Supply response to countercyclical payments and base acre updating under uncertainty: an experimental study.

The 2002 Farm Security and Rural Investment Act contains two features that added complexity to farmers' planting decisions, and may have introduced new incentives that make cropping decisions based partly on potential government payments, rather than expected market returns. These are (a) the prospect of earning countercyclical payments (CCPs) on the farmer's endowment of historically produced base crop acreage when prices of these crops fall below pre-established levels; and (b) the option for farmers to update the allocation of base crops--from which direct payments (DPs) and CCPs are made--to reflect recent (1998-2001) production history. (1)

These Farm Bill changes have positive and negative effects. For farmers, the upside is reduced uncertainty and revenue risk. Farmers' concerns over uncertain ad hoc supplemental payments (given during 1998-2001 crop years to enhance payments in the 1996 Farm Bill) are alleviated by "institutionalizing" a subsidy program of CCPs through 2007 (Westcott, Young, and Price 2002). The base acre updating option provided flexibility for farmers who wanted to change the mix and amount of the different program crops eligible for subsidies for 2002-2007. The disadvantage is that both CCP and updating can cause a farmer to plant more base crop regardless of market conditions, leading to an inefficient allocation of resources (see Orden 2002; Miller, Barnett, and Coble 2003; Westcott 2005; Young et al. 2005). Although CCPs would be made on the basis of historic, not current, planting decisions, observers recognize that risk-averse producers may face incentives to continue producing their base crops as a strategy to minimize revenue risk and variability. In this event, producers may align current plantings with their base acreage even when their price expectations indicate that higher (current year) returns could be earned by growing an alternative (nonbase) crop. (2) As for base acreage updating, farmers' current production choices may be influenced by their expectations of how each crop will be treated under future legislation. If they expect an updating option, they may plant for base to increase their expected future subsidy eligibility.

As a result, CCPs and the base acreage updating option under the 2002 Farm Act have potential supply response implications. The two open questions we address in this paper are: (a) By increasing the lower bound on income when the base crop is planted, do CCPs cause farmers to shift investment toward the base crop and blunt price signals from nonbase crops? (3) (b) Does the possibility of updating base acres cause farmers to continue or enhance their plantings of program crops in an attempt to secure future income from program payments? (4) We examine these questions by designing a lab experiment on how producers with heterogeneous risk preferences allocate resources under three cases: (a) a baseline of price uncertainty without CCPs; (b) price uncertainty with CCPs; and (c) price uncertainty with future policy uncertainty. We assess how cases (b) and (c) affect income and markets relative to the baseline.

Our results support some of the criticisms of CCPs and base acre updating. We find that with CCPs, laboratory decision makers increased their investment in the base crop relative to the baseline case. Adding updating and policy uncertainty, they continued to rely relatively more on the base crop than under a more policy-neutral environment. The implications of increased base acre plantings are several: lower potential income to producers who choose to reduce their revenue risk; decreased efficiency of crop markets due to distorted allocation decisions; depressed base crop prices, which further reduces income; and an increased likelihood of subsidy payments.

Overview of 2002 Farm Act Commodity Provisions

The 2002 Farm Act employs three primary methods to provide income support to field crop producers (principally wheat, feed grains, cotton, rice, and oilseeds): direct payments (DPs), CCPs, and marketing loans. Marketing loans and DPs were also available under the 1996 Farm Act, while the target-price system of CCPs represents the reintroduction--in modified form--of deficiency payments, which were eliminated by the 1996 Farm Act. Although this article focuses on the impact of CCPs and the base updating option, we briefly summarize the main features of each program to review the different sources of market income and program payments available to eligible farmers. We also summarize the options to establish and update base acres and yields, on which direct and CCPs are made. (5)

Direct Payments

Under this program, eligible farmers entering into an agreement with USDA receive annual fixed DPs during 2002-2007. Similar to the annual production flexibility contract (PFC) payments made under the 1996 Farm Act, DPs are based on a producer's historical production (base acres and yields) and are made (with some limitations) regardless of his or her current planting decisions or current market prices. The notable difference from the 1996 Act is that oilseed producers (e.g., soybeans, peanuts) became eligible. The payment equals a fixed payment rate for each crop multiplied by the payment acres (85 % of base) multiplied by the DP historical yield.

Countercyclical Payments

CCPs are available to producers for covered commodities with base acres whenever the effective price for that commodity is below a predetermined target price. The per-unit payment rate for CCPs equals the amount by which the target price exceeds the effective price. The effective price equals the direct payment rate plus the higher value of (a) the market price or (b) the commodity marketing loan rate. Similar to DPs, CCPs are made regardless of what crop the producer currently grows (with some limits). The amount of the CCP is equal to the payment rate for each crop multiplied by the payment acres (85 % of base) multiplied by the CCP payment yield. (6) Similar to DPs, producers do not have to grow the base crop to receive CCPs, but unlike DPs, CCPs depend on current market prices for the base crop. If the effective price is above the target price, no CCP is received on the base crop.

Marketing Assistance Loans and Loan Deficiency Payments

Nonrecourse loans with marketing loan provisions operate as they did under the 1996 Farm Act, with some revisions to loan rates, and with eligibility extended to additional commodities (peanuts, wool, mohair, honey, pulses). Farmers must produce the covered program crop to be eligible for marketing loans. When market prices are below the loan rate, producers benefit from the program in two ways. First, farmers can repay the commodity loan at a lower "loan repayment rate" that reflects market prices. The difference between the initial loan and the amount repaid is the marketing loan gain. Second, a producer can opt not to take the loan and instead receive the marketing loan benefit directly by taking the difference between the loan rate and (if lower) the loan repayment rate as a loan deficiency payment (LDP).

Base Acreage and Base Update Option

The 2002 farm legislation allows farmers who received direct (PFC) payments during 19962002 to choose between keeping their old base acreage or updating base acres to reflect average planted acres for eligible commodities during the 1998-2001 crop years. Producers select one of the two options for all covered commodities. Although base yields for DPs still reflect yields during 1981-1985, producers who update their base acres to reflect 1998-2001 plantings have the option of updating yields on which CCPs are made. CCP yields are set at the higher of (a) 93.5% of average yields on planted acres during 1998-2001, and (b) average 1998-2001 yields plus 70% of the difference between program yields for PFC payments and average 1998-2001 yields.

Experimental Design: General Structure and Specific Elements

We designed the experiment to reflect the underlying incentives of the 2002 Farm Act. In the experiment, a participant allocated his or her acres into either a base crop or a nonbase crop, or both. We mimicked current planting choices by asking subjects to allocate a fixed number of tokens (i.e., acres) to a Blue option (base crop) and a Red option (nonbase crop). (7) For example, if a subject had 100 tokens, he might allocate 40 to Blue and 60 to Red, or in some other combination totaling 100.

Each subject's task was to allocate tokens under different experimental environments defined by economic and policy circumstances. Three cases were defined: (a) the Baseline case: price uncertainty with DPs only; (b) the CCP case: the baseline plus the potential of CCPs; and (c) Policy risk case: the CCP case plus policy uncertainty. Ten rounds were used for each case, giving a total of thirty rounds. This design allowed us to compare behavior in the CCP case and the Policy risk case against the Baseline case to better understand how CCPs and policy risk (including the possibility of mandatory base updating) affect behavior. (8) Consider each case in detail.