McConnell Campbell R., Brue Stanley L., Barbiero Thomas P. Microeconomics. Ninth Edition

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With other products, modest price increases to cover taxes may have smaller

effects on sales. The excise taxes on gasoline, cigarettes, and alcoholic beverages pro-

vide examples—for these products few good substitutes exist to which consumers

can turn as prices rise. For these goods, the seller is better able to shift nearly all the

excise tax to consumers; prices of cigarettes have gone up nearly in lockstep with the

recent, substantial increases in excise taxes on cigarettes.

PROPERTY TAXES

Many property taxes are borne by the property owner because there is no other

party to whom they can be shifted. This is typically true for taxes on land, personal

property, and owner-occupied residences. Even when land is sold, the property tax

is not likely to be shifted. The buyer understands that future taxes will have to be

paid on it, and this expected taxation will be reﬂected in the price the buyer is will-

ing to offer for the land.

Taxes on rented and business property are a different story. Taxes on rented prop-

erty can be, and usually are, shifted wholly or in part from the owner to the tenant

by the process of boosting the rent. Business property taxes are treated as a business

cost and are taken into account in establishing product price; hence, such taxes are

ordinarily shifted to the ﬁrm’s customers.

Table 19-3 summarizes this discussion of the shifting and incidence of taxes.

The Canadian tax system has undergone two major changes within the past two

decades: (1) the 1987 Tax Reform and (2) the Goods and Services Tax (GST). Keep

in mind that we refer to the federal government only; each province also levies

taxes, some in conjunction with the federal government.

The 1987 Tax Reform

Spurred on by the tax reform in the United States that signiﬁcantly lowered mar-

ginal tax rates, the Canadian government simpliﬁed the personal income tax from

11 categories to only 3. The result was a lower marginal tax rate, which, combined

with provincial levies, had been as high as 64 percent. The tax reforms also eliminated

502 Part Four • Microeconomics of Government and Public Policy

TABLE 19-3 THE PROBABLE INCIDENCE OF TAXES

Type of tax Probable incidence

Personal income tax The household or individual on which it is levied.

Corporate income tax Some economists conclude the ﬁrm on which it is levied bears the tax;

others conclude the tax is shifted, wholly or in part, to consumers and

resource suppliers.

Sales tax Consumers who buy the taxed products.

Speciﬁc excise taxes Consumers, producers, or both, depending on elasticities of demand and

supply.

Property taxes Owners in the case of land and owner-occupied residences; tenants in the

case of rented property; consumers in the case of business property.

Recent Canadian Tax Reform

goods and

services tax

(gst)

Federal tax

that replaced the

federal sales tax in

Canada; it is 7 per-

cent on a broad

base of goods and

services (the only

exemptions are agri-

cultural and ﬁsh

products, prescrip-

tion drugs, and

medical devices);

businesses remit the

difference between

the value of their

sales and the value

of their purchases

from other ﬁrms.

<www.ctf.ca>

Canadian Tax

Foundation

tax deductions in favour of tax credits. The top federal marginal tax rate has come

down to about 45 percent.

Subsequent to these reforms the federal surtax was increased and a claw-back

provision was introduced that in effect took back part of the social insurance bene-

ﬁts, primarily employment insurance and family allowance, paid to higher income

Canadians. Both of these provisions made the income tax system more progressive.

The GST

The controversy surrounding the introduction of the GST was unprecedented.

Much of the dispute arose because of misunderstandings and a concerted and

highly publicized effort by the ofﬁcial opposition in Parliament, the Liberal Party,

to defeat the legislation.

The GST is similar to a value-added tax (VAT). It is much like a sales tax, except

that it applies only to the difference between the value of a ﬁrm’s sales and the value

of its purchases from other ﬁrms. Firms are allowed a tax credit equal to the taxes

paid on their inputs. Most European nations currrently use VATs as a source of rev-

enue (see Global Perspective 19.1).

