`Market stabilization' is a declared objective of the European Community's Common Agricultural Policy (CAP), but doubt remains whether commodity prices, farm income or some third variable should be stabilized. In Discussion Paper No. 740, Research Fellow Ron Anderson notes that many farmers face significant income risk, but private markets could manage this risk in principle, so there is no general market failure to justify such a broad-based public policy of price stabilization as the CAP. Anderson constructs a dynamic, two-region model (for the EC and the rest of the world) to assess the impact on the stability of agricultural incomes, prices and expenditures of a large-scale reform of the CAP. If trade and storage patterns are determined in a competitive market, they will stabilize commodity prices when both regions employ ad valorem tariffs, but changes in storage costs have greater effects than changes in tariffs. Introducing futures contracts eliminates private risk premiums and hence reduces storage costs. This stabilizes prices considerably, but trade will have the same effect.

Suppose, however, that the EC defends a price floor with variable import levies and export subsidies while the rest of the world applies flat tariffs. Then any increases in the price floor raise EC mean prices and farm incomes and reduce price volatility but have little effect on farm income volatility, for which the CAP is an inefficient means of stabilization. But mean prices and income fall and price volatility rises in the rest of the world, so the CAP discourages private storage in the EC but encourages it elsewhere. Anderson's model predicts that the 1992 reform, which sought to set the floor at the underlying competitive levels, will raise EC producer price volatility by a factor of three, but maintaining this lower floor will not eliminate trade tensions; the rest of the world will still have a lower mean price than the EC and therefore tend to remain an exporter.

Market Stabilization and the Reform of the Common Agricultural Policy
Ronald W Anderson

Discussion Paper No. 740, November 1992 (IT)