The Concise Encyclopedia of Economics

Agricultural Price Supports

by Robert L. Thompson
About the Author
Most governments around the world intervene actively in the operation of their agricultural markets. The ways they intervene and the reasons they do so depend in large part on the wealth of the country. Governments in poor Third World countries routinely impose price controls to keep food prices artificially low. They do so to gain favor with their more politically powerful urban residents. Though numerous (and partly because they are numerous), peasant farmers do not organize politically and therefore have much less political power than their urban brethren. The irony of this situation is that by artificially depressing the price of food, Third World governments reduce incentives for farmers to produce and reduce the availability of food from indigenous sources.

This has been particularly prevalent in Africa, the one continent to experience consistently declining per capita food production in the postcolonial period. In many African nations, state marketing boards are granted a legal monopoly to buy agricultural products from farmers and to resell them to domestic consumers and in export markets. Such boards often pay farmers only a third to half of the domestic consumer price or the export price. The result, according to the World Bank, is that after growing 0.2 percent per year in the sixties, per capita food production in sub-Saharan Africa fell at the rate of 0.9 percent per year from 1970 into the early eighties.

In highly developed countries, on the other hand, the opposite occurs. As development proceeds, the percentage of a nation's population employed in agriculture declines. The shrinking number of farmers makes organizing in interest groups easier. Furthermore, political redistricting often lags behind the shift in population to the cities. As a result, rural districts often have more legislative representatives and enjoy greater political power than their numbers would suggest. Farmers use this power to seek higher and more stable farm prices via legislation or fiat.

But good political organization is not the only reason that farmers succeed in getting governments to raise their prices. A second reason is that farmers are often viewed as disadvantaged. Rural communities lack many of the amenities that cities have. And because labor productivity is generally lower in agriculture than in manufacturing, wage rates are lower. Also, technological change tends to expand agricultural production faster than consumption, reducing the price of farm products. In 1870, for example, the price of wheat was over eleven dollars per bushel in 1991 dollars. Today, it is only about four dollars per bushel, a drop of over 60 percent. Although consumers gain by paying lower prices, the incomes of farmers drop. As labor leaves agriculture in search of higher income in the cities, the reduced supply of farmers causes the remaining farmers' incomes to rise back to their previous level. This can take years, however.

A third reason governments intervene to support farm prices is that they often are volatile. Weather conditions, over which farmers have no control, are an important determinant of how much a farmer harvests in a given year. The resulting variability of production in the face of relatively stable demand causes farm prices, and farmers' incomes, to vary from year to year. This may cause economic hardship for farm families in a bad year. It may also cause farmers to go bankrupt because modern farming requires large investments in specialized facilities and equipment.

Forms of Price Support

It is easiest to support the price of an agricultural product if a country's farmers do not produce enough of it to meet domestic consumption. The rest is made up through imports. In these cases the country simply imposes an import duty or quota until the domestic price rises to the desired level. Growers receive the higher price, and consumers pay the higher price for both imports and for domestic production. For example, in the mideighties, when the world market price of sugar was four cents per pound, United States import quotas were so limiting that the domestic wholesale price exceeded twenty cents per pound.

When a country grows more of a product than it consumes, supporting the price is more complex and requires a substantial bureaucracy. Legislating a minimum legal price below which a good cannot be sold rarely works. So instead of legislating minimum prices, governments sometimes try to raise prices artificially by limiting production. Each farmer may be issued a quota that stipulates how much he can sell in a given year. This is done with peanuts in the United States and milk in Canada. Limiting supply can raise market prices as long as government inspectors monitor the market to ensure that no production beyond the quota is sold for a lower price. Limiting production effectively cartelizes the industry, and the government enforces the cartel.

While this policy raises prices, the only people who benefit are the individual farmers who receive the quotas when they are initially allocated. Because of their scarcity, the quotas immediately take on value. All future entrants must buy a quota to gain the right to sell the product. That raises the investment required to become a farmer and the cost of production. Once the original quotas are sold to new farmers, those farmers become a strong lobbying force against ever giving up quotas.

