trade compromises between the european community and the united states: an interest group-game...

Trade Compromises between the European Community and the United States: An Interest Group-Game Theory Approach

Martin Johnson, Economic Research Service,

Louis Mahe, Ecole Nationale Supkrieure Aqronomique de Rennes, France, and

Terry Roe, University of Minnesota

The role of special interests in the prolonged U.S. and European Community negotiations of agricultural policies under GATT are measured by an estimated political payoff function (PPFL The analysis searches for mutually acceptable agmments between the United States and the Eumpean Community using a world trade model coupled with game theory. Results suggest that it is in the best interest of the United States (resp. EC) for the EC (resp. US) to liberalize while the other follows the status quo. Mutual gains in PPF values to both counties are unlikely to exist without altering each country’s action space. Permitting compensatory payments to the most influential groups yields liberalization. but free trade does not result.

The difficulty in the Urt~gtmy Round of negotiating an agreement to liberalize trade in agricultural products suggests that more than economic efficiency motivates government behavior. In spite of the stalling of negotiations in December 1990, the willingness of most governments to pursue further negotiations on liberalized trade in agricultural products suggests their beliefs that they could be better off

Address correspondence to T. Roe, Economic Dex-elopntcnt Center, Uni~ersi~ of Minnesota.

19% Buford Avenue. St. Paul. Mh’.

Johnson is an Economist with the Apicuhure and Trade Analysis Division of the Economic Research Service. Mahe is Chair of the Department of Economic and Social Science. Ecole Nationale Supkieure Apnomique de Rennes. Fiance. Rm is Professor of Agricultural ad Applied Economics. University of Minnesota. This research was supported by the Agriculture

and Trade Analysis Division of the Economic Research Ser\;ice thrvugh a Cooperative .Q-eement and by the Center for International Food and Agricdural Policy. The views and opinions expressed herein are solely thox of the authors.

Received February 1992; final draft accepted August 1992.

Journal of Policy Modeling 15(2):199-222 (1993) Q Society for Policy Modeling. I*3

199 016!-893%93/s6.00

200 M. Johnson, L. Mahe. and T. Roe

through cooperation. This paper focuses on these issues. A partial equilibrium world trade model based on 1986 trade data, a commonly used reference pair._ for negotiations, is used to estimate a noncooperative agricultural policy game between the United States and the European Community. The game quantifies agriculture’s special status in the United States and the European Community by measuring how agricultural policies affect agricultural interest groups, producers, consumers, and taxpayers. Simulations focus on the negotiating positions of the United States and the European Community in the Uruguay Round to search for mutually acceptable trade agreements.

There are two principal findings. It will most likely be difficult to attain major trade liberalization without some form of decoupled payments. Decoupled payments allow both the United States and the European Community to liberalize, because liberalization leads to political and net social gains, regardless of the policies of the other, but free trade does not. Without decoupled payments, any politically acceptable liberalization is likely to be small.

Many authors summarize the motives behind agricultural policy through the welfare of producers, consumers and through policy costs. Gardner (1987) models the objective of agricultural policy as the maximization of producer welfare subject to government budget and consumer welfare constraints. Rausser and Freebairn ( 1974), Riethmueller and Roe (1986), and Oehmke and Yao (1990) model the objective of agricultural policies as the unconstrained maximization of a social welfare function of producer welfare, consumer welfare, and govem- ment budget. This paper adopts the latter approach and, for the re- mainder of the paper, refers to the social welfare function as a political payoff function (PPF).

Extending the idea of rational government behavior, Karp and McCalla ( 1983), Sarris and Freebairn ( 1983), Paarlberg and Abbot ( 1986), Tyers ( 1986), and more recently Harrison et al. ( 1989) have modeled the strategic interaction of governments in agricultural trade. Like Karp and McCalla and Sarris and Freebaim, the solution to the game is a Nash equilibrium. In contrast to Paarlberg and Abbot and Tyers, governments’ beliefs about their influence on world prices are consistent with and implied by world market clearing conditions. Har- rison et a!. use a generdl t,;uilibrium, global trade model developed by Whalley (1985, 1986) to search for a Nash equilibrium and for the possibility of a treaty that would leave both the United States and the European Community better off. Their payoffs are money metric meas- ures of utility change from a base period as opposed to the political payoff function employed here. Their aggregation of agricultural pol-

TRADE COMPROMISES BETWEEN THE EC AND THE U.S. 201

icies precludes the analysis of protection and support of individual commodities, which differ widely across commodities. Our approach approximates the actual policy instruments manipulated by the two governments, thereby measuring the instruments’ effects on commodity specific interest groups more closely. Still, the results share the feature that free trade is not in the interests of both countries and that dominant strategies exist.

1. THEORY

Throughout the following it should be understood that all vectors are row vectors unless stated and the country subscript is suppressed except when needed. For simplicity, exchange rates are subsumed in the notation.

l.A. An N Commodity: A Three-Country Trade Model

The framework underlying the empirical analysis can be character- ized as as follows. Two large countries and the rest of the world (an aggregation of many small countries) produce, consume, and trade N commodities. Aggregate production, consumption, and trade in large country i is summarized by vectors of supply, demand, and excess demand.

Farms in large country i produce some subset of the N traded commodities, taking prices, technology, and endowments as given, to maximize profit. Aggregate supply is

Y(P,;Z,) = (Y,(P,;Z,), . . . . Y,(P,;Z,)). (1)

where P’ = (P,, . . . ,P,) is the vector of the farm prices of the N traded commodities, and ZJ is a vector of exogenous factors, such as prices of inputs and factor endowments. Demand for the N agricultural commodities is summarized by the vector of demand functions

X(P,;Z,) = (X,(P,;Z,), . . . . XJP,Z))

and the corresponding indirect utility function by

W

U(P,.;Z, 1. (2b)

where P,. = (P,.,, Pc.2, Pc.3, . . . , Pc.N), the vector of consumer prices for the N commodities, and Z,. is a vector of exogenous variables. If the rzlh good is not a final good (e.g., animal feed), then the nrh element in Equation 2 is zero and aX,IaP,.,, = 0 for all k.

