This dissertation evaluates the European Union’s Common Agricultural Policy (CAP) to determine whether it is an effective and viable way of achieving allocation and redistribution of resources efficiently. It examines the current overall performance of this policy and its effect on international trade. To do this requires some research into the background of the CAP, particularly it’s financing by the EU budget, its objectives and its mechanisms. The various reforms are reviewed in order to make an economic evaluation of its implications in international trade of a specified range of agricultural goods. The result shows that the CAP policy instruments are not efficient in resource allocation. Finally, some recommendations on the way forward are suggested as well as how positive effects of the CAP reform could be further reinforced by a reduction in the level of support and improvements in market access could improve the performance of the European Union’s agricultural policies.
The Common Agricultural Policy (CAP) comprises set of rules and mechanisms, which regulate the production, trade and processing of the Agricultural products in the European Union (EU), with attention is being focused increasingly on rural development (European Commission, 1994).
The Common Agricultural Policy (CAP) began operating in 1962, it aims was to provide a fair standard of living for farmers and fairly priced food for all.
The CAP started as a price support system; a government guaranteed minimum price of a good. It began as an effort to guarantee high prices for European farmers; the EU buys the agricultural products whenever the prices fell below a specified support level. This system provides sufficient income to the farmers, the price of agricultural products within the union is set above the world price. “The European Community (EC) may be considered a developed country; its Common Agricultural Policy (CAP) supports agricultural prices above world markets” (Runge and Witzke 1990). In order to prevent the policy from attracting imports, the system was backed by tariffs that offset the differences between the European and world agricultural prices. The support prices set by the European Union have been so high that it stimulated productivity and led to overproduction (excess supply); this resulted in the Union having Butter Mountains and Wine lakes in the 1980s.
The European Union decided to turn the policy into subsidising exports to dispose of surplus production. An export subsidy is paid by the government to offset the difference between European and world prices. It is not an efficient way of allocating resources. This shows that, the CAP price support mechanism does not guide the economy towards efficiency; the government therefore needs to consider the efficiency costs before pursuing a policy.
The Common Agricultural Policy is undeniably complicated and also the most expensive and controversial policy of the European Union. The policy continues to attract criticism which creates tension in the European Union’s relationship with trading partners.
There have been a lot of comments on its sustainability, the continuous problems and also international repercussions. According to Hitiris (2003, p.161),
The policies available to governments differ in effectiveness and in their implications on income distribution and resource allocation. The latter as a rule is affected negatively, in directions other than those which free market would have dictated. This is often justified as a temporary expedient within a spectrum of objectives among which ‘efficiency’ is not ranked high in the government’s list of priorities. The effects on income distribution arise from the direct and indirect costs of financing the policy.
This extract emphasises that a price support system does not guide the economy towards efficiency by optimal resource allocation. This is because direct income support policies are lump sum transfers related to or independent of the volume, price, revenue or income of agricultural activity.
The work of Rayner, et al. argue that,
“world trade in farm products is profoundly influenced by protectionism, competitive export subsidisation and insulation of national markets enshrined in domestic agricultural legislation in the industrialised world … in Particular, pervasive commodity-based price and income support policies depress world prices and distort the location of production and the extent and pattern of trade flows, thereby restricting the potential global benefits from specialisation and trade” (Rayner, et al 1993, p.1513 – 1514).
This quote emphasises the point that in a world of increasing interactions, domestic policy objectives such as the CAP have global effects on international trade. In order to improve trade relations, there has to be a reduction in border protection, export subsidies and other measures that distorts trade.
Also Pelkmans (2001) suggested that “when assessing the CAP in term of policy costs and effectiveness, it does not get high marks”. He also stated that “in terms of the five objectives of the treaty…, efficiency in the sector has gone up, but because of technical progress and heavy investment in powerful inputs, rather than because of trade-induced regional specialisation”.
The aim of this project is to evaluate the Common Agricultural Policy (CAP) to determine whether it is an effective and viable way of achieving allocation and redistribution of resources efficiently.
It will examine how the CAP is financed by the EU budget, analyse the objectives of the CAP, explain the mechanisms of the CAP, and examine the various reforms in order to make an economic evaluation of its implications, the effect it has on international trade and also assess the performance of the policy. It will then give some recommendations on measures that could make the policy more efficient.
STRUCTURE OF THE RESEARCH
The method adopted will involve a review of secondary data; this means it will include various perceptions as well as an interpretation of the relevant theory. The layout of the project will be split into various chapters of emphasis. The first chapter will give a brief introduction to the background of the Common Agricultural Policy (CAP), its objectives and the context in which in was created. The second chapter will look at the mechanics of CAP and also give some relevant economic theory to explain how the policy works.
The third chapter will involve a detailed assessment of the CAP and also take into account the various developments of the CAP (reforms and proposals). The fourth chapter will focus on the reform of some agricultural commodities.
The fifth chapter will focus on analysis of the gains to be made from trade; these gains would be explained with the use of Ricardian and Heckscher-Ohlin model. The emphasis would be to argue whether the gains to be made from free trade have the potential to outweigh border protections that affect agricultural trade.
The sixth chapter will be devoted to analysing the effectiveness of the CAP and establish its impact on international trade.
The latter chapters of the project will be used to assess other agricultural policies and also evaluate the findings and to see whether the CAP guides the economy towards efficiency by optimal resource allocation. The project will conclude with some remarks about the way forward in the future, how positive effects of the CAP reform could be further reinforced by a reduction in the level of support and improvements in market access and how the CAP can be used to improve the performance of the European Union’s agricultural policies.