The GST replaced the federal sales tax, which was levied primarily on manufac-

tured goods and was as high as 13 percent on some products. The GST at present

stands at 7 percent and is levied on a much broader base that includes both goods

and services. The only exemptions are agricultural and ﬁsh products, prescription

drugs, and medical devices.

An important feature of the GST is that exports are exempt since producers can

claim a credit equal to the taxes paid on the inputs used to produce the product.

Moreover, imported goods are subject to the GST, so they do not have an advantage

compared to domestically produced goods.

Reforms of 2000

In the federal government budget of February 2000, major changes to the tax sys-

tem were announced. The most important features are

● Full indexation of the personal income tax system to protect taxpayers against

automatic tax increases caused by inﬂation.

● The reduction of the middle income tax rate to 23 from 26 percent over ﬁve years.

● The reduction of the corporate income tax rate to 21 percent from 28 percent

on small business income.

● The reduction of the capital gains tax.

● The elimination of the 5 percent deﬁcit reduction surtax on middle-income

taxpayers.

The federal government claims that over ﬁve years, the year 2000 tax reforms will

save Canadians some $58 billion in taxes. These tax reforms were at least partly due

to the elimination of the budget deﬁcit in 1998 and the projection of increasing sur-

plus in the ﬁrst decade of the new millennium. But as in the case of the 1987 reforms,

some economists believe that the lower tax rates in the United States also played a

role. An ongoing debate is whether a brain drain to our neighbour to the south is

primarily due to its lower tax rates. It is difﬁcult to assess whether the assertion has

any truth to it because of the difﬁculty of determining whether those that did leave

did so because of the differential tax burden.

chapter nineteen • public choice theory and the economics of taxation 503

value added

tax (vat)

A tax

imposed on the dif-

ference between the

value of the prod-

ucts sold by a ﬁrm

and the value of the

goods purchased

from other ﬁrms

to produce the

product.

We end our discussion of government decision making by considering a question

that has an elusive answer: What is the relationship between individual freedom

and the size and power of government? We make no attempt here to answer this

question; we merely outline two opposing views.

The Conservative Position

Many conservative economists feel that, in addition to the economic costs of an

expanding public sector, there is also a cost in the form of diminished individual

freedom.

First is the “power corrupts” argument. “Freedom is a rare and delicate plant …

history conﬁrms that the great threat to freedom is the concentration of power … by

concentrating power in political hands, [government] is … a threat to freedom.”

Second, we can be selective in the market system of the private sector, using our

income to buy precisely what we choose and rejecting unwanted commodities. But,

as noted previously, in the public sector—even assuming a high level of political

democracy—conformity and coercion are inherent. If the majority decides in favour

of certain governmental actions, the minority must conform. The “use of political

channels, while inevitable, tends to strain the social cohesion essential for a stable

society.”

Because individuals through markets can render decisions selectively, the

need for conformity and coercion is lessened and the “strain” is reduced when deci-

sions are made in the marketplace. The scope of government should be strictly limited.

Finally, centralization of the power and activities of government into bigger gov-

ernment eliminates at least one check on government.

The Liberal Position

Liberal economists are skeptical of the conservative position. They say the conser-

vative view is based on the fallacy of limited decisions. That is, conservatives

implicitly assume that during any particular period there is a limited, or ﬁxed, num-

ber of decisions to be made in the operation of the economy. If government makes

more of these decisions in performing its functions, the private sector of the econ-

omy will necessarily have fewer decisions left to make “freely.” Liberal economists

regard this as fallacious reasoning. By sponsoring the production of public goods,

government is extending the range of free choice by permitting society to enjoy

goods and services that would not be available without governmental provision.

We can argue that it is largely through the economic functions of government that

we have freed ourselves in some measure from ignorance, unemployment, poverty,

disease, crime, discrimination, and other ills. In providing most public goods, gov-

ernment does not typically undertake production itself but, rather, purchases those

goods through private enterprise. When the federal government decides to build an

interprovincial highway, private concerns are given the responsibility of making

many speciﬁc decisions and choices in connection with carrying out this decision.

