Example 94 Supporting The Price Of Wheat

In Example 2.3 of Chapter 2, we began to examine the market for wheat in the United States. Using simple linear demand and supply curves, we found that the market-clearing price of wheat was about $3.46 in 1981, but it fell io about $1.80 by 1985 because of a large drop in export demand. In fact, gov-

In 1983 the Reagan administration introduced the Payment-in-K.ind Program (PIK), under which producers who had already reduced acreage under the Reduced Acreage Program could keep fallow an additional 30 percent of their base acreage. A corn producer, for example, would then he given corn directly from government reserves at an amount equal to 80 percent of the normal yield on the number of fallow acres. The farmer could then sell that corn in the market for cash. The objective of PIK was to remove more land from production (thereby maintaining higher prices by reducing output), and reduce government stocks of grain, which had been growing rapidly. Unfortunately the program did not deal with the inherent inefficiency of price supports.

ernment price support programs kept the actual price of wheat much higher-about $3.70 in 1981, and about $3.20 in 1985. How did these programs work, how much did they end up costing consumers, and how much did they add to the federal deficit?

First, let us examine the market in 1981. In that year there were no effective limitations on the production of wheat, and price was increased by government purchases. How much would the government have had to buy to get the price from $3.46 to $3.70? To answer this, first write the equations for supply, and for total (domestic plus export) demand:

By equating supply and demand, you can check that the market-clearing price is $3.46, and that the quantity produced is 2630 million bushels. Figure 9.13 illustrates this.

To increase the price to $3.70, the government must buy a quantity of wheat Qs. Total demand (private plus government) will then be

FIGURE 9.13 The Wheat Market in 1981. By buying 122 million bushels of wheat, the government increased the market-clearing price from $3.46 per bushel to $3.70.

Now equate supply with this total demand:

This equation can be used to determine the required quantity of government wheat purchases Qs as a function of the desired support price P. So to achieve a price of $3.70, the government must buy

Note in Figure 9.13 that these 122 million bushels are the difference between supply at the $3.70 price (2688 million bushels) and private demand (2566 million bushels). The figure also shows the gains and losses to consumers and producers. Recall that consumers lose rectangle A and triangle B. You can verify that rectangle A is (3.70 - 3.46)(2566) = $616 million, and triangle B is (J4)(3.70 - 3.46)(2630 - 2566) = $8 million, so the total cost to consumers is $624 million.

The cost to the government is the $3.70 it pays for the wheat times the 122 million bushels it buys, or $452 million. The total cost of the program is then $624 + $452 = $1076 million. Compare this with the gain to producers, which is rectangle A plus triangles B and C. You can verify that this gain is $638 million.

Price supports for wheat were clearly expensive in 1981. To increase the surplus of farmers by $638 million, consumers and taxpayers together had to pay $1076 million. But in fact taxpayers paid even more. Wheat producers were also given subsidies of about 30 cents per bushel,, which adds up to another $806 million.

In 1985 the situation became even worse because of the drop in export demand. In that year the supply and demand curves were as follows:

You can verify that the market-clearing price and quantity were $1.80 and 2232 million bushels, respectively.

To increase the price to $3.20, the government bought wheat and imposed a production quota of about 2425 million bushels. (Farmers who wanted to take part in the subsidy program-and most did-had to agree to limit their acreage.) Figure 9.14 illustrates this situation. At the quantity 2425 million bushels, the supply curve becomes vertical. Now to determine how much wheat Qs the government had to buy, set this quantity of 2425 equal to total demand:

Price

(S per bushel)

1800 1959

2232 2425

Quantity

FIGURE 9.14 The Wheat Market in 1985. In 1985 the demand for wheat was much lower than in 1981, so the market-clearing price was only $1.80. To increase the price to $3.20, the government bought 466 million bushels and also imposed a production quota of 2425 million bushels.

1800 1959

2232 2425

Quantity

FIGURE 9.14 The Wheat Market in 1985. In 1985 the demand for wheat was much lower than in 1981, so the market-clearing price was only $1.80. To increase the price to $3.20, the government bought 466 million bushels and also imposed a production quota of 2425 million bushels.

Substituting $3.20 for P, we see that Qs must be 466 million bushels. This cost the-government ($3.20)(466) = $1491 million.

Again, this is not the whole story. The government also provided a subsidy of 80 cents per bushel, so that producers again received about $4.00 for their wheat.12 Since 2425 million bushels were produced, that subsidy cost an additional $1940 million. In all, U.S. wheat programs cost taxpayers nearly $3.5 billion in 1985.

Of course, there was also a loss of consumer surplus and a gain of producer surplus. You can calculate what they were.13

The administration later decided to reduce the support price but increase the direct income subsidy, so farmers came out about the same. Was this a sensible change?

In 1990, agricultural programs were estimated to cost American taxpayers more than $20 billion, and to result in a loss of consumer surplus of about $24 billion. See J. Bovard, "Farm Subsidies: Milking Us Dry," New York Times, July 20, 1990.

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