1 THE BACKGROUND OF CAP
Economic integration and harmonisation are important features of the European Union; this began with the European Coal and Steel Community (ECSC) at the Paris Treaty in 1951. The ECSC was formed by six member countries with the aim of removing barriers to trade of coal and steel among member countries (Germany, Belgium, Netherlands, Luxembourg, Italy and France).
The success of the European Coal and Steel Community led to the formation of a common market; the European Economic Community (EEC) at the Treaty of Rome in 1957. Agriculture was high on the agenda when the treaty of Rome was being negotiated; there was a need to ensure food security as a result of the post war shortages.
The European Economic Community now the European Union has since grown to 25 member states with 2 additional countries (Romania and Bulgaria) set to join in 2007. The treaty of Rome defined the general objectives of a Common Agricultural Policy (CAP) and its principles were set out at the Stresa conference in July 1958.
The Common Agricultural Policy comprises of a set of rules and mechanisms, which regulate the production, trade and processing of agricultural products in the European Union (EU), with attention being focused increasingly on rural development (European Commission, 1994).
The main objectives of the Common Agricultural Policy as stipulated in Article 33 of the Treaty of Rome are as follows;
to increase agricultural productivity by promoting technical progress and by ensuring the rational development of agricultural production and the optimum utilisation of the factors of production, in particular labour;
thus to ensure a fair standard of living for the agricultural community, in particular by increasing the individual earnings of persons engaged in agriculture;
to stabilise markets;
to assure the availability of supplies;
to ensure that supplies reach the consumers at reasonable prices.
In order to attain these objectives, Article 34 of the Treaty provides for the creation of the common organisation of agricultural markets (COM) which, depending on the product, will take one of the following forms:
common rules on competition;
compulsory co-ordination of the various national market organisations;
a European market organisation.
Article 34 also states that, “the common organisation established in accordance with paragraph 1 may include all measures required to attain the objectives set out in Article 33, in particular regulation of prices, aids for the production and marketing of the various products, storage and carryover arrangements and common machinery for stabilising imports or exports”.
In 1960, the CAP mechanisms were adopted by the six founding member states and in 1962; the Common Agricultural Policy came into force.
1.1 The Budgetary cost of CAP
When Common Agricultural Policy (CAP) began operating in 1962, it aims to provide a fair standard of living for farmers and fairly priced food for all. The CAP is one of the most important policies of the European Union. It costs European tax payers EUR 54.8 billion; the EU budget for 2006 is EUR 121.2 billion, 36% of which is spent on Agriculture.
Figure 1.1 EU Budget Expenditure 2006
Source: Data from europa.eu
Figure 1.1 shows a breakdown of the total EU budget expenditure.
Competitiveness and cohesion constitutes an important redistributive instrument in the EU; it includes cohesion funds which involves expenditure in the poorest regions. Competitiveness includes expenditure on human resource development, environmental improvement, research and innovation, technology transfer and community development.
Agriculture expenditure (CAP) includes rural development and direct aids.
Natural resources include fostering rural development and protecting the environment.
EU as a global partner includes external relations, enlargements and humanitarian aid.
Citizenship includes expenditure on freedom, security and justice.
Other – includes administrative expenditure and compensations to new EU members.
The CAP is made up of two pillars; the first Pillar of the CAP absorbs 68.2% of the Agricultural expenditure towards intervention in agricultural markets and 16.7% towards direct aids, a total of which is EUR 43279.72 million. The second Pillar of the CAP accounts for 15.2% towards rural development. Most of the criticism about the budget is related to the CAP as its main recipients and benefactor.
The CAP essentially consists of a mechanism of subsidising agriculture through the price process, the EU council of farming ministers set minimum prices for most agricultural products. The CAP affects the price and supply of the most basic commodities such as cereal and sugar; it replaced the national agricultural policies of member states, abolishing the restrictions on agricultural products traded internally.
1.2 Reasons for Government Intervention
Market failures are one of the reasons for government intervention in agricultural policy. These include the impact of the climate on agricultural production, price fluctuations in a free market and also low income elasticity of demand for agricultural products. There is also a strategic argument for intervention that a secure food supplies is essential to any nation, the aim is to maintain a constant supply of agricultural products at stable prices and protect farm income from severe decline.
Broadly speaking, agricultural protectionism had been established in many countries since the 1930s. Agriculture is said to be historically considered special for economic, social, political and strategic reasons. It is also reported that in almost every industrial country and many less-developed countries, governments intervene in the agricultural sector by attempting to modify its course and to regulate its production and trade (Hitiris 2003).
It could then be argued, that the economic reason for intervention is because prices are unstable in a free market, price elasticities of demand for food products are low because they are a need, this means that a slight change in the quantity will lead to a large change in price. Supply is perfectly inelastic in the short run as farmers will not be able to increase the supply of their products until the following season.
2 THE GENERAL MECHANISM OF CAP
This Chapter will look at the mechanics of the Common Agricultural Policy (CAP) with detailed economic analysis in order to demonstrate how the policy works.
Article 34 of the EC Treaty which is devoted to the gradual development of the CAP stated that, one or more agricultural guidance and guarantee funds should be created to enable the common organisation of agricultural markets fulfil its goals.
In 1962, the council set up a single fund to finance all community market and structural expenditure in the various agricultural sectors. The European Agricultural Guidance and Guarantee fund (EAGGF) was formed. The guidance section manages funds intended for policies of structural reforms and the development of rural areas. The guarantee section of the fund finances the intervention policies of the CAP. The management of the EAGGF is chaired by the Commission and assisted by the EAGGF committee, made up of representatives from member states. The committee of the EAGGF deals exclusively with matters relating to the guarantee section of the European Agricultural Guidance and Guarantee fund, such as regulations that applies to agricultural markets or price and income support.