Trade in the N commodities is summarized through excess demand


E(P,.P, ;z,.z, 1 = xv, ;z, 1 -- Y(P,Z,). 13)

The generic element of E is E,,. Commodity n is exported or imported as E,, is negative or positive.

Governments intervene in their domestic markets through price instruments and demand/supply shift instruments. Price instruments. denoted A$, for producers (f) and A::,, for consumers (c) of commodity II. indirectly or directly affect the farm and consumer prices of the N commodities. Letting P,,.,, be the world price of commodity II. the following domestic price functions are defined

P,” = P,,(A~,.P,,.,L and P,,, = P,,,(AI:,.P ,,,, 1. 11 = I. . . . . N. (4)

Some examples: If the government sets the domestic price, then A,,, = Pjn forj = f, c, and world price is a trivial argument of the function. If no action is taken; then domestic price equals world price. If an crd vulorem tariff is used, then domestic price is a function of the world price and the tariff: A$, = A:!,, = Arp and ye = P ,.,, = ( 1 + Af:)P ,,.,,.

Shift instruments, AT,, and A:.,,, shift supp!y and demand functions by altering other aspects of the decision problems of producers and consumers (e.g., input subsidies, acreage-reduction schemes. food stamps). They are implicit elements of the vectors of exogenous variables Z, and Z,.. To make their existence explicit, make the following partitions: ZY = (Ai& and Z,. = (A.l.,z,.), where A,; and A;\ are the analogous row vectors.

The supply ( I ), demand (21, and excess demand (3) equations can be expressed as ftinctions of policy instr-ument by substituting the exogenous variable partitions and domestic price functions of Equation 4 to obtain

Y(P,(A:‘,P,,),A;.i,). (I’)

XW, (AI’.P,, LA:..?, 1. and (?a’)

EV,lA:‘.P,, LP, (AI’J’,, ,.A;.A:.&.Z, ). (3’)

where P,(A,!‘,P,,.) = (qi,(A,PI,P,,.I)r . . . , P,,(&,,P,,,)), j = J1 c.

Introducing the country subscript, let the large countries be countries 1 and 2 and let the rest of the world be country 3. The vector of excess demand functions in the rest of the world is E,( P,,.;ZJ, where Z> is a vector of excess demand parameters in the rest of the world. World markets are competitive by assumption; world prices adjust to clear world markets. Hence,

EI(“JA:;. p,,).P, ,(A!‘,.P,,).A;,.A’< ,;i,,

+ EzWAV,, LP, ,(A!‘,.P,, LA;, .A:,;Z,) + E,(P,,;z,) = 0, (5)

TRADE COlvaPROMlSES BETWEEN THE EC AND THE U.S. 203

where 0 is an N by one vector of zeroes. Suppose that Equation 5 implicitly defines world prices as functions of the actions of the two governments (this is necessary for the game to be well defined). Then

p, = P,(A;a.Ai”, .A;, .A:, &.Af,. A;.A:,;i , ,&,Z,,. (6)

Sufficient conditions for Equation 6 to be well defined are straight- forward for some action spaces. For example, if governments set domestic prices. then it is sufficient that E,(P,Z,) be monotonic in P,, and take on all positive and negative values for positive P,..

LB. Political Payoff Functions

In choosing agricultural policies, governments consider the effects of their policies on the welfare of various groups, namely, producers, consumers. and taxpayers. Moreover, since agricultural policies can make some groups better off at others’ expense, governments must weigh the weff&re gains of one group against the welfare losses of others. We represent these trade-offs by a political pay& function (PPF). a weighted. additive function of commodity quasi-rents, indirect utility of consumers. and the costs of agricultural policies to tax payers. Hence. the arguments of the PPF are functions of the agricultural policies of the two governments.

To condense notation. let -i be the “other” country, iet Ai = (AB..A,.i) = (A$,Ajj&!,,A;T,). and suppress i?,, &, Z,. Producers are ag- gregated by commodity group. The welfare of each producer group is the protit obtained from the production and sale of the commodity. Therefore. assuming differentiability, the welfare associated with the production of the nth commodity is the line integral

as commodity n is a net output or net input respectively. Let

Il(P,;Z,) = (II,(P,:z,h . * . . rI,(P,;z# (7)

be the vector of quasi-rents over the N subsectors. To express commodity quasi-rents as a function of the policies of

governments. substitute for fj by using Equation 4, for ZJ by using the partition described above, and for P,,. by using Equation 6 to obtain

il,ca, A ,) = ll,(P,j(~;.P,,(~,.A ,)).A;). (7’)


Similarly, substituting into Equation 2b the domestic price function, the exogenous vectot partition, and the world price function. one ob- tains indirect utility as a composite function of the actions of the two governments:

ti,(A,.A ,) = U,(p,,(Af,.p,,(A,.A ,)).A:,). (8)

To define the budget in the N agricultural commodities, let T denote transpose. Then, aggregate consumer expenditures are P,X, producers receive P,r, and excess demand is purchased (sold) in world markets at prices P,,. for P,F. Hence, using Equations 1 and 2 and substituting for E with Equation 3, the budget is

B(P,.P, .P,;z) = (P, - P,,jW(P,Z) - (P, - P,)*r(P,;z,h (9)

Making the proper substitutions for !$ P,., P,,., and Z as before. the budget of government i becomes a function of both governments‘ agricultural policies:

&A,.A. ,) = B,(P,,(A;,P,(A,,A ,LP,,(A~,.P,,(A,.A ,hp,,(~,.A ,k~;,.A:,h (9’)

Finally, normalizing on the budget and using Equations 7’. 8, and

9’, the PPF is

V,(A,.A ,j = ii,I,(A,.A ,)*A ,; + IIJA,.A ,)A,, + &A,. A ,). (10)

where Ali is an N by one, strictly positive vector and h,.i is a positive scalar. The (&, A,,) are the political weights of the respective commodity groups and the aggregate consumer in country i.

