The CAP, with its system of internal price support (IVL and export subsidies) has entailed major distortions in agricultural world markets, with massive welfare effects on other importing and exporting countries. We shall here assess these distortion, and argue that the pressure they entail on the part of major exporting countries was a fundamental force behind the 1992 MacSharry reform package.
The effects of CAP on the world market for agricultural products are harmful both when the EC continues to be a net importer and when it switches from being a importer to an exporter.
A - The EC as an importer : VIL depresses world prices
1 - Graphic representation and assumptions
· The figure represents the EU domestic market (on the left) and the world market (on the right).
· The EU is a large market, whose behaviours influence world prices. This is reflected by the fact that the EU faces an upward sloping curve of ROW supply of imports.
· For simplification purpose, in the present case whereby the EU is net importer, we assume that the Rest Of the World is net exporter. Therefore, the world price is determined by the confrontation between the EU demand and the ROW supply.
2 - World market without CAP
In a situation of free market with no governmental intervention, the world price is determined on the world market as a result of the EU demand for imports and the ROW supply of such imports. The resulting world price is Pw1.
3 - World market with CAP : implication of VIL and MIP
The CAP imposes a Minimum Import Price, which is enforced through a Variable Import Levy which systematically bridges the gap between the administratively determined MIP (Pw + VIL = Minimum Import Price)
Therefore, EU economic agents do not face the world price Pw1 any more, but a higher price : MIP.
The result is that the EU is insulated from the world market forces. It is the administrative price MIP (and not the world price Pw), which now determines the EU import demand.
[ Given the fact that the MIP has consistently been higher than Pw1, the CAP system results in a depressed EU import demand (indeed domestic producer find it more rewarding to produce, increase the domestic production, while consumers decrease their consumption because of higher prices) ]
The EU demand for imports from the rest of the world becomes exogenous from the world market. Its level is Qcap. Given the fact that the MIP is above Pw1, Qcap is lower than Q*. This exogenous and weakened level of EU import demand depresses world prices
B - EC as an exporter : export subsidies and intervention depress world price
1 - Graphic representation and assumptions
· The figure represents the EU domestic market (on the left) and the world market (on the right).
· The EU is a large market, whose behaviours influence world prices. This is reflected by the fact that the EU faces a downward sloping curve of ROW demand of exports.
· For simplification purpose, in the present case whereby the EU is net importer, we assume that the Rest Of the World is net importer. Therefore, the world price is determined by the confrontation between the EU supply and the ROW demand.
2 - World market without CAP
In a situation of free market with no governmental intervention, the world price is determined on the world market as a result of the EU supply of exports and the ROW demand for such exports. The resulting world price is Pw1.
3 - World market with CAP : implication of intervention buying and export subsidy
The CAP provides producers with a minimum guaranteed price (floor price) for which they face a flat demand curve. In the event that the stocks exceed the domestic demand, the surplus is sold on the world market at the current price.
Moreover, producers who directly sell their production on the world market are subsidised by the CAP. They receive a Variable Export Subsidy which bridges the gap between the current world price and the administrative domestic price.
Once more, the EU economic agents are insulated from the world market forces. They base their decisions only on the administrative domestic price that they get anyway for their production.
The EU supply of export becomes exogenous from the world demand. Its level is Qcap. Given the fact that the MIP is above Pw1, Qcap is lower than Q*. This exogenous and boosted level of EU export demand depresses world prices.
Critics have argued that the use of VILs is a major cause of price instability in the world markets. Indeed, both the external control devices (VILs, MIPs) and the intervention buying (along with its system of export subsidy) render world price more volatile.
A - The EU as an importer : VILs make world price less stable
1 - Graphic representation and assumptions
· We assume that the EU is the only importer on the world market.
· We assume that the EU is big enough to influence the world price
Assumes that the world supply curve undergoes a shock and shifts downwards to S'. Negative demand shock affects the market : S1 ̃ S2
2 - World market without the export subsidy scheme
Without CAP, the world price decrease form P* 1 to P* 2. Indeed, EU importers faced with a lower price, increase their imports. The EU is not insulated from the world market forces, and its demand is reactive to the world price.
3 - CAP's MIP and VIL make the EU demand curve world price- inelastic
Under the external control scheme of the CAP, the EU sets up a Minimum Import Price through a Variable Import Levy which bridges the gap between the world price and the MIP.
Therefore EU consumers are isolated from the world market. Their demand is not reactive to changes in the world price.
They demand Dpac, whatever the world price is. Qpac is completely determined by the MIP and their demand curve. The EU demand curve under a given MIP, is completely inelastic to the world price.
4 - Thus CAP makes world market less stable
The decrease in world demand does not result in a decrease on the part of EU producers (thanks to the intervention price and export compensation). This drives further down the world price to Pw3 (which is lower than Pw 2, the non intervention equilibrium world price).
Thus, the use of the VIL amplifies the fall of world price whenever a positive supply shock occurs.
B - The EU as an exporter : export subsidies make EU world price less stable
1 - Graphic representation and assumptions
· We assume that the EU is the only exporter.
· We assume that the EU is big enough to influence the world price
Assumes that the world demand curve for EU imports undergoes a shock and shifts downwards to S'. Negative demand shock affects the market : D1 ̃ D2
2 - World market without the export subsidy scheme
Without CAP, the world price decrease form Pw 1 to Pw 2. Indeed, EU producers faced with a decreased price, reduce their production, while consumers increase the domestic consumption. The EU is not insulated from the world market forces, and its supply curve is reactive to the world price.