The intervention in agricultural markets through support mechanism have been aimed at maintaining a constant supply of agricultural products at stable prices and protecting farm income from severe decline. This is because the support for agriculture is due to the recognition of problems in the sector; such as the impact of the climate on agricultural production, price fluctuations in a free market and also low income elasticity of demand for agricultural products.
Furthermore, technological advances have increased the supply of agricultural products, but because of the decreasing returns to scale in agriculture, and the relative inflexibility of farm sizes, the rate of increase has been less than that of the manufacturing industry.
As stated earlier, the European Union Common Agricultural Policy (CAP) began as a price guarantee policy designed to benefit both producers and consumers and to stabilise the market. The prices for individual agricultural commodities are fixed each year through a process of political negotiation. These prices are maintained by the main policy instruments of the CAP which includes tariffs, Import quota, intervention price and export subsidies. These will be illustrated with standard graphs from economics text books.
2.1 Price Support
The CAP started as a price support system; a government guaranteed minimum price of a good. It began as an effort to guarantee high prices to European farmers; the EU buys agricultural products whenever the prices fell below a specified support level. This system provides sufficient income to farmers, the price of agricultural products within the union is set above the world price and also above the price that would clear the European market.
This will be illustrated by a standard graph see McDonald and Dearden (1999), using the market for wheat as an example.
From the graph above, D represents the demand curve for wheat by consumers in the EU, while S represents the EU supply curve for wheat. The target price for wheat set by the EU council of agricultural ministers is P4; this is the maximum for a standard quality of produce. The target price is usually set well above the world market price, P1 and also above the equilibrium price in a closed economy. A threshold price is then calculated by allowing for transport and distribution cost; this is shown as Price P3.
However at the target price of P4, there will be excess domestic supply and hence a threat of competition form imports which would lead to fall in the market price. In order to ensure that imported wheat does not enter the EU at a price less than the threshold price, a variable import levy is imposed. This is equal to BW; the difference between the world price P1 and the threshold price P3.
In addition to this, the EU removes the excess supply from the market by setting an intervention price, P2. This is the minimum or the lower limit of market price at which producers can expect to sell any quantity of output they can produce. So if the price of wheat falls to P2, the EU will buy cereals to support the price.
This shows that fixing producer prices above the market equilibrium price encourages excess supply, this is because farmers know that the more they produce, the larger the subsidy they get.
2.2 Export Subsidies
With Protection in place, mechanisms had to be used to prevent excess domestic supply which drives prices too low. The European Union use export subsidies to dispose of surplus domestic production. An export subsidy is paid by the government to offset the difference between European and world prices. The EU compensates exporters by paying them the difference between high EU prices and the generally lower world market price.
The price of the exporting country will rise from PW to PS, while in the importing country, price falls from PW to Ps*.
Policies such as price support and export subsidies usually result to consumer and producer surplus, this is because prices set above market clearing levels (equilibrium) leads to excess supply. From figure 3 above, domestic consumers loss is the area a + b; while producers gain is the area a + b + c; government subsidy is the area b + c + d + e + f + g (the amount of exports times the amount of subsidy). This shows that the cost of an export subsidy exceeds the benefits.
This is not an efficient way of resource allocation because a price support system leads to inefficient overproduction, also the cost involved in disposing the excess supply which puts a strain on the budget and the combined cost to European consumers and taxpayers exceed the benefits to producers. An efficient allocation of resources requires that Marginal benefit (Revenue) equals Marginal social cost. Therefore, lowering these subsidies will reduce the effect of the European Union’s distortion on world markets.
However, not all mechanisms apply across all regimes: for example there has never been intervention for intensive livestock (such as pigs and poultry) or sheep, there are no export subsidies on sheep-meat, and there are different mechanisms in the horticulture sector. There is also an array of other market management tools, including production quotas (which limit dairy and sugar production), “set-aside” (introduced to limit cereals and oilseed production), wine planting rights, and processing/production aids in the fruit and vegetables, flax and hemp and sugar sectors (HM Treasury, 2005).
As a consequence of the CAP price support mechanism, by the 1980s, there were grain and butter mountains, as well as milk and wine lakes due to excess production. The imbalance between demand and supply needed to be addressed, which led to a need for a reform of the CAP.
3 CAP REFORM AND PROPOSALS
There have been several attempts made to implement changes to the CAP. This is due to the fact that the CAP is constantly under external pressure especially from the United States who wants a reduction in the subsidy on agriculture. As discussed in chapter 1, CAP is a burden to the EU budget due to the high level of price support. It accounts for 36% of the total expenditure of the budget. It is also not favourable to other countries because it reduces their export prices and distorts international trade.
The CAP has been criticised for reducing world market prices and also for having high levels of protection for EU agriculture. It has been reviewed and has evolved over the years through reform packages. This chapter will examine the various reform packages from the early 1970s to the most recent in 2003. It will also assess the General Agreement on Tariffs and Trade (GATT) Uruguay Round and also the World Trade Organisation (WTO) Doha round and how they have influenced the reform of the CAP.
The first proposal to reform the CAP was in 1968 by Dr Sicco Mansholt the vice-President of the commission who was at the time responsible for the CAP. This was as a result of overproduction of milk, sugar and wheat that emerged at the end of the transition period to common prices. The Mansholt plan advocated for a radical restructure of the CAP which stipulates that EU agriculture had considerable excess capacity; that structural adaptation should be stimulated to allow farmers to earn a living; and that price levels should be used to guide production.