1.C. A One-Period Policy Game between Two Governments

Equation 10 explicitly links the policies of the two governments with their objectives. What is lacking is how cit!er government chooses its agricultural policies. More precisely, how is the game between the two governments resolved, and how are production, consumption, and domestic and world prices subsequently determined‘? The following describes an equilibrium in which a government, given the policies of the other, chooses policies to maximize its PPF.

More formally, a lrest response correspondence is defined for each government. Then the equilibrium is defined using the best response correspondence. For a give41 A _,, Government i chooses AT, a best response to A ,, such that

V,(A:.A ,I 2 V,(A,.A ,I. V A, E A,. (II)

TRADE COMPROMISES RETWEEN THE EC-’ AND THE 1l.S. 205

where A, is the set of actions (policies) available to sovemment i. Thus. every A I in A , has a set of actions in 4 that satisfy Equation 1 I. The set defines the best response correspondence of A ,. It is a correspondence, not a function. b~susc a given A ._ a my have many best responses. A pair of actions (A:. A? ) is an equilibrium if A? is a best response to AT and vice verse. that is. (A:. A)) satisfies Equation 11 t-or all i.’

Consider the ditTerentiable case of the model. Difkentiating Equa- tion 11 with respect to A,, and A,,. the tirst-order neees.sary conditions for a maximum atz

An element-by-element description of Equation I2 is available from the authors.

For a given A I. if V, is concave in A,. then any A: that solves Equation 12 maximizes V,. so it is a best nzsponse to A (. Thus Equation 12 implicitly detines the best nzsplnse correspondence (of interior points) A” (A i)e AT (A ,) is single valut4. a function. if and only if Vi is strictly concave in A, for all values of A #. (A?. AQ) is a Nash equilibrium if a\’ I 4‘4 b 0 11 [I a\*, ICA~.%-\~b = c; . (12) z Furthermonz. by the b$icit Function Th~~~rn. t.AT. A$) is a locally unique Nash equilibriun~ if the Jacobians of Equation I3 ate of fuli rank.

I.D. Treaty Action Spaces

Suppose the governments of the two I~ge countries negotiate to improve their positions relative to the one-period equilibrium that they

206 M. Johnson, L. Mahe. and T. !?oe

currently pursue. If both governments are sovereign and rational as described above, then no treaty would be signed or complied that did not make both governments better off. Furthermcirc, if zovemments can delay agreement, a necessary condition for a treaty to be signed and complied with would be the existence of actions (Al, AS) such that

V,(A:,AJ) 2 V,(AF,Af) and V,(AJ. A:) 2 V,(A,*,A:). (14)

Call the set of actions that satisfy Equation 14 the treaty action space and the elements of this space treaty actions. In subsequent simulations, we search for treaty actions.

LE. Estimation of a Policy Game between the United States and the European Community

The empirical framework. is provided by the Moditle International SimplifiC de Simulation (MISS). It is similar to the model of Tyers and Anderson (1986) and of the USDA’s SWOPSIM (Roningen. 1986), except that actions of the nature mentioned above are expiicitly specified. It is a static, partial equilibrium trade model of seven commodities that is initialized to 1986 data. The model specifies production and demand elasticities for the United States, the European Commu- nity, and for the rest of the world as an aggregate. Production elasticities satisfy the profit- maximizing conditions of a firm with a multi- output production technology, and demand elasticities satisfy the implications of utility maximization. The empirical properties of the model are provided in Mahe, Tavera, and Trochet (1988) and hence are not discussed here.

The commodities modeled are wheat and coarse grains (grains), oil seed cakes (cakes), feed grain substitutes (FGS) (this includes millings and other vegetable by-products, corn gluten feed, maniac, and citrus pulp), beef, pork and poultry, milk and milk products (dairy), and sugar. The commodity groups in the PPFs are grains, oil seed cakes, beef, pork and poultry, dairy, and sugar. Feed grain substitutes are excluded because neither government directly supports its FGS’s producers.

A brief characterization of how the policies of the United States are modeled is the following: For grains, target price fixes producer price, whereas the loan rate and the Export Enhancement Program (EEP) place a wedge between consumer price and world price. The Com- modity Credit Corporation’s (CCC) support for oil seeds is modeled as a wedge between world and domestic price. Pork and poultry price follows world price; no action is taken. For sugar, domestic price is


fixed through import quotas. Dairy prices are largely determined through CCC purchases, with average consumer price slightly below average producer price. This complex program is simply modeled by fixing domestic prices. For beef, voluntary export restraints fix domestic price. Thus, there are seven relevant U.S. policy instruments (USDA, 1989).

For the the European Community a variable levy fixes consumer prices in grains, whereas the coresponsibility payment system decreases farm prices from consumer prices at the margin. For oil seed cakes and FGS, consumer price equals world price by a previous General Agreement on Tariffs and Trade (GATT) agreement that fixed the tariff at zero for most of these products. Producer price of oil seed cakes is fixed. Domestic milk and sugar prices are fixed and protected by the variable levy system with production quotas on milk and sugar production. Beef and pork and poultry are supported by the variable levy system. Hence, there are seven instruments for the European Community (Mahe and Tavera, 1988).

Assume that MISS approximates the differentiable case of Equation 12 for policy instruments. Since the number of instruments for the United States and the European Community equals the number of pohticai weights, estimates of (Aus, hEc) can be deduced from nu- merical approximations of Equation 13 derived from MISS; by con- struction, observed policies will be a Nash equilibrium for 1986. See Appendix A for a detailed exposition of the estimation procedure.