A leading economist has summarized the liberal view in these words:

Trafﬁc lights coerce me and limit my freedom. Yet in the midst of a trafﬁc jam on

the unopen road, was I really “free” before there were lights? And has the alge-

504 Part Four • Microeconomics of Government and Public Policy

The Issue of Freedom

Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), p. 2.

Ibid., p. 23.

fallacy of

limited

decisions

The false notion

that there are a

limited number of

economic decisions

to be made so that,

if government

makes more deci-

sions, there will be

fewer private deci-

sions to render.

braic total of freedom, for me or the representative motorist or the group as a

whole, been increased or decreased by the introduction of well-engineered stop

lights? Stop lights, you know, are also go lights.… When we introduce the trafﬁc

light, we have, although the arch individualist may not like the new order, by

cooperation and coercion created … greater freedom.

chapter nineteen • public choice theory and the economics of taxation 505

Paul A. Samuelson, “Personal Freedoms and Economic Freedoms in the Mixed Economy,” in

Earl F. Cheit (ed.), The Business Establishment (New York: John Wiley & Sons, 1964), p. 219.

A single rate of tax on Albertan’s

personal incomes would be pro-

gressive, fair, and a beneﬁt to al-

most every taxpayer. Last week,

the Alberta Income Tax Review

Committee recommended pre-

cisely such an idea to the provin-

cial government. Unfortunately,

some politicians and pundits re-

acted with outright hostility as if

the committee suggested club-

bing baby seals instead of low-

ering taxes.

Here is what they recom-

mended: that Albertans stop cal-

culating provincial income tax

as a percentage of federal tax.

Right now, Albertans tally up

their federal taxes and then take

44 percent of that amount (plus

surtaxes) to come up with their

provincial taxes. The report rec-

ommended Albertans calculate

their personal income taxes

based on taxable income—all

deductions and credits will still

be there—and a single tax rate

of 11 percent.

Why should this change

matter? Because the committee

also proposed a provincial basic

personal exemption of $11,620

(compared to the federal credit

of $6456/$6956—the latter for

low-income earners) and—hold

your breath—indexing it for in-

flation. If successfully imple-

mented, 78,000 low-income Al-

bertans will no longer pay

provincial income tax. And when

indexed for inﬂation, provincial

taxpayers will be protected

against “bracket creep” taxa-

tion. Hell will ﬁrst need to freeze

before Ottawa indexes federal

tax brackets for inﬂation. And as

it will need to snow in Hades be-

fore the federal exemption is

raised to a decent level, it is

worth the change to get the ball

rolling on these two concerns.

So what’s the problem?

Plenty, according to those who

argue the tax system should pe-

nalize productivity and wealth

creation through steeply higher

tax rates according to income.

They may not object to a gener-

ous basic personal exemption,

but they claim a single rate of 11

percent amounts to a ﬂat tax

where the rich would pay the

same rate of tax as the poor. A

single rate, some say, is not

“progressive.”

Nonsense. Because of the

$11,620 exemption, higher in-

comes would still pay a greater

percentage of their total income

in provincial taxes. Earn $10,000

and you pay zero in provincial

income taxes, whereas a $30,000

wage earner would pay 6.7

percent. Earn $60,000 and the

province’s take would be 8.9 per-

cent of your total income. (Don’t

panic if that looks like you would

pay more. None of those ﬁgures

include the effect of tax credits.)

Tax rates would still be pro-

gressive but not as harshly steep

as now.

Some claim a single tax rate

would hurt middle income earn-

ers. Poppycock. A revenue neu-

tral change to the tax system

would make some people pay

more if others are to pay less. To

avoid that, the committee had

to propose tax relief for almost

everyone. (OK—a single grocery

clerk making $30,000 a year will

pay an extra 36 bucks if this

ALMOST EVERYONE WINS WITH

A SINGLE RATE OF TAXATION

In an opinion piece in the Calgary Herald, Mark Milke,

director of the Canadian Taxpayers Federation,

extols the merits of the ﬂat tax.

506 Part Four • Microeconomics of Government and Public Policy

proposal goes through, but he or

she will appreciate the sacriﬁce.)