Johnson (2000), suggested that the plan would have meant that half the existing farmers – those on small and unviable holdings – would have to leave the land and massive spending on rural infrastructure and industry would have to take place. This was to attack the essence of CAP – high support prices which are above all what farmers want.
Also according to El-Agraa (2004), the Mansholt plan rightly addressed the main problems of agriculture, not adequately functioning markets and inefficient resource use in agriculture. However, the strategy proposed to overcome the problem was questionable.
Consequently the proposed reform was not accepted due to political opposition to the plan, it was considered too ambitious and inadequate. A less radical version of the Mansholt’s structural programmed was agreed in 1972 with the aim of modernising European agriculture.
There were several attempts to reform the CAP from the late 1970s onwards and despite the continued structural changes; there was growing crisis with the policy. The supply and demand for agricultural products were not balanced, this led to increasing surpluses and also an increase the expenditure. The only major reform to the CAP was the introduction of dairy quotas in 1984; this was a major change in the policy instrument since the CAP was established.
The next major effort to reform the CAP was in 1988, as a result of growing concern in the cereals sector and rise in the budget cost. The European council agreed on a package of reform measures, including the “agricultural expenditure guideline”, which limited the percentage of CAP expenditure in the overall budget. 1992 Reform
The most recent large-scale CAP reforms occurred in 1992, 1999 and 2003.
The process of the 1992 CAP reform began in 1991 when the Agriculture commissioner at that time Ray Macsharry put forward discussion on the development and the future of CAP. The proposal was based on a price cut of about 30% for cereals in order to bring prices closer to the world prices. There was also a compensation for large farmers to set-aside a certain percentage of their arable land, and a 5% cut in the intervention price for butter.
The 1992 reform of the CAP led to a substantial reduction in intervention prices, a concept of direct payments to farmers in the cereals sectors, which mean a partial decoupling of support from product, was introduced.
The model of the 1992 reform was expanded in the 1999 reform as well as additional changes which the commission described as ‘the biggest ever negotiated for the European Union’s Common Agricultural Policy’
In June 2003 the EU reformed the CAP. This reform completely changed the way the EU supports its farm sector. There was a switch of most CAP subsidies from price support to direct income payments. In a recent publication by the European Communities (2006), it was established that “the most significant single simplification effort in the CAP has been the consolidation of a large number of direct income support payments made to farmers into one payment- under the Single Payment Scheme (SPS). A major aim of the SPS is to release farmers’ entrepreneurial potential”. This is an important step towards the “decoupling” of support to farmers so that the payments they receive are less dependent on what they produce.
Decoupling is meant to ensure that farmers no longer have an incentive to over produce; instead they would receive flat payments which would be linked to factors such as rural development and environmental protection.
In its assessment of the impact of the Common Agricultural Policy (CAP) reform agreed in 2003, the OECD says “increased decoupling will reduce distortions to international trade and help boost farm incomes”. The evaluation suggests only a modest fall in production of the main commodities covered by the reform in the EU, although net exports are expected to decline more sharply.
The implementation of the 2003 CAP reform began in 2004; the single payment scheme will replace most of the previous area payments between 2005 and 2007.
The replacement of the price support mechanism as an instrument of the CAP by the direct income support payment independent of production which is subject to compliance with environmental, food safety, etc, will promote competition which will make the agricultural sector more competitive, lead to efficient production and better exploitation of economies of scale. Market signals should be allowed to influence agricultural production.
Agricultural trade is significant to the European Union; as the world’s largest importer and the second largest exporter of agricultural products, the motivation for these reform packages was a result of the failure to meet its original objectives as well as foreign pressure. The EU is a member of the World Trade Organisation and the CAP is constantly under global pressures and has been on the agenda of major multilateral negotiations such as; the General Agreement on Tariffs and Trade (GATT) Uruguay round and the current World Trade Organisation (WTO) Doha round.
3.1 The General Agreement on Tariffs and Trade – Uruguay Round
The GATT’s Agricultural agreement was negotiated in the 1986-1994 Uruguay Round. A framework of rules and reduction in protection and trade-distorting support was established. This was a significant step towards fairer competition and reduced distortions to trade. Member governments had the commitment of improving market access and also reduce trade distorting subsidies in agriculture. This process began in 1992 and was implemented over a six year period for developed countries and ten years for developing countries.
3.2 WTO- Doha round
The World Trade Organisation (WTO) is the successor to GATT. It is currently made up of 147 nations, with the objective to multilaterally reduce the barriers to international exchange.
The Agricultural agreement in the Uruguay round was agreed to be incorporated into the ministerial conference in Doha Qatar, that began in 2001. The Multilateral trade negotiations known as the Doha Development Agenda includes the opportunity to re-balance trade rules in favour of developing countries and boost the world economy.
4 SECTORAL ASSESSMENT AND REFORM
The major reform of the common agricultural policy in 1992 has led to a significant reform of some sectors. It has resulted to the introduction of instruments for providing economic support that that reduces the incentives to distort trade. These include the commodities such as cereals and sugar which are highly traded. This chapter will analyse the implications of the CAP reform with reference to the cereal and sugar market on international trade.
4.1 Cereals regime
Cereal is at the core of European agriculture and agricultural support has impacted it. Cereals include wheat, maize and barley. Before the 1992 CAP reform, the cereal market was characterised by high market prices above the world market, consistent income support as well as import levy and export subsidy. Given that income support results to excess production, the EU became a substantial net exporter as production continued to increase and domestic consumption remained the same. The increasing price support and disposal of the excess supply was a burden to the budget and also a distortion to the trade, there was a need for a reform of the cereals regime.