Table 1 presents the estimates of (AUS, AE’) . For a given policy instrument, the estimated weights reveal the government’s optimal income transfer among income groups. For example, sugar policy in the United States essentially trades sugar producer gain for consumer welfare loss. Taking the ratio of sugar producer weight to consumer weight, the acceptable trade at the margin is one European Currency Unit (ECU) gain in the quasi-rent of sugar producers for a 1.90-ECU loss in consumer surplus. One interpretation of the political economy behind the PPF (Olson, 1965, and Becker, 1983) is that agricultural producers band together in lobbies to achieve through agricultural policies what they could not achieve in the market.

Those adversely affected by the policies then lobby to counteract the agricultural lobby. By distorting agricultural markets, policies dis- tribute the gains from production, consumption, and trade to favor groups with greater political weights. Hence, the political weights reflect the relative political influence of interest groups in the political process.

Technical reservations must also be added: MISS is calibrated on

208 M. Johnson. L. Mahc. and T. Rw

Table 1: Policy-Goal Function Weights and Their Ranking by lntcrcst Grcwp for

the USA and the EC, (1986)*

United States European Community

Rank Weight (A”‘“) Rank Weight (A”‘)

‘Sugar

3airy

Animal feeds

Grains

Budget

Beef

Consumers

Pork and poultry

1.56 I I .s7 1.29 2 1.46 1.23 4 I .32 I.15 3 1.34 I.00 6 I .OO 0.92 4 1.32 5.87 8 0.83 0.85 7 0.95

*Estimated values of A, are based on Equation IS

observed data, whereas governments decide policies beforehand. Fur- thermore, (Aus,h”c) satisfy approximate necessary first-order conditions of differentiable functions. Voluntary farmer participation in U.S. programs and production quotas in the European Community imply globally nondifferentiable and possibly discontinuous PPFs. Therefore, 1986 policies need not be a Nash equilibrium of the estimated game. To check the model’s internal consistency, simulations were conducted to check the hypothesis that 1986 policies are best responses for the estimated 19% PPFs and therefore that they are a Nash equilibrium for the estimated game. This hypothesis was found to be robust.

Of course, internal _ consistency of the estimated model does not prove that the estimated game is the only game that has 1986 as a Nash equilibrium. First, the political weights could merely be first- order approximations of the partial derivatives of another function. Second, other weights, close to the estimated weights, may also satisfy the robustness criterion above. Third, other stylized approximations of the “true” actions of governments would imply estimated games with other political weights. Therefore, a test of the model cannot be an affirmation of its assumptions or uniqueness. Rather, a test of the model is the consistency of its predicted treaty action spaces with the proposals of the United States and the European Community at the Uruguay Round.

2. SIMULATIONS OF U.S. AND EC PROPOSALS

The simulations explore the rationale of the U.S. and the EC negotiating positions in the GATT. Simulations are conducted in the


spirit of, but not on, the U.S. and EC proposals. The analysis suggests that farm losses of the politically most influential groups in both the United States and the European Communii_v from liberalization will need to be compensated in order to achieve actions that appear both politically feasible and welfare improving.

2.A. The U.S. Proposal

The action space of the game is designed as progressive steps toward free trade by first eliminating export subsidies and then by liberalizing all but the dairy and sugar sectors. Article XVI of the GATT disallows the use of export subsidies except to relieve a temporary domestic surplus of a primary agricultural commodity (Dam, 1970). Of course this exception has been badly misused by the United States and the European Community. The (ber) simulation is designed to explore the consequences of an agreement prohibiting subsidies and restitution for exported commodities. These prohibitions remove the budget costs of producer price subsidies for an exported commodity, which then forces governments to cut producer price supports and to decrease consumer prices when they exceed world price. Sugar and beef prices in the United States and oil seed cake prices in the European Community are unchanged, because the United States and the European Community are net importers of these commodities. The partial free trade (pft) simulation is free trade for most of the crop (grains and oils seeds) and the beef sector. Dairy and sugar policies remain at the status quo, since they are viewed as being particularly resistant to change. The last simulation is free trade in all commodities.

More precisely, the possible actions simulated for the United States are:

sq: the status quo of 1986; ber: ban on producer and export subsidies; free trade in all com-

modities except beef, sugar, and dairy; self-sufficiency in dairy is followed. whereas sugar prices and beef quotas remain at the status quo;

pft: partial free trade; free trade in grains, animal feeds, beef, and pork and poultry; dairy and sugar policies remain at the status quo;

ft: free trade; free trade in all commodities.

For the European Community they are:

sq: the status quo of 1986; ber: ban on export restitution; ad valorem tariffs are used to attain


self-sufficiency tn viains, bee:‘, pork ,nd poultry, daic 1 ;nd sugar; price differeiAals,-in percent, between producers and consumers remain at the status quo; the farm price of oil seed cakes is unchanged;

pft: partial free trude; rate of protection is lowered to 20 percent ad vulorem for grain, beef, and oil seed cakes; dairy and sugar prices remain at the status quo; free trade in pork and poultry;

ft: free trade; free trade in all commodities.

Two games are presented in Table 4; the United States chooses the row, the European Community chooses the column. The economic results are summarized in Tables 2 and 3. Before discussing the game matrix of PPF values, the key economic outcomes are summarized.

ECONOMIC RESULTS. The economic results of the simulations can be only briefly summarized here. For comparable experiments, namely free trade-free trade, the results obtained from the model are similar to those obtained by the EC/US Study Group (EEC, 1988). In general, liberalization causes large increases in the world prices of grains, beef, sugar, and dairy, decreases in the prices of oil seed cakes and FGS, and smaller changes in the price of pork and poultry. Three factors drive these results: (1) crop production shifts in the United States from grains to oil seeds; (2) feed input use in the European Community moves away from oil seed cakes and FSGs to grains; and (3) lower feed input demand for beef, dairy, and pork and poultry producers in the European Community result from the contraction of the animal sector.

