Counter-Cyclical Payments Under the 2002 Farm Act: Production Effects Likely to be Limited

An important issue in assessing CCPs is whether they influence production decisions of farmers, and thereby distort commodity markets. Such concerns are important for a number of reasons. First, any changes in production brought on by these payments would affect prices, domestic uses, and exports of the crops, as well as reduce overall economic efficiency in the agricultural sector by altering the use of land and other resources. Second, from a domestic policy perspective, programs that affect production and prices are also less efficient than direct transfer payments in supporting farm sector income, an important goal of agricultural programs. Third, the design and effects of agricultural programs are of interest internationally in continuing trade negotiations and under existing trade agreements of the World Trade Organization.

Economists often frame the question of potential distortionary aspects of farm programs in terms of how coupled or decoupled a program may be. Farm programs can be considered to be coupled or decoupled depending on (a) whether the program benefit depends on the level of production, and (b) whether production is affected by the program benefit. An answer of "yes" to both means the program is fully coupled, while an answer of "no" to both means the program is fully decoupled. While such a classification provides a useful frame of reference for describing different farm programs, in practice, there is a wide continuum between these end points, both in terms of program features and potential effects. Additionally, effects of specific farm programs can vary across time periods and locations, depending on factors such as market conditions and sector structure.

So where do CCPs fit compared with other farm commodity programs in the 2002 Farm Act? Marketing loans are fully coupled since they are available on all production and their link to market prices means they affect production decisions of farmers. Direct payments are mostly decoupled, since they are paid on a fixed, historically-based quantity rather than on current production and are not dependent on market prices or other factors that would affect production. Direct payments may still have some influence on production, reflecting general wealth effects, changes in risk attitudes, and providing liquidity to farmers, so these payments may not be fully decoupled.

CCPs fall in between these two programs, having some properties similar to mostly decoupled direct payments and other properties similar to fully coupled marketing loans. Like direct payments, CCPs do not depend on current production since they are paid on a fixed, historically-based quantity. However, similar to marketing loans, CCPs are linked to market prices so there may be some influence on current production decisions of farmers, which would potentially make CCPs at least partially or somewhat coupled.

Income Support Properties of CCPs

For example, the legislative definition of the CCP payment rate can be expressed for corn as follows:

CCP payment rate _corn = (Target price) _corn - [(Higher of season average price or loan rate) _corn + (Direct payment rate) _corn]

or equivalently, by rearranging terms:

CCP payment rate _corn = (Target price) _corn - (Direct payment rate) _corn - (Higher of season average price or loan rate) _corn

Corn program provisions for 2004 illustrate some properties of CCPs. Program provisions for corn include a loan rate of $1.95 a bushel, a target price of $2.63 a bushel, and a direct payment rate of $0.28 a bushel. These provisions may at first give the appearance that CCPs provide benefits for any season average price below the $2.63 target price. However, the direct payment rate of $0.28 is netted out before CCPs are made, which results in CCPs providing benefits for season average prices below $2.35 for corn, which can be referred to as the "effective target price."

With these program provisions, Figure 1 shows that no counter-cyclical payments are made for corn if the season average price is at or above the $2.35 per bushel "effective target price." CCPs increase as the season average price declines from $2.35 to the $1.95 loan rate. CCPs are then fixed and at their maximum level for season average prices at or below the $1.95 loan rate.

This dependence of CCPs on season average prices means that these payments may or may not relate directly to the market price an individual farmer receives. Further, CCPs are not affected by a farmer's current production. They are paid on a constant, pre-determined quantity for a farm, equal to 85% of a fixed acreage base times a fixed CCP payment yield. Farmers retain nearly full planting flexibility and may receive CCPs for the base acreage crop regardless of whether that crop (or any crop) is planted on those acres.

CCPs May Reduce Price-Related Revenue Risks

However, because counter-cyclical payments are linked to market prices, they may influence production decisions indirectly by reducing revenue risk associated with price variability in some situations.

Effects of CCPs are different at different levels of prices. If farmers expect prices to be below loan rates (as occurred for rice and cotton in 2002/2003), then CCPs are at their maximum levels and become more like "fixed" payments. Research has shown that fixed payments act like general income transfers to farm households and have only small effects on output (Burfisher and Hopkins, 2003, 2004). Alternatively, if price expectations are above the "effective target price," then CCPs are zero. In this situation, there is no income transfer to farmers provided by CCPs, although there would still be some protection against downward movements in prices.