The 1992 CAP reform provided the legislative framework that will govern agricultural policy for the period 2000 to 2006. This reform package involves a gradual reduction of administered prices for cereals, partially compensated payment based on area planted. As a result, the price support for cereals were reduced by 30 %, farmers were entitled to claim area payments as compensation and larger farmers payment was based on the condition that they set aside a specified proportion of their arable land.
According to a report by the OECD(2005), “Area payments for cereals and oilseeds are based on historic, regional yields and are paid on condition that producers set aside a defined percentage pf their arable land: small-scale producers are exempt from the sets-aside requirement”.
Furthermore, the GATT Uruguay Round Agreement on Agriculture imposed a number of commitments on the EU cereals policy which included import access to the cereals market and also restrictions to the volume of subsidised exports.
Consequently, there have been changes in the EU cereal market due to the increase in domestic consumption and also the emergence of bio ethanol a new market for the use of cereals (wheat, Maize).
The table below shows the medium-term projections that depicts the outlook for the EU cereal market.
Table 4.1 Total cereals balance sheet in the European Union, 2002-2013 (mio t)
Usable production 263.6230.2286.1253.3262.2262.5262.9265.4266.3269.7271.6274.6
of which bioenergy 0.00.51.82.184.108.40.206.220.127.116.11
of which intervention8.95.817.414.614.815.812.611.610.59.89.39.1
EU-N10: Ten new Member States
Source: European Commission
These medium-term projections appear to be moderately positive for most EU cereals, with increase in the usable production as well as increase in consumption. This could due to the expansion of domestic consumption as a result of the growth in the livestock industries and the emerging bio-ethanol and biomass demand, or the increase of cereal exports.
4.2 Sugar regime
Despite the various reforms of the Common Agricultural Policy, the sugar regime remained unchanged for almost 40 years. According to the European Commission (2004), the common market organisation (CMO) in the sugar sector was set up in 1968 aiming to ensure a fair income to European Union (EU) producers and self supply of the EU market. Since then it has received very few modifications and it is the only sector that has so far stayed out of the 1992 Common Agriculture Policy (CAP) reform process, which essentially involves increase of competitiveness by compensating institutional price cuts with direct income payments.
The EU regime for sugar is intensively regulated, it is characterised by “an extremely high support price, a rigid quota system and a state control of the relationships between beet growers and sugar factories”.
The sugar regime limits the quantities supported through a three-tier system of quotas; A, B and C. The A tier of quotas is allocated to factories and transferred by them to farmers in terms of guaranteed quantities and prices, which is supported by intervention prices. Sugar factories pay a levy on the production beyond their A- quota but within maximum B-quota, the C sugar includes the unrestricted quantities of sugar exceeding the A and B quota. The price of C sugar can be equal to the world market price and can only be sold outside the EU without export subsidy.
This regime became untenable as production grew faster than consumption, sugar prices were three times the world market price and the export system was regarded as a distortion to trade. As a result, on the 1st of July, 2006, the sugar sector was radically reformed in order to bring it in line with the other CAP reforms. This reform will involve about 36% cut in the guaranteed minimum sugar price, some compensation for farmers and a restructuring fund for uncompetitive sugar producers to leave the industry. After the reform, the EU is expected to become a net importer of sugar and export is expected to drop drastically, bringing it in line with its WTO commitments.
Therefore the sugar market will be competitive and there would be fewer distortions to international trade.
5 THE IMPACT OF CAP ON INTERNATIONAL TRADE
This chapter will focus on analysis of the gains to be made from trade; these gains would be explained with the use of trade model analysis such as the Ricardian and Heckscher-Ohlin model. The emphasis would be to argue whether the gains to be made from free trade have the potential to outweigh border protections that affect agricultural trade.
International trade plays an important role in the ability for countries to grow and develop its economy. Appleyard et al, (2006) suggested that International transactions have been becoming increasingly important in recent years as countries seek to obtain the many benefits that accompany increased exchange of goods, services and factors.
This means that a country cannot operate in a vacuum or have all the resources needed, it will depend on export of some goods and services from another country and vice versa, hence the need for interdependent. There are various theories that emphasise the gains to be made from trade; one of the earliest of these was in the 18th century by David Ricardo.
5.1 The Model of Comparative Advantage
The concept of comparative advantage developed by David Ricardo is known as the Ricardian model which is based on the assumption that “international trade is solely due to international differences in productivity of labour” (Krugman and Obstfeld, 2006). This theory is used to demonstrate that trade is mutually beneficial to countries.
Ricardian model suggests that the fundamental force that determines international trade is comparative advantage. A country has a comparative advantage in producing a good if the opportunity cost of producing that good relative to other goods it produces, is lower in that country than in another country. For example, country A has a comparative advantage over country B in producing a good if the cost of producing that good, relative to the cost of producing other goods in A, is lower than the cost of producing that good in B, relative to the cost of producing other goods in country B.
This means that a country’s cost relative to the costs of other goods it produces, is lower than the other country’s. Trade between these countries would be mutually beneficial when each one has a comparative advantage over the other.
However, this is not the same as having an absolute advantage. A country has an absolute advantage when the cost of producing a unit of commodity is lower than the cost of producing it in another country. This is an argument developed by Adam Smith in his book the Wealth of Nations which suggested that international trade is mutually beneficial for all trading countries and that every country benefits from being able to export those commodities which it produces efficiently and being able to import those commodities which it produces inefficiently. This theory probably limits the basis for mutually beneficial trade because if country A has an absolute advantage over country B in all its commodities, then there would be no opportunity to trade.