SUPPLY AND PRICE EFFECTS OF U.S. LIBERALIZATION WHEN THE E.C. FOLLOWS THE STATUS Quo. In the partial free trade simulation (pft), the abolition of the target price system decreases the farm price of grains in the United States with the result that resources flow into the production of soybeans and to some extent into sugar. Conse- quently, the world price of grain increases (9.1 percent), and the world prices of animal feeds and sugar decrease. Lower animal feed prices increase the production of pork and poultry and dairy in the United States, resulting in lower world prices for these commodities. The removal of beef protection in the United States increases the world price of beef (1.1 percent), but the combination of a lower domestic beef price and lower feed prices results in a negligible change in U.S. beef production.

The ber simulation departs from pft by maintaining U.S. beef pro-


Tahk 2: Eco~emic Results from Game Simulations, Percent Change in World Prices from 1986 Status Quo Base Prices

Policy options

USA: Row EC: Column w ber PR n

SQ Wheat & coarse grains

Oil cakes & veg. protein

Cereal substitutes (FGS)

Beef meats

Fork & poultry

Milk & byproducts Sugar. unrefined

ber Wheat & coarse grains Oil cakes & veg. protein Cereal substitutes (FGS)

Beef meats

Pork & poultry

Milk & byproducts

Sugar, unrefined

Pfi Wheat & coarse grains



Beef meats

Pork 1G poultry

Milk & byproducts

Sugar, unretined

Ft

Wheat & coarse grains



Beef meats

Pork & poultry

Milk & byproducts

Sugar, unrefined

0.0 51

0.0 -6.1

0.0 - 16.7

0.0 6.5

0.0 I.5

0.0 18.3

0.0 5.2

8.6 13.6

-2.1 - 8.6

-2.1 - 18.4

- 1.2 2.7

-0.7 1.0

7.4 26.6

-0.5 4.8

9.1 14.7 14.4 15.3 - 2.0 -7.5 -0.7 -6.5 - I.5 - 17.3 - 14.0 -25.8

1.1 5.3 8.8 12.9 -0.5 I.3 I.5 - 2.4 - 1.8 10.0 -3.3 40.3 -0.4 4.4 -3.6 24.5

7.1 12.5 12.4 14.4

-4.9 - 10.4 -3.9 - 8.0

- 3.4 - 19.2 - 16.3 -25.0

0.1 4.4 7.8 12.4

- 1.4 0.2 0.5 - 2.4

22.0 36.6 20. I 40.3

7.4 12.4 4.0 24.5

6.9 7.7 -0.2 -6.3

- 14.2 - 25.6 II.2 17.4

1.7 -3.2 -3.4 29.9 - 3.9 18.7

14.0 14.9 - 1.4 -6.9

- 10.7 - 25.8 8.3 12.5

- 5.8 -2.4 5.6 35.9

-3.6 17.4

FGS includes the following animal feed composites: corn gluten. maniac. citrus pulp, millings, and other

vegetable by-products.

tection while decreasing the farm and consumer price of milk until the United States is self-sufficient. The abolition of the target price system produces the same shift of crop production from grains into animal feeds and sugar as did pft, but the lower U.S. price for dairy products


depresses demand for animal feeds. Consequently, under ber, the decline in world price of animal feeds is greater, and the increase in the world grain price is less than under pft. Lower feed prices than pft means higher world production of beef and pork and poultry, thus reducing the world prices of these commodities relative to pft.

The removal of dairy supports and beef protection in the free trade simulation decreases the domestic demand for animal feeds and increases U.S. excess supply with the result that world market prices decline by about 4.9 percent and 3.4 percent for oil seed cakes and FGS, respectively. However, relative to pft this decline reduces the amount of resources transferred from grain production. Consequently, the increase in world grain prices tends to be smaller under free trade than under the previous scenarios. Lower animal feed prices increase the production of pork and poultry, thereby lowering their world price. The change in U.S. excess demand for beef is negligible because of the countervailing effects of declines in beef and feed prices.

PRODUCTION AND PRICE EFFEC’TS OF EC LIEFRALIZATION WHEN THE UNITED STATES FOLLOWS THE STATUS Quo. In the pft simulation, EC grain, beef, and oil seed cakes prices are reduced dramatically. Consequently, resources !!ow out of grain and oil seed cakes. Lower EC prices for grains lead EC beef, pork and poultry, and dairy producers to substitute grains for animal feeds. This substitution effect and the contractionary effects to beef and pork and Foultry due to liberalization decrease EC excess demand for oil seed cakes and animal feed substitutes, thereby strongly depressing the world price of FGS (14.2 percent). Thus, world grain and beef prices increase by 6.9 and 11.2 percent.

Under ber, grain and beef protection is higher than under pft. Hence, the increases in the world beef and grain prices are smaller than under pft. Imposing self-sufficiency on the EC milk and sugar sectors, the excess supply of these commodities on world markets falls, causing the world prices of these commodities to rise by 18.3 and 5.2 percent, respectively. The prices of the remaining commodities change only marginally. Together, the policies of ber cut the world prices of animal feeds more than the policies of pft and increase the world price of the other commodities.

Finally, the free trade simulation increases the world market prices of grain, sugar, beef, and dairy more than ber or the pft simulation since ft results in the largest cuts in EC subsidies of these commodities and the resuiting decline in their excess supplies. Thus the crop and input demand effects of these libcralizatitins on animal feed prices are

TRADE COMPROMISES RETWEEN THE EC AND THE U.S. 213

greatest under ft. Indeed, the world price of FGSs declines by 25.6 percent as opposed to the estimated 16.7- and !4.2-percent declines in the ber and pft simulations. The decline in the price of oil seed cakes is slightly less under free trade than under ber as the abolition of the cake subsidy in the EC offsets the liberalization of other policies.