More common than issuing quotas is the practice of requiring (or paying) farmers to take land out of production. This "set-aside" approach rarely is very effective at supporting agricultural prices. Farmers are not stupid; they set aside their least productive land first. Furthermore, a policy that creates artificial scarcity of land induces farmers to intensify their production practices on each acre that remains in production, raising its yield. So unless very large reductions in acreage are required, set-asides alone rarely reduce production very much. Moreover, intensifying production often requires heavier doses of fertilizer and agricultural chemicals, with potentially adverse environmental consequences. For example, farmers in the European Economic Community (EC), where support prices for grain are higher than those in the United States, use more than twice as much fertilizer per acre than U.S. farmers. As a result a number of northern European countries are encountering elevated levels of fertilizer nutrients in their groundwater.

The most common U.S. approach to supporting the price of an exportable agricultural product is to create a government agency to buy any quantity of a product offered by the country's farmers at the guaranteed "support price."

That keeps market prices at or near the support price. Within the United States Department of Agriculture, this agency is called the Commodity Credit Corporation (CCC). Support prices must be accompanied by import quotas. Otherwise, foreign producers would sell their products in the U.S. market as long as the U.S. price exceeded the price they could get elsewhere. If that happened, the U.S. government would wind up guaranteeing the U.S. price to farmers around the world. A U.S. example is dairy products, which the CCC buys to support the farm price of milk. Quotas limit imports of dairy products to less than 3 percent of consumption. The CCC disposes of the commodities it buys in ways that will not displace market demand and depress the domestic market price. For example, dairy products are often given away to low-income people, in the school lunch program, and as foreign aid.

A variant of this policy is designed to stabilize market prices. The CCC buys grain at the support price, stores it, and releases it back into the market if the market price rises to a prescribed trigger level of, say, 140 percent of the support price. In this manner the policy protects growers against the risk of low prices but also protects consumers against unusually high prices. This type of government program can provide some protection against wide swings in prices if the acquisition (support) price is set at about 75 percent of a five-year moving average of market prices (leaving the highest number and the lowest number out of the calculation). The markup between acquisition and release price should cover the cost of operating the buffer stock program.

Farm organizations, however, often lobby to raise the acquisition and release prices, so that "stabilization policy" becomes price support policy. When this happens, government inventories tend to rise without limit until the stabilization agency exhausts its budget for buying the product. This is exactly what happened when the Federal Farm Board, the predecessor of the CCC, tried to support the U.S. prices of wheat and cotton in 1929. At that point the agency has to subsidize the export of the inventories, with the taxpayers picking up the loss on the operation.

The United States currently uses a hybrid approach to price supports that also involves loans. At harvest the CCC gives grain farmers nine-month loans equal to their production times the support price. The support price is called the "loan rate." The CCC accepts the grain as collateral for the loan. If, during the term of the loan, the market price rises above the support price, farmers repay the loans with interest and sell the grain in the market. If the market price remains at or below the loan rate, farmers forfeit the grain to the CCC, keep the money, and have no further obligation. Such loans are called nonrecourse loans, meaning that the lender has no claim on the borrower beyond the collateral (in this case the crop).

Price Supports Cause Overproduction

By supporting prices above the market-clearing level, governments encourage farmers to expand production. To produce more, farmers apply more inputs per acre. They also compete against one another for the finite amount of farmland, bidding up its price. In this way the value of the price supports is capitalized (incorporated) into land prices. Thus, it is the owners of farmland, and not farmers per se, who are the principal beneficiaries of agricultural price supports. (See Ricardo.)

Price supports cause larger production and smaller consumption (since consumers will buy less of any good as its price rises), resulting in overproduction at the support price. The only way for the price support agency to get rid of its inventories is to use export subsidies to make them cheap enough that foreigners will buy them. The EC uses this approach for grains. From the midseventies to early eighties, internal EC grain prices were 150 to 200 percent of the prices at which other countries were willing to export their grain. Subsidies to agriculture account for over two-thirds of the total EC budget.