The Ricardian model demonstrated that even though a country may be absolutely more efficient than another in the production of tradable all goods, nevertheless trade will be mutually beneficial. Ingham, (2004) suggests that the principle of comparative advantage suggest that a country should specialise in the commodity in which in has comparative advantage, and export it to another country in exchange for a commodity in which it has a comparative disadvantage, is fundamental to the doctrine of free trade.
Another argument however suggested that the Ricardian model predicts an extreme degree of specialisation that we do not observe in the real world, the model also neglects the possible role of economies of scale as a cause of trade, which leaves it unable to explain the large trade flows between apparently similar nations (Krugman and Obstfeld, 2006).
This argument is persuasive because the Ricardian model is only based on one factor of production (labour) and also assumes that the underlying market structure is Perfect Competition. However where there is no obvious comparative advantage, through specialisation, a country can lower its costs through economies of scale.
Although the model has been refined over the years, the essential argument for free trade based on comparative advantage remains on unchanged.
5.2 Heckscher-Ohlin Model
Eli Heckscher and Bertil Ohlin were two Swedish economists who shed more light on the basis of comparative advantage. The Heckscher-Ohlin Model shows that comparative advantage is influenced by the interactions between nations’ resources (the relative abundance of factors of production) and the technology of production (which influences the relative intensity with which different factors of production are used in the production of different goods) (Krugman and Obstfeld, 2006).
The theory emphasises the relationship between proportions in which different factors of production are available in different countries and the proportions in which they are used. Hence a country’s pattern of trade, the goods and services it exports and imports are determined by its factor endowments (export relatively abundant factor and import relatively scare factor). This means that a country would have a comparative advantage in commodities which use more of their relatively abundant factor of production, so a labour intensive country will export labour intensive goods and a capital abundant country will export capital intensive goods.
International trade is believed to have strong income distribution effects this is because relative prices of goods as a result of trade have very strong effects on the relative earnings of resources. Although this trade model is useful in analysing the effects of trade on income distribution, it has some limitations. Some arguments have been centred on the fact that trading nations usually have similar factor endowments; this is because most trade is between countries with similar structured economies also trade is usually in commodities which have very similar factor requirements.
Another argument suggests that for an explanatory model, its present-day relevance is very limited. If ever applied anywhere, it was probably only in the period 185-75 when reductions in transport costs opened up vast areas of cheap, fertile land, and made available exports of land-intensive agricultural products from North and South America and Australia.
The Ricardian and Heckscher-Ohlin trade models have some assumptions in common; they both assume that the underlying market structure is perfect competition, they also assume constant cost to production and that there are no economies of scale. However, the Ricardian model assumes that the only factor of production is labour while the Heckscher-Ohlin model assumes that several factors of production are utilised as commodities have different factor intensities. Empirical evidence have been favourable to the predictions of the Ricardian model than the Heckscher-Ohlin model, it is believed that most researchers do not agree with the assumption that differences in resources alone can explain the pattern of world trade.
5.3 Gains from trade
Having looked at the Ricardian model with suggest that trade is mutually beneficial (everyone wins) and the Heckscher-Ohlin model which suggests that there are losers as well as winners from trade, it is important to analyse how trade has the potential to benefit some if not all participants. This will be analysed by using a production possibility frontier; this is a curve that shows the combination of two goods that can be produced with fixed quantities of input. This will be demonstrated by the graph from Krugman and Obstfeld, 2006.
The above graph shows production possibility frontier; which is the boundary between the combinations of food and cloth that can be produce and the combinations that cannot be produced. The budget constraint represents all possible combinations of food and cloth that the country could consume given the world relative price of cloth.
The curve shows that with the absence of trade, the economy’s production and consumption were at point 2 on its production possibility frontier (PPF). However after trade, the economy can now consume at any point on its budget constraint. This shows that it is possible for the economy to be better off as a result of trade.
There are gains to be made from trade because it expands the choices of goods and services available thereby making the market competitive.
6 EVALUATIONS OF THE OBJECTIVES OF CAP
Having looked at the Mechanism of CAP and assessed the gains to be made from trade, one must ask, therefore whether the CAP guides the economy towards efficiency. As stated earlier, government intervention generally leads to a dead weight loss, this results of a net loss from the policy which shifts surplus from one group to another. A price support and import tariffs results to large deadweight loss; this is an economic inefficiency. This inefficiency is a sum of the loss from producer surplus resulting from inefficient excess domestic production and the loss of consumer surplus resulting from higher domestic prices and lower consumption.
Hitiris (2003), states that “by restricting imports and promoting domestic production and exports of agricultural commodities, government policies adversely affect the production and trade of other sectors of the economy and the country’s international comparative advantage”. He further suggests that “this occurs because the policy promotes the growth of the agricultural sector and agriculture related industries at the expense of other sectors and national welfare”.
The original five objectives of the CAP highlighted in the Treaty of Rome would be used to assess the efficiency of the policy.
6.1 Increase agricultural productivity
The first objective of the CAP is to increase agricultural productivity. Productivity can be measured by output per unit of input, high prices for agricultural products attract more inputs into the farming sector and render new technologies more profitable; and price stability helps encourage a higher input/output model of agriculture. Although agricultural production methods have changed remarkably over time, some methods and technologies have merely been modified.
There has been an a raise in the volume of production as a result of the price support mechanism, and according to a report by HM Treasury (2005), in the UK and across much of the EU, a relatively small percentage of farmers accounts for the bulk of agricultural production. Over 80 per cent of UK food production now comes from just one quarter of all farms, with the largest 10 per cent of farms producing over half of total food output.
