Common Agricultural Policy (CAP)

Common Agricultural Policy (CAP)

„The Common Agriculture Policy is the single most idiotic system of economic mismanagement that the rich western countries have ever devised.“

(The Economist, 29. September 1990)

ECONOMICS OF COMMON AGRICULTURAL POLICY

The Common Agricultural Policy (CAP) is a system of European Union agricultural subsidies and programmes. Major part of compulsory expenditures of the EU budget follows from CAP, it represents about 43% of the EU's budget for 2007 The need of common agricultural policy as a coordinated protection of the agricultural markets was explicitly formulated in the Rome Treaty and details were worked out at the conference at Stressa in 1958 and developed afterwards during the process of European integration.

Agriculture: The Common Agricultural Policy (CAP)

EU Budget: Spending on EU activities

EU Trade: External Trade Relations

CAP still disproportionate part of spending

Budget costs drive CAP reform

Trade policy determines CAP changes

CAP still dominates EU response to trade demands

The Triangle

Why Regulation of Agricultural Markets? Common agricultural policy is being extensively criticized and is a source of permanent conflicts among member states in the EU. The question is whether a special treatment of agricultural sector is just a result of long-term lobbying of some influential groups in the EU, or whether it has some objective economic justification. We shall try to resume some economic arguments about specific features of agricultural markets compared to other sectors of economy.

a) Income elasticity of demand for food Income elasticity of demand - the ratio of relative increase of demand to the relative increase of income. Let y = f(M) be demand for a good as a function of income M, then income elasticity of demand is

ed(M) indicates by what percentage demand for a good increases if the income increases by 1%. Relation between demand and income can be expressed by so called Engel's curve. On the horizontal axis there is a level of income, on the vertical axis corresponding level of demand.

d

dyM dyy

(M) = = e dM y dMM

Fig. 8.2 illustrates Engel's curve of so called luxury good: from some level of income increase of income by 1% leads to more than one percent increase of demand, income elasticity of demand is greater than 1. Demand grows faster than income.

Fig. 8.2, Engel’s curve for luxury goods

Fig. 8.3 illustrates relation between demand and income for so called necessities, goods for which from some level of income 1% increase of demand leads to less than one percent increase of demand. Income elasticity of demand is less than 1. Demand grows slower than income.

Fig. 8.3, Engel’s curve for necessities

It was empirically established that in economically developed countries income elasticity for food, and generally for most of agricultural products, is less than 1. This can lead to the situation characterized by Fig. 8.4. Growth of productivity and technological progress leads to the shift of supply curve for food from S1 to S2, while the growth of prosperity and income leads to the shift of demand curve for food from D1 to D2.

Fig. 8.4, Farmers’ income can decrease

We can see that supply grows faster than demand. Then equilibrium moves from E1 to E2, equilibrium demand for food increases from q1 to q2, market price of food decreases from p1 to p2, and farmers’ income changes from 0p1E1q1 to 0p2E2q2. If p2(q2-q1) < q1(p1-p2), then with economic development and growing prosperity in the whole society the total income of farmers decreases.

b) Price elasticity of supply and demand for food and market adjustment Let y = S(p) be a supply function and x = D(p) be a demand function on a single commodity market. Price elasticity of supply is defined as the ratio of relative increase of supply to the relative increase of price:

It indicates, by what percentage supply increases if price increases by 1%.

Sp

dyp dyy

(p) = = e dp y dpp

Price elasticity of demand is defined as the ratio of relative increase of demand to the relative increase of price:

It indicates by what percentage demand decreases if price increases by 1%.

Dp

dxp dxx(p) = = -e dp x dp

p

Fig. 8.5 illustrates mechanism of market adjustment on partial market (so called cobweb diagram).

Fig. 8.5, Market adjustment process converges to equilibrium price

Comments to market adjustment Starting from some price p0 in the initial period producers supply corresponding quantity, but it is sold for price corresponding to market demand Then producers adjust the quantity according to the price in the previous period etc. In our case this process converges to the equilibrium price p* corresponding to the equilibrium state E. The process of market adjustment converges if the price elasticity of demand (at least in neighbourhood of equilibrium price) is greater than price elasticity of supply.

it was empirically established, that on most of agricultural markets in economically developed countries price elasticity of demand is less than price elasticity of supply: supply for food responds to price changes faster than demand Then, on agricultural markets we can expect the situation expressed in Fig. 8.5.

Fig. 8.5, Market adjustment process diverges from equilibrium price

c) Market equilibrium and costs Fig. 8.6 illustrates very frequent situation on agricultural markets, when market equilibrium does not guarantee cost covering price.

Fig. 8.6, Market equilibrium might not cover costs

In the situation of market equilibrium (point E) the revenues of producers are given by the area 0qEEpE, while the total costs correspond to the area 0qECpE. The producers are not covering production costs (the difference between total costs and revenues is given by area pEECpC), while they have no economic motivation (at least in a short-run) to exit the market, because revenues are higher than fixed costs). The cost covering price pC is greater than equilibrium price.

Because of specific features of agricultural sector, given by low income elasticity of demand for food, lower price elasticity of demand for food than price elasticity of supply and market instability and by the cost structure, almost any national economy uses some form of regulation of agricultural markets. The question is how effective these regulatory policies are.

Objectives and Principles of CAP

The initial objectives were set out in Article 39 of the Treaty of Rome:

1. to increase productivity, by promoting technical progress and ensuring the optimum use of the factors of production, in particular labour;

2. to ensure a fair standard of living for the agricultural Community;

3. to stabilize markets; 4. to secure availability of supplies; 5. to provide consumers with food at reasonable

prices.