The United States takes a different approach for grains. With minor exceptions the United States does not make its domestic consumers pay more for grain than foreign buyers pay. Instead, the U.S. government combines price supports with income supports that are known as deficiency payments. In normal years the market price is above the support price, and the CCC accumulates few inventories. A so-called target price is then set at a somewhat higher level than the support price, usually through political bargaining between farm organizations and the federal government. The government then pays to producers, as an income supplement, the difference between the target price and the higher of the support price or the market price. To receive this income transfer, a farmer must set aside a prescribed fraction of his historical acreage planted in that crop, as documented in the county office of USDA's Agricultural Stabilization and Conservation Administration. The payment is made on only a finite volume of production equaling a prescribed fraction of the acreage planted each year times a fixed fraction of the historical yield per acre.

The deficiency payment was once paid on a farmer's full production. This encouraged farmers to intensify production and to plow up more land (often highly erodible) to qualify for larger government deficiency payments. As the program has evolved, the payments have been decoupled from production decisions. A farmer cannot gain larger deficiency payments from either planting more land or intensifying input use on the acres in production. In this sense the deficiency payments have moved far in the direction of becoming lump-sum income transfers that are not affected by current or future production decisions. But since the deficiency payment is made on a fraction of the historical acreage planted on a given farm, the land on farms with larger historical bases is worth more than land on farms with smaller bases. Once again, the value of the government payments is capitalized into the price of land.

Many people believe that the low income of farm families justifies price supports. The benefits of most farm programs, however, are distributed to farmers in proportion to the volume they produce or to the number of acres they own. In 1989, for example, 71 percent of the farmers in the United States each sold less than $40,000 worth of products. They received only 16 percent of government price-support payments. In contrast, 15 percent of all U.S. farmers each sold over $100,000 worth of products, and their average net cash income was $68,850. That 15 percent of the farm population received 62 percent of all government payments. One can conclude that farm program payments show little correlation with need.

Agricultural price supports often stimulate larger production, tax consumers, and impede international trade. They often transfer income from lower-income consumers to wealthier owners of farmland. Price supports do little to help farmers with below-average incomes because benefits are distributed in proportion to sales. A more efficient and equitable way to help low-income farmers would be to transfer income to them directly.

Although few commercial farmers have low incomes, their incomes are highly variable because variability in weather and in exports create instability in supply and demand. Nevertheless, there are ways to reduce this risk other than through government price supports. One is insurance. Farmers can purchase government-subsidized crop insurance against natural disasters. Farmers can also buy a form of price insurance in the futures markets. Commodity-futures options are really a form of price insurance for which a farmer pays a premium (the price of the option). Before planting his crop, a farmer can purchase a guarantee of a minimum price, without incurring the obligation to sell at that price should the market price be higher at harvest time. More sophisticated commercial farmers employ the full range of price insurance instruments available to reduce their market risk. But these instruments are used less by farmers than they would be if the government did not provide a subsidized form of price insurance through its price-support programs.

About the Author

Robert L. Thompson is the director of world development at the World Bank in Washington, D.C. He was previously dean of agriculture at Purdue University and the assistant secretary for economics with the U.S. Department of Agriculture.

Further Reading

Council of Economic Advisers. "Food and Agriculture." In Economic Report of the President 1984, 112-44, 1984.

Economic Research Service. The 1990 Farm Act and the 1990 Budget Reconciliation Act. USDA/ERS misc. pub. no. 1489. 1990.

Johnson, D. Gale. World Agriculture in Disarray, 2d ed. 1990.

Knutson, Ronald D., J. B. Penn, and William T. Boehm. Agricultural and Food Policy, 2d ed. 1990.

Paarlberg, Don. Farm and Food Policy: Issues of the 1980s. 1980.

Thompson, Robert L. "U.S. Agriculture Policy: Components, Goals, and Possibilities for Change." Food Policy 15 (June 1990): 199-208.

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