BILATERAL LIBERALIZATION. Bilateral liberalization has mixed effects on world prices across commodities (see the diagonal of Table 2). For grains, dairy, and sugar, bilateral liberalization tends to rein- force the direction of price changes under unilateral liberalization. For instance, in the case of grains, world price increases are greater under bilateral than under unilateral liberalization. For animal feeds, beef, and pork and poultry, a distinct pattern of price changes under bilateral relative to unilateral liberalization does not emerge because the direct effects of liberalization are confounded by the indirect effects of the liberalization of other commodities.

WELFARE AND BUDGET IMPLICATIONS OF LIBERALIZATION. AS is well-known, the EC variable levy system transfers income to producers from consumers and the budget. Hence, EC liberalization tend to give rise to large consumer gains, regardless of U.S. actions. When the United States pursues the status quo, consumer gains to EC reform range from I I .4 billion ECUs for pft to 24.4 billion ECUs for free trade (Table 3). Budget savings are also large but always smaller than the consumer surplus gains. Furthermore, most EC budget savings are realized under ber since most budget outlays are from export restitutions.

In the U.S. case, most income transfers to producers occur through the budget, except for dairy and sugar policies. Hence, when the EC pursues the status quo, consumer surplus gains in the United States when it liberalizes range from only 1 billion ECUs under pft to 7.5 billion under free trade. Budget savings dominate the other gains; they range from 14.9 billion ECUs under pft to 16.5 billion under free trade. Consequently, the greatest marginal budget savings occurs from sq to pft when deficiency payments on grains and oil seed cakes are removed. Thereafter, the marginal budget savings decline.

Under ber for the European Community, sectoral quasi-rents decline significantly, ranging from 16.4 to 16.7 billion ECU; and they tend not to be sensitive to U.S. actions. From ber to ft they decline an additional I I .3 billion ECUs. rhus incremental losses are large from both liberalizations, and they tend to be spread across all sectors as well. Similarly, the decline in quasi-rents to U.S. producers of the

-

Tab

le

3:

Eco

no

mic

R

esu

lts

fro

m

Gam

e S

imu

latio

ns,

C

han

ges

in

Bu

dg

et

Sav

ing

s,

Pri

adu

cer

and

Co

nsu

mer

S

urp

lus,

an

d N

et

So

cial

Gai

n

Rel

ativ

e to

th

e 19

86

Sta

tus

Qu

o

(bill

ions

o

f E

CU

s)

Pol

icy

opti

ons

sq

her

Pft

n

US

: ro

w

EC

: co

lum

n U

SA

E

C

USA

E

C

USA

E

C

USA

E

C

q B

udge

t sa

ving

s

Frod

ucer

su

rplu

s C

onsu

mer

su

rplu

s

Soci

al

gain

ber

Bud

get

savi

ngs

hodu

cer

surp

lus

Con

sum

er

surp

lus

Soci

al

gain

P@

B

udge

t sa

ving

s

Prod

ucer

su

rplu

s

Con

sum

er

sutp

lus

Soci

al

gain

ft

Bud

get

savi

ngs

Prod

ucer

su

rplu

s

Con

sum

er

surp

lus

Soci

al

gain

0.0

0.0

1.8

8.5

2.0

4.7

2.5

11.7

0.0

0.0

- 0.

Y

- 16

.4

- <I

.Y

- 13

.0

-2.3

--

27.

7 0.

0 0.

0 -

0.6

14.2

-0

.7

11.4

0.

I

24.4

0.0

0.0

0.3

6.4

0.4

3.0

0.3

8.5

16.3

0.

3 16

.2

8.6

16.3

4.

9 16

. I

Il.7

-

16.2

0.

0 -

14.5

-

16.6

-

15.5

-

II.1

-

13.5

--

27.

I

2.4

0. I

0.

8 14

.4

+ I.

9 9.

5 -0

.3

24.3

2.5

0.4

2.3

6.6

2.8

3.3

2.3

8.9

14.9

0.

2 13

.8

8.4

14.9

4.

8 15

.4

11.6

- 14

.4

0.0

- IO

.9

- 16

.5

- II

.7

- 12

.4

- 11

.7

.- 27

.5

1.0

0. I

-2

.2

14.4

-

1.5

I I.

3 -

1.7

24.7

I.5

0.1

0.8

6.3

1.8

3.7

2.0

8.9

16.5

0.

6 15

.7

8.8

16.7

S.

Y

16.6

II

.7

-21.

0 -0

.1

- 18

.5

- 16

.7

- IX

.7

- 12

.9

- 16

.4

- 26

.7

7.5

0.3

4.4

14.7

5.

3 11

.7

2.5

23.8

3.0

0.9

2.6

,$L

*.

f-+

3.3

4.7

2.7

8.8


grain, dairy. and sugar are large, but, in this case, the declines closely corresponci to budget savings. The declines range from 14.4 billion ECUs under pft (mostly losses to grain producers) to 21 billion under free trade (mostly losses to grain, dairy, and sugar producers).

The United States and the European Community exhibit similar levels of political influence (Table 1 ), but their different instruments give rise to different PPF trade-offs from liberalization. The analysis suggests two general-though key-types of trade-offs. First, in the European Community, there is a key trade-off between consumers and producers through the variable levy system. This becomes important in Game 2 below because EC budget savings, which are vitally important to decoupling, are not sufficient to compensate completely the losers from liberalization. In the United States, the PPF trade-off tends to be between the budget and producers.

Second, a comparison of social gains under unilateral with gains under bilateral liberalization indicates that the own effects of iiberai- ization tend to r), -inate. Liberalization in the United States (resp. European Comu ,,,tity) does have incremental welfare consequences in the European Community (resp. United States) but they are always small compared to the sole effects of any EC unilateral liberalization. For example, the budget savings in the United States from ft is at least 16 billion ECUs, but the greatest change in budget savings to the United States from an EC liberalization is only 0.2 billion from sq to ber.