For prices in the middle, (from the loan rate up to the "effective target price"), CCPs are changing and their effects may be changing as well. In this price range where CCPs vary, if the base acreage crop is planted, then changes in producer revenues due to changes in market prices are partly offset by the counter-cyclical payments, thereby reducing revenue risk associated with price variability.

There may be some potential avenues for CCPs to have production effects because of this reduction in revenue risk. Farmers' production decisions and acreage allocations are based on expected net returns, which reflect expected prices, yields, and production costs. Importantly, expected prices are part of expected net returns.

What are the price-related revenue risks underlying the production decision? If the expected corn price is $2.20 a bushel when a farmer makes production decisions, but the realized price is $2.15, then without CCPs the farmer faces the full reduction in prices (from the expectation) in the realized revenues.

With CCPs, however, the price-related revenue risk is reduced if the base acres crop is planted. The link of CCPs to market prices results in CCPs being negatively correlated, on average, with expected net returns that are used for determining supply response. If the expected price used by a farmer in determining production choices turns out to be incorrect, CCPs provide a partial offset to the change in net returns from the initial expected level. For example, if the expected corn price is $2.20 a bushel, but the realized price is $2.15, the farmer now faces only part of the reduction in prices (from the expected level) since CCPs increase and partially offset the price decline.

Potential Responses by Farmers

On the one hand, the revenue risk reduction feature of CCPs could influence farmer behavior if there is some value to the farmer of reducing the variability of expected revenues, such as for a risk-averse producer. For these producers, the revenue stabilization consideration would supplement the typical profit maximization incentive underlying planting decisions and may, in some market situations, encourage farmers to plant the program crop for which they have base acreage. If the base acreage crop is planted, the season average market price of the crop produced would be the same price used to determine the counter-cyclical payment, so the reduction in variability of total revenues due to CCPs is most direct.

On the other hand, because prices for different crops tend to move together, CCPs for one crop may provide some reduction to price-related revenue risks associated with the production of other crops. For example, the correlation between national season average prices for corn and soybeans during 1975-2003 was about 72%. This cross-commodity effect suggests that CCPs may provide a general reduction in revenue risks rather than a crop-specific effect. Net returns among alternative crops would remain the primary consideration underlying production choices. In this case, CCPs would not necessarily hold production in the base acres crop and any market distortions in the mix of crops planted due to the revenue risk reduction provided by CCPs would be minimal. Next, while a number of studies indicate that farmers are risk averse (Chavas and Holt, 1990, 1996, for example), other risk reduction instruments already exist to manage risks. Thus, with revenue risk reduction now provided by CCPs as part of farm programs, farmers may adjust their use of these other farm and nonfarm risk management strategies. Some effects may have impacts on production choices, while others may not. For example, with increased protection against risk, a farmer may switch some land to riskier crops that provide higher mean expected returns, but also higher variability of those returns. Alternatively, farmers may change the mix of other risk management tools used, such as revenue insurance, hedging, and options, without necessarily having production effects.

Additionally, a large portion of output in the U.S. agricultural sector is produced by a small share of large producers. In 1999, for example, 85 percent of the value of U.S. agricultural production was produced by 16% of farms (USDA). Evidence that risk aversion decreases as income rises (Chavas and Holt, 1990, 1996) suggests that risk aversion may also tend to decline as the size of farms increases. Thus, with larger farms that account for most production being less averse to facing risk, this lowers potential production effects of CCPs due to risk reduction. And while smaller farms may be more risk averse in their farm enterprise, off-farm income may reduce the overall level of household income risk.

Finally, to the extent that CCPs protect farmers' revenues against downward movements in prices, other farm programs may already provide some protection against price declines. For example, the commodity loan program with marketing loan provisions already provides income support to farmers that protects revenues against the risk of downside price movements below loan rates.

Conclusions

Thus, effects of counter-cyclical payments would be expected to be relatively less distortionary than coupled programs (such as marketing loans) with regard to efficiency in the marketplace in the allocation of resources. CCPs would be relatively more effective than coupled programs in terms of efficiency of domestic policy in providing support to farm income, and would be relatively less distortionary with regard to international market signals that could affect global trade.

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