Tuesday, 27 November 2012

Common Agricultural Policy Part 1 - Price Fluctuations

The Common Agricultural Policy is a massive deal in Europe and the European Union. It's a very expensive policy that started out back in 1962 as a simple price support policy. It has two key objectives: to stabilise prices and to provide income support for social reasons. If you look at the distribution of farms across Europe, it is clear to see why this is needed. The biggest 7% of farmers own roughly half the land, whilst the smallest 50% of farmers own only 7% of land. This is a massive inequality and could lead to monopoly powers, outlandish prices and other such problems if it went unregulated.

We'll first look at a few of the characteristics of the agricultural industry. There are many producers, all are price takes. There are also many consumers, all of which are also price takers. There is generally freedom of entry and exit into the industry. It's about as close to perfect competition as you could get in a realistic scenario. Governments need to intervene for many reasons:
  • To reduce price fluctuations.
  • Raise farm incomes.
  • Protect rural communities.
  • To encourage greater self-sufficiency.

Firstly, I'm going to focus on the price fluctuations. In the short term they are caused by instability and the fluctuations in the harvest (good or bad!). Let's assume that the demand for a crop were to rise one year, which would cause a shift to the right of the demand curve. Supply in the short term obviously cannot react to this because supply is fixed each year depending on what is planted. This demand rise will cause a rise from price P1 to P2. This is all shown on the diagram below.

The farmers observe this rise in price and then next year they increase their supply to the market. At P2 the farmers decide that Q2 is the correct quantity to supply to the market. However, at this amount supplied, demand is outstripped and therefore price must fall to P3. The year after, at price P3 a different amount is supplied by the farmers, but at this supply more is demanded and therefore price rises again. This will continue, as shown on the diagram below we can see that the market is slowly spiralling towards a point of equilibrium at which both consumers and producers would be happy. 

We call this concept a stable cobweb. This price fluctuations and changes are supply are making the market more and more stable as over time the fluctuations get smaller until equilibrium is finally met. In this case, the government wouldn't need to intervene in the agricultural industry. However, there is the opposite case. An unstable cobweb could appear. The case of this occurs when the supply of the crop is very elastic. Diagramatically, the supply curve will be much flatter. The same instance as above will occur, demand increases causing a price rise as supply is fixed. In the second term supply is increased due to this new price, but there is oversupply and price has to fall... and so on and so forth. Except, when the supply curve is elastic this doesn't spiral towards equilibrium, it spirals away from it as can be seen in the diagram below.

This shows one of the cases in which the government would need to intervene in the agricultural industry, hence the Common Agricultural Policy. The price fluctuations in this unstable cobweb would keep getting worse and worse if left to market forces. 

Next we'll move on too supply side shocks. This is when supply is affected, either for good or for bad, and therefore the supply of the crop isn't as expected. Once again, diagrams are an easier way of showing this. The first case will be a bad harvest, where supply of the crop is less than what was expected. The diagram below shows this. Supply of the crop has fallen from the expected level of Qe to the actual level of Qa. The area labelled 'b' is income that the farmer has lost, the area labelled 'c' is income gained from this supply side shock. The expected income for the farmer was area 'ab', but the actual income of the farmer is now area 'ac'. If area c is greater than area b then the farmer has gained, otherwise the farmer has lost out due to the bad harvest. Generally, the more inelastic demand is, the greater are 'c' is and therefore the more likely the farmer will benefit. 

I'll quickly go through the other supply side shock as well. As you can guess, this is when there is a better harvest than expected. This causes a shift to the right of actual supply from Qe to Qa. A fall in price is seen from Pe to Pa and once again the farmers income may be affected. Area 'c' is the income gain, area 'b' is the income loss and area 'a' is the income that has stayed constant. If area 'b' is bigger than area 'c' then the farmer has lost out. 

What we have achieved in this blog post is the causes of the fluctuations in prices of harvested goods. This is one of the things the Common Agricultural Policy aims to stop, as stable prices is an aim. In the next post we'll look at what is causing the decline of farmers income and then we'll move on to look at how the government intervenes in this policy to correct these issues.

Stay tuned guys, enjoy!


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