As an income group, those

under $30,000 will see 34 per-

cent of the proposed tax reduc-

tion. Those earning over $100,000

will get 29 percent of the cut. The

middle-income crowd will gar-

ner 37 percent of the proposed

tax relief. (Note to critics: that’s

the largest share.) One can jiggle

those ﬁgures around to argue

that some middle-income group

will see less of the cut than some

high-income group, but so

what? Regardless, the proposals

will shrink the individual bill for

just about everyone.

This is a problem?

Can Alberta Treasury afford

the $500 million tax cut? Yes.

And they owe it to us. This year,

the province will collect $4.2 bil-

lion in personal income tax in

1998–99. That’s $1 billion more

than three years ago. This year’s

total personal tax take also in-

cludes $350 million from the

high-income surtax and ﬂat tax

imposed in the 1980s to ﬁght a

deficit that disappeared five

years ago. Keep in mind that

part of the boom in personal in-

come tax revenues results from

bracket creep taxation. And need

we address the Canada Pension

Plan increases, which Alberta

agreed to and will take $320 mil-

lion more out of Albertan’s pock-

ets in 1999 than in 1998? On a

personal level, the CPP hikes will

cost a $35,800 salary an extra

$700 a year by 2003 when com-

pared with 1996. Both levels of

government should compensate

Canadians for that tax hike.

Despite this year’s small

provincial tax reduction, taxes

are still historically high in Al-

berta. Fifteen years ago, the

provincial income tax rate was

38.5 percent with no surtaxes on

top. Are critics of tax relief say-

ing Alberta cannot live with tax

rates closer to where they were

during the Lougheed era?

Of course, the province could

cut taxes without changing how

we calculate them. But de-link-

ing provincial taxes from Ottawa

means provincial taxes would no

longer be automatically raised

by federal bracket creep. And a

single rate would preserve pro-

gressivity in the tax system, but

without destroying the incen-

tives to work, save and invest, as

is currently the case under the

steeply progressive and punitive

Ottawa-linked rates.

There is nothing radical about

a single rate of taxation. Five

American states have a single

rate. Another nine have no state

income tax whatsoever. As for

the “ﬂat” tax idea—it does exist

in Hong Kong, where the effec-

tive tax rate is 15 percent and

includes a generous basic per-

sonal exemption and charitable

deductions, which of course,

means it is still progressive.

Most important of all, if Alberta

implements a single rate and

combines it with overall lower

taxes, it will pressure the other

provinces and Ottawa to get

their high tax rates down. That

will promote saving, spending

and investing, which will in turn

have a positive effect upon job

creation.

Source: Calgary Herald Editorials,

November 4, 1998. Reproduced with

the permission of Mark Milke,

Alberta Director for the Canadian

Taxpayers Federation.

chapter summary

1. Majority voting creates a possibility of (a)

an underallocation or an overallocation of

resources to a particular public good and

(b) inconsistent voting outcomes. The median-

voter model predicts that, under majority

rule, the person holding the middle position

on an issue will determine the outcome of an

election involving that issue.

2. Public choice theorists cite reasons why gov-

ernment might be inefﬁcient in providing

public goods and services: (a) There are

strong reasons for politicians to support spe-

cial-interest legislation; (b) Politicians may

be biased in favour of programs with imme-

diate and clear-cut beneﬁts and difﬁcult-to-

identify costs and against programs with

chapter nineteen • public choice theory and the economics of taxation 507

study questions

immediate and easily identiﬁed costs and

vague or deferred beneﬁts; (c) Citizens as

voters and governmental representatives

face limited and bundled choices as to pub-

lic goods and services, whereas consumers

in the private sector can be highly selective

in their choices; (d) Government bureaucra-

cies have less incentive to operate efﬁciently

than do private businesses.

3. The beneﬁts-received principle of taxation

states that those who receive the beneﬁts of

goods and services provided by government

should pay the taxes required to ﬁnance

them. The ability-to-pay principle states that

those who have greater income should be

taxed more, absolutely and relatively, than

those who have less income.