3 - CAP export subsidies make the EU supply curve world price- inelastic
Under the export subsidy scheme of the CAP, the EU is committed to subsiding exports and bridge the gap between the administrative price and the current world price. Therefore EU producers have no incentive to reduce their production (despite the fall in world demand), as they can always sell their production on the world market and get a Variable Export Subsidy.
In other words, they produce Spac, whatever the world price is. Therefore, thanks to the CAP, the EU export supply curve is Scap, which is price inelastic.
4 - Thus CAP makes world market less stable
The decrease in world demand does not result in a decrease on the part of EU producers (thanks to the intervention price and export compensation). This drives further down the world price to Pw3 (which is lower than Pw 2, the non intervention equilibrium world price).
The CAP therefore entails a massive excess supply on the world market, which results in an even sharper decrease in the world price.
A - CAP and trade diversion
1 - Community preference
The CAP gave rise to progressive increase in trade distortion up to 1990, notably as a consequences of the principle of community preference.
From the standing point of non member exporters of (temperate zones) agricultural product, not only have they suffered a severe contraction of their EU market
2 - Accession of new MS and trade diversion
The incorporation of a new Member State invariably results in a process of trade diversion, due to 1) the Community preference principle 2) whereby the new EU member switched a significant proportion of its agricultural import from non member to Member State. This was particularly true of the accession to the EC of Eire, the UK, Spain and Portugal.
B - CAP and resource misallocation at world-wide level
1 - The agricultural strength of the EU is not based upon comparative advantage
Under the CAP the EC has changed from a net importer to a net exporter of agricultural products. This turnaround has been the outcome of massive support policies and not of any market-inspired shift in comparative advantage.
2 - The CAP squeezed more efficient producers out of the market
Export subsidies provided under the CAP enable the Community to unload much of its surplus in other countries, squeezing out more efficient producers.
C - Actual implications for non member exporters
Apart from witnessing the contraction of the EU market for their exports, exporting countries also have had to face an intensified competition in other markets from EU's subsided exports.
1 - Australia and New Zealand
Australia and New Zealand were particularly badly affected when the UK joined the EC.
2 - USA
The USA, as the word's largest agricultural exporter, suffered particularly in the early 1980s prior to the inauguration of the Uruguay round of negotiations on GATT in 1986. From 1980 to 1986, USA's agricultural exports contracted by 33 per cent (while EC's export expanded by 36 per cent).
3 - CAP and the developing world
A - The stance of the world exporting countries
1 - Pressure of the USA
Although it was at USA's insistence that agricultural policy was excluded from earlier round of GATT negotiations and agreements, it was made the centrepiece of the Uruguay round. Although agricultural was only one of fifteen negotiation heads, the USA made clear that without a satisfactory solution on agriculture, it would not sign an agreement.
2 - the Cairns Group
The USA was backed in its stance by the so-called Cairns Group of agricultural exporting countries (which includes Australia and New Zealand).
3 -USA's demands : elimination of subsidies and import barriers
At the outset, in 1987-1988, the USA demanded :
- elimination of all trade-distorting subsidies within 10 years
- elimination of all import barriers (including health and non-tariff barriers)
- a progressive phasing-out of government support
4 -USA's demands : Aggregate Measure of Support
- an aggregate measure of support (AMS) to establish initial levels of protection and to monitor progress with their elimination
The important of this condition is apparent. With such an AMS it is possible to negotiate timetables for reducing the distortion. The USA proposed a version called Producer Subsidy Equivalent (PSE).
B - The stance of the EU
1 - Support Measurement Unit versus Producer Subsidy Equivalent
From the outset the EU accepted the need for an AMS but championed its own version : the Support Measurement Unit (SMU).
2 - Refusal of the 'zero support' objective
The EU however, did not accept the objective of eliminating all agricultural support. Proposed instead a 'long term strategy of more balanced support'.
C - Three Issues in the negotiation process
1 - Tariffication : Expression of non-tariff barriers as tariff equivalents
Demand of full EU implementation of this general rule of the GATT
2 - Upper limits to VIL, as a step towards Fixed Import Levy
One aspect of EU policy which was particularly abhorrent to other exporting countries was the VIL and Export Subsidies, since they insulated the EU market from short term fluctuation in world price.
Thus, an important demand from exporting countries was the setting up of upper limits to IVL + non-tariff barriers. This placed an upper limits on protection against imports, and paved the way for fixed tariffs.
Implementation by the EU is weak. Tariffs still change.
3 - Decoupling support to farmers and supply response
As far as trade distortion is concerned, there is no cause for international dispute if a country chose to support its farmers in a way that does not cause supply to exceed competitive free trade levels.
Such payments can be said to be decoupled from supply response.
In the Academia, there has been a hunt to identify forms of support which are sufficiently decoupled.
One device which has been agreed upon by the USA, is a support payment for which farmers can qualify only by adopting certain supply-restricting measures such as setting aside (taking out of production) a proportion of previously farmed land.
̃ Direct income support, on condition of land setting aside.
D - The Blair House Accord (November 1992)
This agreement contained four critical elements to be phased into the CAP over the period 1992-1999.
1 - Commitment to tariffy
. all existing non tariff border measures, and reduce tariff levels by 36 per cent.
Community preference has been maintained (the 'special safeguard clause')
2 - Commitment to reduce internal support
by 20 per cent. It is crucial to note that new compensation payments are not counted here, since they do not affect international trade.
3 - Commitment to reduce export subsidies
. by 36 per cent.
4 -A peace clause
No trade action against each other until 2000
The Blair House accord, which formed the basis of the final GATT agreement, paved the way for the Council of Ministers to approve the MacSharry reform of the CAP in 1992, before the Uruguay round was concluded, in a way which reduced the impression that the EU had been forced into reformed by external international pressure.