Disentangling the Consequences of Direct Payment Schemes in Agriculture on Fixed Costs, Exit Decisions and Output

The consumer v. citizen argument also finds its voice in U.S. agricultural trade policy.  Taxpayer (citizen) financed policies (subsidies) act as “direct payments” to farms (also known as coupled payments).  Consumer financed policies shift the cost of the agricultural product to the buyer through trade measures.  

Disentangling the Consequences of Direct Payment Schemes

Payments to farms generally come in two forms: fully coupled loan deficiency payments (LDPs) and decoupled production flexibility contract payments (PFCs).  Decoupled payments can potentially cross-subsidize the agricultural product while coupled payments can directly distort operational decisions of farms.

Nancy H. Chau and Harry de Gorter, the authors of this paper, explore some of the consequences of using decoupled direct payments for farms.  Following the 1996 FAIR Act, the termination of government programs led to an increase in direct income support payments to farms.  The effects of the policies are analyzed as to if they distort trade and aggregate production.  Also, the existence of policies to cover fixed costs F can distort trade by encouraging unproductive farms to remain operational instead of leaving the market. 

It is important to consider how infra-marginal subsidies affect the ability of a farmer to cover their fixed and variable costs (2).  These subsidies can come in a variety a forms and make specifications such as quotas, base acreage, and crop selection requirements.  Sometimes, the distortion is so great that not only do these unproductive farms remain in the industry, but they actually expand output beyond the quote or base acreage established by the policy tied to a given subsidiary program (2).

Figure 2(a):

Table 2Avariable definitionsFor personal purposes I want to note areas g and e of the figure.  Area g shows us the variable profits from exports while area e shows that raising output beyond B due to increasing returns (6).

The possibility of foreign trade allows farms to cross-subsidize.  They can allow for profits in one operation while permitting losses in another if the world price is greater than p'w as in Figure 2 (7).  The distortion can be seen by comparing B with Q* on the x axis.

More important, if the farm can get a higher price for the commodity on the world market, they will choose to export this commodity over sending it to the domestic market.  This is expressed below, with a fixed sales price for the domestic market.  

Another important problem is determining when a farm should exit the market (aka stop farming).  “Whenever fixed cost exceeds the threshold F^ (hat goes above F), the producer would be better off ceasing production and exiting altogether” (10).  F^ is the fixed costs threshold that triggers the exit of a farm.  “The larger F^ is, the larger will be the range of producers who remain in the industry and produce the profit maximizing levels of output e*+B” (11).

The first proposition offered by the authors demonstrate the case of a “natural importer” of the given commodity when pd

Proposition 1

The next point to study is how coupled and decoupled payments  influence the output and export decisions of individual producers.  Definition 1 on page 16 and Definition 2 on page 17 both define situations where decoupled payments are more distorting than coupled payments.  These definitions were established without allowing for the “possibility of exit” of farms.

If there is a large exit of farms, the standard prediction that decoupled payments are more distorting than coupled payments may be reversed.  Another factor to consider is the hazard rate and its size.  Also until now the past formulas have depended on an existing loan rate.  In reality, the higher the loan rate, the more likely that decoupled payments become more distorting (19).  The burden Φ of a decoupled payment  and the dead weight losses of taxpayer financed decoupled payments should also be considered (20).

The next section discusses the welfare consequences of direct payments.  It makes the policy maker consider the objective of the coupled or decoupled payment.  Is the purpose to export more or to raise producer surplus while minimizing costs?  The hazard rate and the possibility of farm exit remain two critical variables that can overturn the expected results (22).  

The total output is given by formula [27] and it evaluates the aggregate output and export consequences of direct payments:

Proof 27

The total cost to finance the two direct payments types is given by the formula [29]

Proof 29In the calibration results section of the paper, coupled and decoupled payments are compared in Table 5A, where the possibility of exit is controlled (no possibility of exit).  The effectiveness of direct payments on exports is the highest through loan deficiency payments (LDPs) based on Definition 1 (25).  LDPs are the more distorting trade policy in this scenario.  Contrarily, “no increase in production flexibility contract payments (PFC) can ever raise aggregate exports when exits are prevented (26).  

5ATable 5B

Even after the possibility of exits is accounted for, coupled payments (direct) are still more trade distorting as seen by Table 5B above (27).  Production flexibility contract payments (PFC) become the most cost-effective way of raising farm profits as these farms operate at reasonable marginal costs.  However, when the exit option is permitted, direct payments can dissuade farms from leaving the industry.  These coupled payments can cover up the negative profits of individual farms and lead to long-term dead weight losses (28).

Unfortunately it cannot be concluded with absolute certainty that coupled payments are always more distorting than decoupled payments.  In the sense of Definition 1, decoupled payments can be more output  over trade  distorting than coupled payments under the following conditions:

  • the variance of the distribution decreases
  • the mean fixed cost rises
  • the farm level own-price supply elasticity increases
  • a rise in the loan rate in combination with a lowering of the decoupled payment

I have a few disagreements with the paper:

The work assumes that an increase in the domestic price of the given commodity would translate into a decrease in consumption.  This is a good assumption for traditional crops, but may be inappropriate for “luxury” or “novelty” varieties of crops that have been recently introduced to a market (banana, mango, blue corn, açaí, etc.) (5). 

In a laissez-faire world economy, when the world price pwis below average total costs ATC* the farm would exit the industry (5).  The author also does not account for auto-consumption.  A  quantity of crops from a farm might never “enter the market”, going directly to the needs of the immediate farm and surrounding community (5).

Lastly, since the authors only considered one agricultural product, there was no room for “substitute” goods.  If substitutes exist, the elasticity of substitution would become an important factor.  If the price of sugar receives a higher price on the global market, and sugar beets receive a higher price in the domestic market, there is no issue.  However, if all crops used for sugar production receive higher prices abroad, it would not be surprising to see less (or none) of the sugar producing commodities remaining in the domestic market.  Obviously, if this dilemma were substituted for “staple crops” (wheat, beef, etc.) there could be more detrimental consequences for local populations.   Therefore, the assumption that demand determines price might not be appropriate.  The demand for a good might not be perfectly correlated (1-to-1) with price increases.  The elasticity of substitution might also be a deciding factor (10).  


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