4. The federal personal income tax is progres-

sive. The ﬂat rate corporate income tax is

regressive. General sales, excise, and prop-

erty taxes are regressive.

5. Excise taxes affect supply and, therefore,

equilibrium price and quantity. The more

inelastic the demand for a product, the

greater is the portion of an excise tax that is

shifted to consumers. The greater the inelas-

ticity of supply, the larger the portion of the

tax that is borne by the seller.

6. Taxation involves the loss of some output

whose marginal beneﬁt exceeds its marginal

cost. The more elastic the supply and de-

mand curves, the greater the efﬁciency loss

resulting from a particular tax.

7. Sales taxes normally are shifted to con-

sumers; personal income taxes are not

shifted. Speciﬁc excise taxes may or may

not be shifted to consumers, depending on

the elasticities of demand and supply. Dis-

agreement exists as to whether corporate

income taxes are shifted. Property taxes on

owner-occupied property are borne by the

owner; those on rental property are borne

by tenants.

8. The 1987 federal tax reform simpliﬁed in-

come taxes and lowered the marginal tax

rate. The 2000 federal tax reform lowered

the personal income tax rate for middle-

income Canadians.

9. The GST is similar to a value added tax. It is

an improvement over the federal sales tax it

replaced because it introduces fewer distor-

tions, exports are exempt, and imports com-

pete on equal footing with domestic goods.

10. Conservatives believe that individual free-

dom shrinks as government grows in size or

power; liberals believe it does not.

1. Explain how afﬁrmative and negative major-

ity votes can sometimes lead to inefﬁcient

allocations of resources to public goods. Is

this problem likely to be greater under a

beneﬁts-received or under an ability-to-pay

tax system? Use the information in Figure

19-1(a) and (b) to show how society might be

better off if Adams were allowed to buy votes.

KEY QUESTION Explain the paradox

of voting through reference to the accom-

panying table, which shows the ranking of

three public goods by voters Larry, Curley,

and Moe:

Rankings

Public good Larry Curley Moe

Courthouse 2nd choice 1st choice 3rd choice

School 3rd choice 2nd choice 1st choice

Park 1st choice 3rd choice 2nd choice

terms and concepts

public choice theory, p. 484

logrolling, p. 486

paradox of voting, p. 486

median-voter model, p. 487

government failure, p. 489

special-interest effect, p. 489

rent-seeking behaviour, p. 490

beneﬁts-received principle,

p. 493

ability-to-pay principle, p. 493

progressive tax, p. 494

regressive tax, p. 494

proportional tax, p. 494

tax incidence, p. 496

efﬁciency loss of a tax, p. 499

Goods and Services Tax

(GST), p. 502

value added tax (VAT), p. 503

fallacy of limited decisions,

p. 504

508 Part Four • Microeconomics of Government and Public Policy

3. KEY QUESTION Suppose there are

only five people in a society and each

favours one of the ﬁve highway construction

options in Table 18-2 (include no highway

construction as one of the options). Explain

which of these highway options will be

selected using a majority paired-choice vote.

Will this option be the optimal size of the

project from an economic perspective?

KEY QUESTION How does the prob-

lem of limited and bundled choice in the

public sector relate to economic efﬁciency?

Why are public bureaucracies alleged to be

less efﬁcient than private enterprises?

5. Explain: “Politicians would make more ra-

tional economic decisions if they weren’t

running for re-election every few years.”

6. Distinguish between the beneﬁts-received

and the ability-to-pay principles of taxation.

Which philosophy is more evident in our

present tax structure? Justify your answer.

To which principle of taxation do you sub-

scribe? Why?

KEY QUESTION Suppose a tax is

such that an individual with an income of

$10,000 pays $2000 of tax, a person with an

income of $20,000 pays $3000 of tax, a per-

son with an income of $30,000 pays $4000 of

tax, and so forth. What is each person’s aver-

age tax rate? Is this tax regressive, propor-

tional, or progressive?

