A threshold price is also set. This applies to imports of food entering the EU and ensures that the price of imports is equal to or greater than the target price. Since the world prices of foodstuffs tend to be lower than those in the EU, this means a levy is placed on imports equal to the difference between world prices threshold prices. The system works as a form of protection for EU farmers.
If world prices are below the intervention prices, then farmers will clearly prefer to sell to the EU authorities rather than export their products. In this case, farmers are encouraged to export their surpluses. However, if there is a shortage of foodstuffs in the EU it can be relieved by reducing the threshold price and by reducing subsides on exports.
The CAP covers a whole range of agricultural products, ranging from milk to beef and through to cereals. Although there are slight differences in the various policies for different goods, essentially the basic theory behind the intervention is the same.
An example I will now discuss is intervention in the cereal market.
The above diagram shows the mechanism of the CAP and its effect on both price and output. The cereals market will face a downward sloping domestic demand curve and an upward sloping supply curve. The market clearing point within the EU is at position E where the demand and supply are equal. We assume that the world price for the cereal, Pw, is below the equilibrium position and that the world supply is perfectly elastic. This results in the world market being able to supply food into Europe at a constant price Pw. The Commission now decides to set the price level of the product in Europe at price Pt, which is the target price. The target price is lower than the current equilibrium level. As the price rises, producers expand their supply of cereals, whereas consumers’ demand decrease. The result is in an excess supply of Q1-Q2.
In order to sustain this price level the Commission has to counter two problems. Firstly it has to ensure that the market mechanism does not reduce the price back to the market clearing level of E, and secondly, it has to prevent imports entering Europe at the world price of Pw, thereby undercutting European producers. The price level is sustained by the agencies across Europe purchasing the excess supply and storing it as a Buffer Stock, and placed the levy on imports, to increase the price, and consequently decrease the demand for imports.
CAP proved to be far more favourable to farmers than to consumers. The farming community in the EU became very good at influencing their individual governments to vote for high intervention prices at the annual price fixing negotiations. Consumers lost out in two ways. First, they had to pay directly for food, which was much higher in price, than it would otherwise have been if it had been bought on world markets. Second, as taxpayers they had to pay for the heavy costs of running the CAP.
In theory, he CAP should have been fairly inexpensive to run. If there was a glut of produce on the market in one season, the EU would buy some of it at the intervention price and store it. The next season, when there was perhaps a shortage, the EU could take the produce out of storage and sell it. Prices would not fluctuate by as much as under a market system and the sale of produce would ensure that the major cost of the system would be administration and storage.
In practice the cost of CAP rose year after year. This was due to the CAP agencies buying more than they were selling. The CAP resulted in considerable excess of many agricultural products. The longer-term effects on supply magnify the problem. As producers are now faced with a guaranteed demand for their products, there is every incentive to produce more. This is exactly what happened in Europe during the 1970s and 1980s. Producers began to increase their levels of production of agricultural products, which led to the accumulation of large surpluses of certain farm products. These surpluses are expensive to store and export, and if they are sold abroad at relatively low prices, they tend to lower world prices and hence reduce the incomes of producers in other countries. The problem with the EU system of guaranteed prices for agricultural products is that it makes farmers incomes dependent upon their outputs.
Increasing output provides problems not only in regards to the surpluses but also to the environment. As land is a fixed factor, the only way in which increasing output was achievable was by increasing yields. Therefore the CAP, encouraged the use of intensive crop and livestock production technique, which resulted in the removal of hedgerows, walls and ditches, and also the use of agri-chemicals. This resulted in several consequences:
- Firstly there is a dynamic effect. With an increased need to have higher yields, farmers use increasing amounts of chemicals. This is turn, encourages the chemical manufacturers to increase new and more sophisticated chemicals, which increase yield even further. This is shown in the diagram below. Increased yield results in increase of supply, from Q2 to Q3.
- The significant amounts of excess supply require large-scale interventionist purchasing by EU agencies in order to maintain the price at the target price. During the 1970s and 1980s this placed considerable financial burden on the EU budget. By 1980 the CAP was consuming 70% of the budget despite agriculture being only a small sector in the combined European economies.
- The guaranteed buying programmes caused large stockpiles of products to build up, for example the grain ‘mountains’. The EU found it increasingly difficult to dispose of these surpluses. To try to help the problem, the Commission began to encourage European producers to export their agricultural products. To encourage this, producers were subsidised for each unit they exported, of value of the difference between the world prices and the EU prices.
- These export subsides not only added to the cost burden of the CAP to the European taxpayer, but also damaged third world agricultural producers. This is because the EU had now adapted a policy of ‘dumping’ agricultural products on foreign markets. This reduced competition and undercut local producers.
- The increased intensification of farming techniques has led to a physical change in the landscape. Soil erosion increased and many habitats were destroyed. Also the increase in chemicals used to increase yields, as side effects on both humans and animals, through the food chain.
In addition to these concerns the CAP has had criticism that the system provides price support rather than income support. This means that huge landowners, who produce large volumes of produce, receive the most from CAP. Whereas, the smaller hill farmers who need the financial help more, receive very little.
In 1968, there was a huge need for reform of the CAP. They attempted to reform it by introducing the Mansholt Plan, which recommended that farm size should increase to enable farmers to enjoy the economies of scale and thus be better able to provide food at world market prices. However, there was political opposition of the plan and so it was never passed.
In 1981 the Commission announced its next set of reforms. The aim of these reforms was to reduce the level of production by cutting prices of agricultural products, gradually. However, once again, the reforms were not fully implemented and so achieved little success.
By 1985, spending on CAP was threatening to exceed the maximum amount permitted in the EU budget. At a summit meeting, later that year, the first measures to resist the CAP problem were announced. In particular a quota system for milk was imposed. Each farm in the EU was given a milk quota based on existing production levels minus a given percentage to reduce the milk surplus, which had developed. This is demonstrated in the diagram below. A quota at output level Q2 restricts the supply of milk. This reduces the excess supply from a level of Q3 – Q1 to a smaller level of Q2-Q1, therefore reducing the expenditure under CAP.
The financial crisis worsened despite this and in 1987 Cap was forced to transfer some spending over into 1988 because it had run out of money in its budget. This led to the member countries agreeing to an increase in spending on CAP. In 1980s there was a general agreement that the CAP should be reformed further. The reforms since 1985 have tended to tackle the outcomes rather than the root cause of the problem. The root cause of the problem was that agricultural prices had been set too high in relation to the world price. Too high prices encourage farmers to produce too much and discourage consumption. Surpluses have to be disposed of, sometimes onto world markets at knock down prices, which angers farmers in other countries who complain on ‘unfair competition’. The reforms have concentrated on restricting supply rather than reducing prices. This had consequently not been successful.
The MacSharry reforms aimed to lower agricultural prices to levels, which were more in line with world prices. This was one of the only reforms, which had proved successful. This was hopefully the end to large surpluses.