Also because price support mechanism raises prices above world price, some inefficient farms have able to survive, as a result there is no competition in market. The market for agricultural commodities needs to be more competitive, this will result to efficient production and better exploitation of economies of scale. Increasing competitiveness will bring production in line with demand.
6.2 Increase individual earnings of people engaged in agriculture.
This objective seems to be the main focus of the CAP, but the policy is inefficient in transferring resources to farmers. The OECD (2003) estimated that only around 10% of the CAP market price support actually reaches farmers, in their capacity as farmers; 36% benefits suppliers of inputs such as machinery, pesticides and fertilisers. 26% goes to landowners, some of whom are farmers, while a quarter is lost through economic inefficiencies (deadweight losses).
A direct payment for example does not necessarily guarantee increase in the income of farmers, because it is rapidly capitalised into inputs (land prices), so that the benefit accrues mainly to the landowner. It is said that around 50% of EU farmland is owned by non-farmers, this means that only half of the value of such direct payments actually benefits farmers themselves. Therefore in terms of allocation efficiency, the CAP has not achieved its objectives.
6.3 Market Stability
One of the aims of the CAP is to stabilise the agricultural market. As stated earlier, market failures led to government intervention in the agricultural sector. These includes demand and supply not responsive to price changes in the short run and also the influence of weather and other biological factors of supply. The price support mechanism cannot stabilise market prices and quantities entering the market, this is because prices provides information to farmers on production. However since price support leads to excess production, the European Commission buys and exports the excess supply usually to developing countries, this is know as dumping. Ackrill, (2000) indicated that “the EU exports leads instability by adding to excess supply on the world market, instability has not being eliminated, but moved elsewhere”. As noted earlier, an efficient price mechanism ensures efficient allocation of resources.
6.4 Availability of supplies
‘It has been argued that there is no obvious policy instruments designed to promote the availability of supplies, this objective has been over-achieved, (Ackrill 2000)’.
A secure food supply and self-sufficiency is essential to the EU, intervention in agriculture has resulted in over-production. It is argued that “an attempt to maintain all these objectives simultaneously resulted in a complicated system of border measures and subsidies that led to virtually uncontrollable overproduction. For example, between 1975 and 1986 the EC moved from being an overall net importer of agricultural produce to being a net exporter of cereals, sugar, beef, and veal” (Buckwell 1991, cited Patterson 1997). Also, intensive agriculture could adversely affect the long-term fertility and productive capacity of the soil.
6.5 Getting supplies to consumers at reasonable prices
The European Union’s Common Agricultural Policy has not achieved this objective. This is because the intervention policy sets price of agricultural commodities above the world price and above the price where the market is at equilibrium (where demand equals supply). Also to prevent the policy from attracting imports, the system is backed by tariffs that offset the differences between the European and the world price. This is a distortion to trade and does not guide the economy towards efficiency.
7 EVALUATIONS OF OTHER AGRICULTURAL REFORM POLICIES
Agricultural policy reform is usually a response to pressure (external or budgetary). A reform takes place when the benefit to change outweighs the cost. This chapter will focus on the comparisons of Agricultural reform policies of other countries particularly the United States of America, Australia and New Zealand. It will look at the similarities with the CAP as well as differences and also the implications of the CAP reform on the USA and New Zealand policies.
7.1 USA Farm Policy
The US farm programme began in the 1930s and its aim was to maintain farm income and stabilise domestic prices. The Agricultural Adjustment Act was signed in 1933; the law introduced the price support programs, including production adjustments, and incorporated the Commodity Credit Corporation. The price support payments were financed mostly by processing taxes on the specific commodity. Further adjustments were made between 1938 and 1996.
The overall progress in policy reform since 1986-88 has improved market orientation. The level of producer support has decreased, but sugar and milk continue to be very highly supported through market price support. There has been some shift away from payments based on output or area to counter-cyclical and direct payments based on past area with no requirement to produce. Although potentially less distorting, counter-cyclical payments, together with marketing loans that also offset lower prices, continue to be significant and limit market signals
A Farm security and Rural Investment Act was signed in 2002, it is commonly referred to as the 2002 Farm Bill. The bill, with most of its provisions taking effect in 2002, reauthorized programs for six years and includes loan rates, target prices, and direct payments for covered commodities. The lowered the payment limit on direct payments, loan deficiency payments, and marketing loan gains.
The 2002 U.S. farm bill has been widely criticised for increasing subsidies by up to 60%, which will further competing agricultural producers in other countries, hence a distortion to trade.
7.2 New Zealand farm Policy
The New Zealand farming sector specialises in export production. In the 1970s, the farm sector was heavily protected by price supports
However since 1984, subsidy programmes for agriculture were discontinued or phased out as part of a general reform programme for the economy. The government have removed policies resulting to excess agricultural production and trade distortions. According to a report by the OECD, the level of producer support is the lowest across OECD members, domestic and border prices are aligned, and payments are only provided for pest control or relief against climate disasters.
The Reform policy affected farmers as they were dependent on subsidies, they however survived the subsidy cuts by slashing their own spending, purchasing only essentials, implementing more efficient methods and diversification. Without subsidies, they began to operate on the basis of market demand. New Zealand’s Agriculture is a market driven export-oriented sector, and trade policy is continuing to press strongly for more open global agricultural markets, while domestic policy efforts continue to address environmental and food safety issues.
7.3 Australia farm Policy
In Australia, as in most nations, the agricultural sector was regulated intensely. But since the early 1980s, Australia championed agricultural trade liberalisation by deregulating the sector. This was partly because Australia took a leading global role in promoting the issue of agricultural trade liberalisation during the Uruguay Round of the GATT.