8. What is meant by a progressive tax? A re-

gressive tax? A proportional tax? Comment

on the progressivity or regressivity of each of

the following taxes, indicating your assump-

tion concerning tax incidence: (a) the federal

personal income tax, (b) a 7 percent general

sales tax, (c) a federal excise tax on automo-

bile tires, (d) a municipal property tax on real

estate, (e) the federal corporate income tax.

KEY QUESTION What is the inci-

dence of an excise tax when demand is

highly inelastic? elastic? What effect does

the elasticity of supply have on the incidence

of an excise tax? What is the efﬁciency loss

of a tax, and how does it relate to elasticity of

demand and supply?

10. Advanced analysis Suppose the equation for

the demand curve for some product X is P =

8 – .6Q and the supply curve is P = 2 + .4Q.

What are the equilibrium price and quantity?

Now suppose an excise tax is imposed on X

such that the new supply equation is P = 4 +

.4Q. How much tax revenue will this excise

tax yield the government? Graph the curves

and label the area of the graph that repre-

sents the tax collection “TC” and the area

that represents the efﬁciency loss of the tax

“EL.” Brieﬂy explain why area EL is the efﬁ-

ciency loss of the tax but TC is not.

11. (The Last Word) What are the merits of a sin-

gle rate of taxation? What is the main draw-

back of a single rate of taxation?

internet application question

1. Some economists contend that public agen-

cies generally are less efﬁcient than private

businesses. Federal Express, <www.fedex.

com>, competes directly with Canada Post,

<www.Canadapost.ca>, for delivery of ex-

press mail and packages. Assume you need

to send an express letter and a package from

your address to either Halifax or Vancouver.

Based on their interactive rate and options

calculators, which service is more competi-

tive as to price and delivery? Does a lower

rate with greater delivery options mean

greater efﬁciency? Why or why not?

IN THIS CHAPTER

OU WILL LEARN:

That in the short run

there is signiﬁcant price and

income instability in the

agricultural sector.

•

The effects of subsidies,

price supports, and price

ceilings in agriculture.

•

About recent agricultural

policy reforms in Canada.

Canadian

Agriculture:

Economics

and Policy

f you eat, you are part of agriculture! In

Canada, agriculture is economically impor-

tant for several reasons:

● Agriculture accounts for about 1.5 per-

cent of gross domestic product (GDP).

Consumers spend about 10 percent of

their personal consumption expendi-

tures on food.

● Agriculture is an industry that, in the

absence of government farm programs,

is a real-world example of the pure-

competition model (Chapter 9). The in-

dustry consists of many price-taking

firms selling virtually standardized prod-

ucts and can be understood by applying

the supply and demand tools of com-

petitive markets.

TWENTY

● Agriculture provides evidence of the intended and unintended effects of gov-

ernment policies that interfere with the forces of supply and demand.

● Farm policies are excellent illustrations of Chapter 19’s special-interest effect

and rent-seeking behaviour.

● Agriculture reﬂects the increasing globalization of markets. In recent decades

the economic ups and downs of Canadian agriculture have been closely tied to

Canadian access to world markets. Canada’s agricultural exports totalled $21.7

billion in 1999, amounting to 6.6 percent of total Canadian merchandise exports.

These realities justify a full chapter on agriculture. Speciﬁcally, we want to examine

the problems in agriculture that have resulted in government intervention, the types

and outcomes of that intervention, and recent major changes in farm policy.

Over the years, Canadian farmers have faced severely ﬂuctuating prices and peri-

odically low incomes. Agriculture has always been a risky and difﬁcult business.

There are actually two separate problems: the short-run farm problem of year-to-

year ﬂuctuations in farm prices and incomes and the long-run farm problem of the

declining agricultural industry.

Short-Run Problem: Price and Income Instability

The short-run farm problem is the result of (1) an inelastic demand for agricultural

products, combined with (2) ﬂuctuations in farm output, and (3) shifts of the

demand curve for farm products.

