are used to maintain noncooperative collusive agreements (Stiglitz, 1979). For example, a collusive agreement may take the form of all firms setting a single price. If any firm were to charge a different price, then all firms would behave competitively and lose their share of monopoly profits (Friedman, 1986). Thus each firm has an incentive to maintain its price, even in the face of demand shocks, and some form of quantity rationing will be imposed. Empirical support for this theory is given by carlton (1986), who found significant price rigidity in some industries and a strong correlation between industry concentration and rigidity.

The second type of microfoundation for sticky prices is that price changes are costly and will be made only when the benefits of changing the price exceed the costs (Mussa, 1981; Taylor, 1979, 1980; Sheshinski and Weiss, 1977). When costs are high it is less likely that prices will respond to a shock to the economy, even if this shock means that there are some benefits to changing a price. This lack of response is exactly what characterizes a sticky or fixed-price market.

The costs of changing prices can include a fixed or "menu" cost, often associated with printing new price lists and menus or retagging consumer items, and a variable cost that is sometimes used to represent the loss of customers due to price increases (Rotemberg, 1982). High menu costs appear to be more important in consumer markets than in agricultural markets because of different trading procedures. Contracts for raw agricultural products are negotiated orally on exchanges such as the Chicago Board of Trade, and changing the price entails little more than calling out the desired price. Changing the prices of consumer goods is more complicated since the prices are usually marked on the items, sometimes indelibly on the container, and packages usually contain relatively small quantities so that a large amount of retagging is required. The implication is that menu costs will reduce price flexibility more in consumer markets than in agricultural markets, resulting in the usual fixed-price flex-price classification. Moreover, it is argued that relatively small menu costs can give rise to price fluctuations of observed magnitudes and to other changes in behavior that cause welfare effects (Akerlof and Yellen, 1985; Parkin, 1986).

The third microeconomic explanation of fixed prices is that the manufacturing sector depends on long-term, fixed-nominal -wage labor contracts. This factor market fixity can lead to rigid output prices in the manufacturing sector and price overshooting in the flex-price sector (Taylor, 1980; D, Lucas, 1986). Most of this literature proceeds from the empirical observation that long-term, fixed-nominal-wage contracts do exist (D. Lucas, 1986; Rotemberg, 1982; Gordon, 1981; Gray, 1976). However, models assuming the existence of fixed-wage contracts do not in themselves provide a microfoundation for sticky prices because they do not explain why agents would agree to a fixed-wage contract (Azariadis and Stiglitz, 1983). Possible microfoundations for fixed-wage contracts have been union intervention (Chen, 1987), asymmetric information between the firm and worker (Gray, 1976), and implicit contracting with asymmetric information (Rosen, 1985).

Despite the significant advances in understanding of the microeconomic foundations of disequilibrium, there are still many problems to be overcome before an adequate theoretical explanation can be claimed. For example, the asymmetric information microfoundations for sticky nominal wages usually assume that each individual's information set is exogenously given (e.g., Townsend, 1982), whereas a satisfactory explanation must realize that each agent endogenously determines his information set based on the expected costs and benefits of acquiring that information. Moreover, once an adequate microeconomic foundation for sticky prices has been found, the implication that price fixity implies market failure may no longer hold. For example, Rosen (1985) finds that the implicit contract labor models "allocate resources through a subtle and 'flexible' nonlinear pricing mechanism, which sometimes gives the outward appearance of rigidities in observed real wages and prices. But these observed rigidities signal little about market failure" (p. 1145).

On empirical grounds, there are arguments both for and against disequilibrium rationales for farm programs. Some argue that there is no sound evidence that disequilibrium is a persistent feature of agricultural factor markets. They point to the massive intersectoral resource adjustments that have occurred--with labor moving out of agriculture and capital moving in--as evidence that disequilibrium is at most a short-run phenomenon (Gardner, 1981). Others argue that persistently low factor returns in agriculture indicate that disequilibrium is pervasive (Brandow, 1977). Additional evidence often cited in favor of disequilibrium rationales for farm programs is the relative variability of agricultural prices as compared to most nonagricultural prices (Andrews and Rausser, 1986) and the relatively rapid response of agricultural prices to economic shocks such as monetary disturbances (Frankel, 1986).

Empirical examinations of labor contracts in manufacturing sectors are consistent with the rigid-wage rationale for the fixed-price flex-price model (Poterba, Rotemberg and Summers, 1986; Rotemberg, 1982; Taylor, 1980; Gray, 1976). However, there is little evidence quantifying the influence of these fixities on commodity prices in either the manufacturing sector or in the agricul...