THE RESULTS OF THE GAME. Game I: By inspection, the status quo is the unique Nash equilibrium of game 1 (Table 4); it is a strongly dominant action for the Unites States and the European Community.. Note also that when the United States (resp. European Community) plays the status quo, it always gains irom EC (resp. United Statc:I;P liberalization2 Hence, it appears in the self-interest of each to en- courage the other to liberalize while maintaining its own status quo. Moreover, there is no mutual liberalization for which the European Community gains, but the United States gains if it pursues pft or her if the European Community pursues pft or ft. The European Com- munity would not be interested in these options, since it loses in each of these mutual liberalizations. Finally, it is irrational for the United States to propose just ft, ft because it experiences a loss.

--

‘Gains (losses) &:r to an increase (decrease) in the value of the PPF for the respective country

unless otheMse indicated.

216 M. Johnson. L. Mahe. and T. Roe

Table 4: Policy-Goal Function Values for Alternative U.S. and EC Trade

Liberalization Strategies and Decoupled Payments

us/EC* - sq

Game one: using 1986 action space

ber Pfi ft

sq 0. 0’ 412. - 1.699 637. - 235 697. - 5.407

ber -5h0. 517 - 234. - I.554 165. - 1.4% 233. -4.691 Pfl --653. 299 - 144. - 1.795 192. - l.XOS 540. - 4.94x ft - 2.075, I ,020 - 1.472. - I .433 - 1.329. - 656 -- x77. - 4.409

Game two: using decoupled payments

US/EC* w ber' pft’ ft’

sq 0. 0 412. 2.057 6.37. - 79X 697, I6

her’ 1.216. 517 2.4x4. 2.32 2.x53. 354 2.96X. 640

Pf?’ I .466. 299 I .905. I .93 I 2,071. - I68 2,606. 424

ft’ 1.559. I.020 2.099. w*__ ’ 755 - 2,400. I.334 2.600. X6X

*Set text for d~linition of actions.

‘The clcrncnts of each cell arc V”‘. V”‘

If the U.S. and EC objectives were soley to maximize net social gains, then inspection of the net social gain results reported in Table 3 reveals that ft.ft is a Nash solution when the game is based on these values alone.’ And, all action pairs are candidates for a treaty action since neither country is made worse off relative to the status quo. Consumer groups and those concerned with U.S. and EC budget transfers would tend to advocate free trade actions. However, there are numerous instances where U.S. consumers are made worse off, whereas there are no cases where EC consumers are made worse off. These results also suggest that various interest groups prefer different treaty actions. The problem faced by the political process is the relative importance to attach to these diverse groups. The PPF summarizes the resolution of the competition among these groups for political influcrrccl.

Wcse findings appear consistent with the observed attitudes of the !Z.uruQcan Community and the United States in the current GATT round of nc:fotiations. It is rational for the United States to try to force the

‘Our treatment ol actions are discrctc. Thus II is posihlc that rhc Nash solution only lies

“close” to free trade.

TRADE COMPROMISES BETWEEN THE: EC AND THE U.S. 217

European Community to liberalize agricultural trade, by, for example, blocking the negotiation on other issues, since such a course of events provides a political ant! economic gain to the United States even if it pursues the status quo. Perhaps more importantly, the European Com- munity makes policy reform feasible in the United States; the positive Vu’ values appearing in columns pft and ft of Table 4 (Game 1) suggest that the United States could now capture a political gain from policy referm that was not possible with a unilateral U.S. move alone.

These results also explain why the European Community has been consistently reluctant, first to initiate a deregulation of the common agricultural policies (CAP) unilaterally, and second, to engage into a multilateral process of liberalization. The negative PPF values for the European Community suggest that its rehtctance comes about because no political gain can be captured by rechrcing support in the context of the current policy instruments, even if the United States liberalizes. The different political trade-offs in the European Community anti the United States suggested by this ana1ysi.s appear consistent with the contrast between the passive attitude of the Community and the active and aggressive efforts of the United States to press for reform during this round of the GATT.

Game 2: The 1986 proposal of the United States at the Uruguay Negotiating Round called for free trade in agricultural products with the provision that governments could make decoupled payments as incom:: transfers to farmers (National Center, 1988). Since 1986, the United States has based payments to farmers on traditional yields and acreage, whether they plant or not, as part of the set-aside program (USDA, 1989).

Recently, the European Community has considered similar policies. For example, the EC substitution of payments per hectare for the feed grain crushing subsidy component of its oil seeds policy and the July 1991 CAP reform project put forward by the EC Commission, introduced a dramatic shift in policy instrumentation toward decoupling income support from supply behavior. The proposed reforms include payments tied to the crop area and not to yield for grains, a headage premium for beef and dairy cattle, government certificates for dairy producers, and early retirement schemes. There innovations suggest the desire of policymakers in the European Community to compensate producers for price support cuts in a manner that lessons the effects of policy to distort producer incentives.

In the spirit of these policies, Game 2 alters the action space of Game 1. Explicit transfers of the budget savings accruing from the

218 M. Johnson, L. Mahe, and T. Roe

liberalization policies simulated in Game 1 are made to con-urodity sectors as compensation for the income losses to producers associated with liberalization. The compensation rule is as follows. Complete compensation is offered to sectors with the highest political payoff weights first and then to sectors of lower weights until the budget savings are exhausted. Sectors with weights lower than one are excluded from compensation. The distributional rule maximizes the PPF, given that the total transfer is no larger than the budget savings from trade liberalization and that no one is overcompensated. As such it is a partial Pareto compensation rule.