INELASTIC DEMAND FOR AGRICULTURAL PRODUCTS

In industrially advanced economies, the price elasticity of demand for agricultural

products is low. For farm products in the aggregate, the elasticity coefﬁcient is

between .20 and .25. These ﬁgures suggest that the prices of agricultural products

would have to fall by 40 to 50 percent for consumers to increase their purchases by

a mere 10 percent. Consumers apparently put a low value on additional farm out-

put compared with the value they put on additional units of alternative goods.

Why is this so? Recall that the basic determinant of elasticity of demand is sub-

stitutability. When the price of one product falls, the consumer tends to substitute

that product for other products whose prices have not fallen. But in relatively

wealthy societies the substitution effect for food is very modest. Although people

may eat more, they do not switch from three meals a day to, say, ﬁve or six meals a

day in response to a decline in the relative prices of farm products. Real biological

factors constrain an individual’s capacity to substitute food for other products.

The inelastic agricultural demand is also related to diminishing marginal utility.

In a high-income economy, the population is generally well fed and well clothed; it

is relatively saturated with the food and ﬁbre of agriculture. Consequently, addi-

tional farm products are subject to rapidly diminishing marginal utility. It takes very

large price cuts to induce small increases in food and ﬁbre consumption.

FLUCTUATIONS IN OUTPUT

Farm output tends to ﬂuctuate from year to year, mainly because farmers have lim-

ited control over their output. Floods, droughts, unexpected frost, insect damage,

510 Part Four • Microeconomics of Government and Public Policy

Economics of Agriculture

short-

run farm

problem

The

sharp year-to-year

changes in the

prices of agricul-

tural products and

in the incomes of

farmers.

long-

run farm

problem

The tendency for

agriculture to be a

declining industry

as technological

progress increases

supply relative to an

inelastic and slowly

increasing demand.

<www.cfa-fca.ca/

index_e.htm>

Canadian Federation

of Agriculture

and similar disasters can mean poor crops, while an excellent growing season

means large crop yields. Such natural phenomena are beyond the control of farm-

ers, yet those phenomena exert an important inﬂuence on output.

In addition to natural phenomena, the highly competitive nature of agriculture

makes it difﬁcult for farmers to control production. If the thousands of widely scat-

tered and independent producers happened to plant an unusually large or an

abnormally small portion of their land one year, an extra-large or a very small farm

output would result even if the growing season were normal.

Curve D in Figure 20-1 suggests the inelastic demand for agricultural products.

Combining that inelastic demand with the instability of farm production, we can see

why farm prices and incomes are unstable. Even if the market demand for agriculture

products remains ﬁxed at D, its price inelasticity will magnify small changes in out-

put into relatively large changes in farm prices and income. For example, suppose that

a “normal” crop of Q

results in a “normal” price of P

and a “normal” farm income

represented by the green rectangle. A very large crop or a poor crop will cause large

deviations from these normal prices and incomes because of the inelastic demand.

If a good growing season occurs, the resulting large crop of Q

will reduce farm

income to that of area 0P

. When demand is inelastic, an increase in the quantity

sold will be accompanied by a more-than-proportionate decline in price. The net

result is that total revenue, that is, total farm income, will decline disproportionately.

Similarly, a poor crop caused by, say, drought will boost total farm income to that

represented by area 0P

. A decline in output will cause a more-than-proportionate

increase in price and in income when demand is inelastic. Ironically, for farmers as a

group, a poor crop may be a blessing and a large crop a hardship. With a stable mar-

ket demand for farm products, the inelasticity of that demand will turn relatively

small changes in output into relatively larger changes in farm prices and income.

FLUCTUATIONS IN DEMAND

The third factor in the short-run instability of farm income results from shifts in the

demand curve for agricultural products. Suppose that somehow agricultural output

chapter twenty • canadian agriculture: economics and policy 511

FIGURE 20-1 THE EFFECT OF OUTPUT CHANGES ON FARM

PRICES AND INCOME

Normal farm

income

Because of the

inelasticity of demand

for farm products, a

relatively small

change in output

(from Q

to Q

or Q

)

will cause a relatively

large change in farm

prices (from P

to P

Farm income will

change from the

green area to 0P

or 0P