Australia’s reforms were introduced in the early 1980s and were implemented over a longer period of time than in New Zealand. Overall, significant progress has been made since 1986-88 in removing policies creating agricultural production and trade distortions. The level of producer support remains very low and domestic producer and world prices are broadly aligned. Deregulation of the dairy industry has increased the economic efficiency of the sector and lowered consumer retail milk prices.
Like New Zealand’s farmers, Australia’s farmers survived reforms through diversification. The market encouraged Australian farmers to diversify according to their comparative advantage, not to produce according to the receipt of a government subsidy. They expanded beyond wheat, beef, and wool into increased production of products and varieties more suited to Australian conditions.
Having looked at the reform of other agricultural policies, New Zealand and Australia have adopted similar approaches to their reform programme. This involves cutting agricultural policy and the liberalisation of agricultural trade which is market driven. On the other hand, the US approach is similar to the EU in reducing the level of support and introducing direct payments. Although the level of support available to farmers in the US is less than that of the EU, both policies are regarded as distortions to trade.
The European Union needs to look at the positive examples of New Zealand and Australia as models for reform; this would show its commitment to the World Trade Organisation’s proposal to eliminate trade-distorting subsidies.
8 CONCLUSION AND RECOMMENDATIONS
This project has reviewed the Common Agricultural Policy (CAP), analysed the original objectives and the context in which it was created. It also assessed how it is financed by the EU budget and its impact on it.
The way the system of the CAP operates was also reviewed. It showed how the policy began as a price support system with five major objectives; to increase agricultural productivity; increase individual earnings of people engaged in agriculture; to stabilise markets; to assure the availability of supplies; and to ensure that supplies reach the consumers at reasonable prices.
The outcome policy instruments adopted has resulted in overproduction of agricultural commodities, examples of which are the famous wine lakes and butter mountains. The surplus production affects the world market for agricultural products. This because as production of agricultural commodities increases, supply becomes greater than demand, this causes prices to drop. In a report Agra Europe stated that , ‘world wheat stocks rose by 70% in the early 1980s and, as a result, world prices fell by over 44% between 1981 and 1896’ (Agra Europe 1991, cited Patterson 1997).
This has resulted in trade disputes especially with the United States who want the EU to reduce its export subsidies and also grant access to the import of agricultural commodities.
The EU has tried to reform the CAP over the years. The various proposals and reform of the CAP was discussed in chapter 3, the policy which began as a price support system has changed to direct income support since the 2003 CAP reform. The replacement of the price support mechanism as an instrument of the CAP to direct income support payment independent of production which is subject to compliance with environmental, food safety, etc, will lead to efficient production, better exploitation of economies of scale and make the agricultural sector more competitive.
Overall, this project argues that the CAP is not an efficient method of allocation of resources and that it also leads to trade imbalances. The following recommendations should be considered in order to make the policy more efficient and reduce its distortion to trade.
To begin with, there is a need for change due to the recent EU enlargement. The Common Agricultural Policy was originally designed by the European Economic Community with six relatively similar countries. However in the course of enlargement, the number of member stated has risen to 25 with Romania and Bulgaria set to join in 2007 and a few candidates countries hoping to join the Union by 2010. The EU member countries have differences in economic structures as well as different agricultural sectors, the ‘one-size fits all’ policy would not be desirable by all member states. For example Denmark and France have a large agricultural sector and are also one the highest beneficiaries of the CAP. On the other hand countries like the UK and Germany have smaller farming sectors.
The question then is in whose favour will the policy beIs it going to be for the benefit of the powerful countriesTo start off with, the continuing conflicts between member states seem to suggest that there is no general likelihood of any substantial changes to the CAP. Germany (the largest net contributor to the EU budget) and the UK are pushing hard for reform of the CAP prior to the enlargement. France at the same time is pushing hard for the retention of the CAP in its present form.
“It is argued that the highly uneven and adverse distribution of net transfers has led to rancorous political disputes over questions of distribution. Arguments over net transfers are explicitly conducted in terms of fairness. While members countries’ preferences for what ought to be considered fair diverge, an effective requirement for consensus is that distribution of net transfers generally be perceived as just. Fairness , in this sense, is virtually an “ideology” (Weizsaecker, V. 1983; Hagedorn and Schmitt 1985 cited Runge and Witzke 1990).
It could then be argued that the CAP was more of a political act than Economic. The CAP needs to be revised taking into account the variations in the farming sector as well as the economies of member states.
Secondly, in other to make the CAP more efficient, the EU needs to significantly reduce the level of agricultural support. In a report by the OECD, ‘import tariffs, export subsidies and domestic output subsidies badly distort production, market and trade’. The report suggested that, ‘if the government break the link between support and production and establish better links between support and what they are trying to accomplish- for instance, environmental sustainability or rural community well-being, they will improve the performance of domestic policies and avoid negative impacts on world markets’ (OECD, 2006).
Lastly, the EU should also lower its import tariffs on farm products in order to improve market access. If the market for agricultural products becomes more accessible to imports, then farmers will be able to compete based on the quality of their products. This will also bring the policy in line with the WTO commitments.
Although it would be difficult for farmers to adapt to these changes, the can however manage risk by diversification or moving into different sector such as hospitality (hotels or bed and breakfast), as the demand for countryside tourism is rising.
Should the European Union commit to reducing export subsidies, domestic support and import duties on agricultural products, a significant step towards reforming the Common Agricultural Policy will be achieved.
The EU should take the lead in implementing agricultural reform. This will be politically difficult, but reforms will produce greater prosperity in the EU agricultural industry, give consumers better prices and expanded choice, and revive the European Union’s credibility in the global marketplace.
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