For every U.S. liberalization and any EC policy, the U . S . budget savings are sufficient to compensate sectors with weights greater than one fully. Mowever, for no EC liberalization in Game 1 are the budget savings sufficient to compensate the losers completely regardless of the U.S. action, because, in contrast to the United States, income support in the European Community is largely from consumers. EC budgetary savings occur only on exports and cannot fully compensate farms for the lost income that was transferred from consumers through high domestic prices.

In the payoff matrix of Game 2 (Table 4), the ’ appended to an action reflects the addition of the transfer to each of Game l’s actions. Through this decoupling, only actions sq, pft’ and pft’, pft’ are not treaty actions since the European Community suffers a political loss in these cases relative to the status quo.

Although the addition of the transfer has no effect on production and consumptions decisions, hence prices, the introduction of transfer payments produces a new Nash equilibrium, and both play ber’. In fact, ber’ strongly dominates every other strategy of the United States and the European Community. It is in the best interest of each to pursue ber’ regardless of the policy choice of the other. Because the expedient political choice is still to let the consumer make an income transfer to farms through a higher domestic price, freer trade results. Free trade does not.

There is an important caveat to these inferences. The compensation rule of Game 2 assumes that $1 in a decoupled transfer has the same marginal impact on the PPF as $1 transferred through commodity policy. If decoupled transfers require more lobbying effort to sustain than do commodity transfers, perhaps because they are more visible and difficult to defend in the political arena, then the assumption is violated and larger budget transfers would likely be required to retain the status quo. The marginal impacts are also likely to bc different for the United States than for the European Community because of dif-


ferences in the source of transfer (budget relative to consumers) and political structures.

3. CONCLUSIONS

Reconciling the special status granted to agricultural policies with the GATT principles has been a major obstacle in obtaining an agreement in the Uruguay Round. To quantify this special staius and to infer likely treaty actions in the agricultural component of the current negotiations, a model is estimated that characterizes the 1986 agricultural policies of the United States and the European Community as rational outcomes of their respective political processes. The model is used to analyze the nature of EC-US agricultural interdependencies in a game framework.

An analysis based on the assumption that country negotiations are motivated by political gains as opposed to maximizing net social welfare yields results that appear mor 4 consistent with the prolonged negotiations. A decoupled transfer payment scheme where those with the greatest political influence are compensated is then evaluated to identify possible treaty actions that are both politically feasible and resource saving. The results are generally consistent with the negotiating positions of the two countries and with policy changes that have occurred in the United States and that are envisaged in the European Community.

There are three major results. Treaty actions that yield fairly large resource savings are possible, but only if the economic losses of the most political influential are compensated. Freer trade, not free trade, is the likely result. EC rebalancing of animal feed protection appears politically feasible, but the rebalancing of tariffs on oil seed cakes and feed grain substitutes are likely to yield small welfare gains.

These results provide insights into the contours of a feasible agreement in the Uruguay round. The results are consistent with the observed evolution of the U.S. negotiating position away from the free trade, USTR (1989), which the prolonged negotiations suggest is not a feasible treaty action given the existing political trade-offs. The emphasis in the negotiations on restrictions in export subsidies, and particularly on grain exports, is consistent with the Nash solution in Game 2 that mainly concerns a ban on subsidies to exported crops relative to animal products. The aggressive stance of the United States in the negotiation process in contrast to the EC passive strategy also appears consistent with the trade-offs in political gains estimated in Game 1. Liberalization of the common agricultural policy in the European Community brings

220 M. Johnson. L. Mahe. and T. Roe

political gains to the United States, whereas the converse is not true. Hence, in terms of agriculture, the European Community has less incentive to be aggressive in the negotiations.

The political feasibility of freer trade when decoupled compensatory payments are introduced also appears consistent with observed policy developments in the United States where the 1990 farm act stresses the introduction of policy instruments that remove the correspondence between these instruments and farmers’ decisions regarding crop yields and acreage. In the European Community too, the discussion of the so-called MC Sharry plan suggests that EC policymakers now realize that reform of the common agricultural policy is only feasible if some form of compensation is provided. Effectively, the MC Sharry plan seeks to attach payments to land, numbers of livestock, or to the farmer rather than to quantities of these commodities delivered to the market. Compensation of this nature is likely to play an important role in the process of policy reform if an agreement is to be found in the GATT. Nevertheless, although some progress toward freer trade in agricultural products appears likely, it does not appear that agriculture will be brought under the principles of the GATT in this round of the negotiations.

APPENDIX A

Political payoff functions are estimated for the United States and the European Community under the hypothesis that observed policies are a single-period Nash equilibrium of a noncooperative game; the United States and the European Community choose policies that maximize their PPF given the actions of the other.

The estimation procedure proceeds as follows. Bj is readily observable. Given differentiable indirect profit and utility functions, duality theory admits the inference of dIIi/dAi and dU,/dAi from observable demand and supply functions. MISS is used to obtain these estimates. Let A”’ and AEc be the instruments set by the United States and the European Community in 1986, the calibration year of MISS. The weights A”’ and A”‘, which may be consistent with the Nash equilibrium hypothesis, are estimated using approximations of the partial differentials, aH ,~ildA,,q ~311 ,,,ldA,,, d~,,,ldA,,. dl?JdA ,.,, d&IdA,,. and a&IdACi, n = 1, . . . , 7, i = us, ec, are evaluated at instrument levels A”’ and AEC. The approximation of the differentials is obtained by taking small changes in A,, and A,.i from A,, and A,.,, denoted AA,, and AA,.,, respectively, and by calculating the resulting charrges in l-1 ,,,,


uu,, and B,. denoted Ali n,, Au,,. and A@, (all other policies being held constant). Then the ratios AII ,/AJ,, AuU/&,.,. ati~bA,, AIi / M,,. u/AB ,.,. aald ~J.U,,. for II = 1. 2. . _ . , 7, and j = I, . . . , N,, i for us, ec, are formed.

Thus consider the discrete approximation of Equation 13

1 I

exists. then

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