The CAP recognized the need to take account of the social structure of agriculture and of the structural and natural disparities between the various agricultural regions and to effect the appropriate adjustments by degrees.

CAP is an integrated system of measures which works by maintaining commodity price levels within the EU and by subsidizing production. There are a number of mechanisms:

Import tariffs are applied to specified goods imported into the EU. These are set at a level to raise the World market price up to the EU target price. The target price is chosen as the maximum desirable price for those goods within the EU.

Import quotas are used as a means of restricting the amount of food being imported into the EU. Some non member countries have negotiated quotas which allow them to sell particular goods within the EU without tariffs. This notably applies to countries which had a traditional trade link with a member country.

An internal intervention price is set. If the internal market price falls below the intervention level then the EU will buy up goods to raise the price to the intervention level. The intervention price is set lower than the target price. The internal market price can only vary in the range between the intervention price and target price.

Direct subsidies are paid to farmers. This was originally intended to encourage farmers to choose to grow those crops attracting subsidies and maintain home-grown supplies. Subsidies were generally paid on the area of land growing a particular crop, rather than on the total amount of crop produced. Reforms implemented from 2005 are phasing out specific subsidies in favour of flat-rate payments based only on the area of land in cultivation, and for adopting environmentally beneficial farming methods. The change is intended to give farmers more freedom to choose for themselves those crops most in demand and reduce the economic incentive to overproduce.

Production quotas and 'set-aside' payments were introduced in an effort to prevent overproduction of some foods (for example, milk, grain, wine) that attracted subsidies well in excess of market prices. The need to store and dispose of excess produce was wasteful of resources and brought the CAP into disrepute. A secondary market evolved, especially in the sale of Milk Quotas, whilst some farmers made imaginative use of 'set-aside', for example, setting aside land which was difficult to farm. Currently set-aside has been suspended, subject to further decision about its future, following rising prices for some commodities and increasing interest in growing biofuels.

The CAP is funded by the European Agricultural Guidance and Guarantee Fund (EAGGF) of the EU. In recent years France has benefited the most from these subsidies. The new accession countries which joined the EU in 2004 have large farm sectors and would have overtaken France as chief beneficiary, but for transitional regulations limiting the subsidies which they receive. The continuing problem of how subsidies for these countries will be paid when they become eligible has already led to French concessions on reform of the CAP. Further concessions will inevitably be necessary to balance the budget.

The CAP guarantees a minimum price to producers, imposes import tariffs and quotas on certain goods from outside the EU and provides a different types of subsidy payments

per hectare of farmland that is maintained in 'Good Agricultural Condition',

in return for specific rural development activities (such as diversification or setting up producer groups), or

for carrying out particular land management activities considered to benefit the environment.

CAP and welfare effects of state interventions agricultural markets frequently face the situation, when the market equilibrium does not guarantee covering the costs (Fig. 8.7) S(p) supply function D(p) demand function Pw world price pA autarky price (closed equilibrium price) pS support price (guarantees desirable income for farmers and desirable consumption for consumers) sS support price supply qS support price demand qA autarky supply, demand

Fig. 8.7, Cost covering price

PROBLEMS Critics argue that too few Europeans benefit from CAP. - Only 5% of EU's population works on farms, and the farming sector is responsible for less than 3% of the GDP of the EU. The number of European farmers is decreasing every year by 2%. - Critics also argue that these subsidies are unfair, because the governments of African countries don't subsidise any farmers. - Additionally, most Europeans live in cities, not rural areas. - However, their opponents argue that the subsidies are crucial to preserve the rural environment, and that some EU member states would have aided their farmers, anyway, causing the reinstatement of trade customs fees.

Many economists believe that the CAP is unsustainable in an enlarged EU.

The inclusion of 12 additional countries in 2004 and 2007 has obliged the EU to take measure to limit CAP expenditure. Poland is the largest new member and has two million small farmers. It is significantly larger than any of the other new members, but taken together the new states represent a significant increase in recipients under the CAP.

Even before expansion, the CAP consumed a very large proportion of the EU's budget, upward of 90% in the late 1980s. Considering that a small proportion of the population, and relatively small proportion of the GDP comes from farms, many considered this expense excessive.

Agriculture

CAP substantially changed over past 14 years (1992, 2000, 2003 reforms)

Still expensive, as direct payments increase budget exposure

Still problematic for trade relations, as high tariffs and generous export subsidies help keep budget cost under control

Effort to shift to “quality” encouragement and “stewardship” payments are underway

Agriculture, contd.

Enlargement adds new burdens to CAP Adds millions of new farmers Poses threat of additional surpluses

Turkish entry would pose serious problems for CAP Huge farm population Protected agriculture unable to meet competition

Enlargement’s impact on agricultural markets are central issue in both trade and budget debates

Agriculture and the Budget

UK trying to tie CAP spending to budget rebate

France objecting, but Germany may switch sides: also concerned about spending

Agreement to review agriculture in 2008, but no change in level projected till 2013

Same date as WTO end to export subsidies

Agriculture and Trade

Agriculture holds back EU in trade diplomacy: relations with US, developing countries, Australia, Canada, etc soured

Commission trying to get rid of the albatross: move to a trade-neutral CAP

Opposition from main gainers from CAP (France, Ireland, also Spain, Portugal)

Germany holds the “swing vote” on trade as well as budget