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mote. e the price ram ring ding have' past don't That e im- mities lping essed i lifee just ;e "aa just. Lt we Zings aged Iresi- inate ated. r ~ Pair- o get look r not ke or lot of have en. record rch on p1e to EiEW. ave. 31 Excerpt from Social and Economic Issues Confronting,the'Pobacco Industry in the Seventies-- A. Frank Bordeau, Jr., and Russell H. Brannon, editors Chapter 16 IMPACT OF ELIMINATING THE TOBACCO PRICE-SUPPORT SUPPLY-CONTROL PROGRAM _.., Garnert L. Bradford and James F. Thompson * Introduction Since the inception of the 193$' Agricultural Adjustment Act, tobacco frequently has been singled out for favorable legislative treatment.' Now, in light of recent politicat winds, especially those centering around' the tobacco-health controversy, it appears that these "good times" may be nearing an end. Is it possible that the tide of public, thus legislative, opinion is feeding on anti-tobacco sentiment to the point that the price-support program is in danger of being elimi- nated? We do not propose to speculate on the politics of this possi'- bility. The fact that a possibility exists, however, makes this topic one that should be analyzed-not in its political context, but as fully as possible in the context of its expected economic impacts. Indeed, the 1970's may be a period when tobacco is singled out for unfavorable legislative treatment. Various aspects of this topic have been considered by economic researchers during the past decade.= Still it has not been analyzed as a single unit, certainly not comprehensively. It is our intent to assess the economic effects of terminating the program i.e., returning to a free market. This preliminary assessment will be limited to the two major types of tobacco, burley and flue-cured. Our analysis is more •Associate Professor of Agricultural Economics, University of Kentucky, and Piofessor of Economics, Murray State University, respectively.

conceptual than empirical im nature and we deal primarily with the agricultural sector, viz., tobacco prices and production, farmland values, and certain facets of farm structure and income. The empiricism is based largely on results from other studies. Thus, the paper is "new" to the extent that it provides a synthesis of the possible effects of this potential radical change in agricultural policy. Long-Run Price and Output Changes Estimation of the effects of any proposed policy change requires some knowledge of the free market demand and supply curves upon which the proposed change would be superimposed. The domestic market for non-processed tobacco has not been free to determine prices and quantities since the 1930's. Thus, the market has generated little in the way of data useful as a basis for supply and demand estimates. Our only recourse in this situation was to reason as best we could on the basis of the bits of data which were available. Factors Affecting Supply. On the supply side, which surprisingly seems to be the easiest one, the fact that an acreage allotment has been necessary for profitable production has given rise to a market in "licenses to produce tobacco." These licenses have taken~ on value commensurate with the extent to which actual prices exceeded what free market price levels would have been, subject to the uncertainty ' Sec J. C. Williamson, Jr. and W. D. Toussaint, "Parity and Support Prices for Flue-Cure& Tobacco", Journal of'Farm Economics, 43: 1, 1961, pp. 13-26, for details on the legislative history pertaining to tobacco price-support legislation. ' Major contributions in this area are: L. M. Hartman and G. S. Tolley, Effects of Federal Acreage Controls on Costs and Techniques of Producing Flue-Cured Tobacco, Technical Bulletin No. 146, North Carolina Agricultural~ Experiment Station, Raleigh; F. H. Maier, et aL, The Sale Value of Flue-Cured' Tobacco Allotment, Tcchnical Bulletin No. 148, Southeast Land Tenure Research Commit- tee, Virginia Polytechnic Institute, Blacksburg, Virginia, 1969; J. A. Seagraves, "Capitalized Values of Tobacco Allotments and the Rate of Return to Allotment Owners" American Journal of Agricultural Economics, 51:2, 1969, pp. 320-335;, V. N. Grise, et al:, An Analysis of the Effect of Selected Economic Variables on the Optimum Location of Burley Tobacco Production Within the Burley Belt, Research Report 8, Department of Agricultural Economics, University of Ken- tucky; D. M. Shuffett and Josiah Hoskins, "Capitalization of Burley Tobacco Allotment Rights into Farmland Values", American Journal of Agricultural Economics, 51(2), 1969, pp. 471-474, and; R. Charles Brooks and J. C. William- son Jr., Flue•Cured Tobacco Programs, 1933-1958, A. E. Information Series No. 66, Department of Agricultural Economics, N.C. State University. ~.

quires upon mestic prices ittle in s. Our n the ces for *26, IOI ion. jects of e-Cured erimenU obacco ommit- graves, otment 20.335; bles on !ey Belt: of Ken- Tobacco icultural Wiliiam- :ries No. 33' attached to the continued value of such licenses.3 This value, in general, has been capitalized into the value of farmland. The market price of tobacco minus the per pound cost of the license provides an estimate of the short-run supply price of tobacco given current conditions, viz., current technology, current prices of variable inputs, current quantities of fixed inputs, and current levels of yield and price uncertainty. In recent years allotments have been at least partially separated from land and'made negotiable with the result that their values are now somewhat explicit.4 Attempts have been made in both the burley and flue-cured areas to estimate the value of an~ acre of allotment by using regression models to relate the value of a farm to the size of the acreage allotment and other quantifiable factors which clearly affect land values.s Certain other factors, mainly site value, were held! approxi- mately constant by the method of choosing the farms to be included in the analysis. Also, since flue-cured allotments can be leased, there is now a separate market for them. The resulting lease rates are another indication of the value of the licenses. Still another indication is afforded by subtracting production costs from the market value of production, the difference being an "abnormal profit" or the maximum amount one could profitably pay for a license. Either the lease rate or the profit per acre can be capitalize& and compared with~ allotment values estimated! by regression methods. Discount rates needed to equate the two are quite high. Perhaps farmers •who buy land with~ allotment attached use a relatively high discount rate, in anticipation that the program could be discontinued with result- ing capital losses. By means of these high discount rates, farmers are in effect carrying,their own insurance against program discontinuance. In the flue-cured production areas, lease rates average around 15 3Scagraves rendered a penetrating analysis of how capitalized value have changed over time and the manner in which such changes are related to the uncertainty factor. This is discussed in more detail by Bordeaux and Hourigan in Chapter 15 of this book. See Seagraves, op.cit„pp. 320-335. 4 In the case of burley prior to 1971 it was necessary to lease an entire farm to obtain the off-site use of the allotment. However, a common practicc was to lease small or unproductive farms, use the burley allotment and leave the remainder of the farm idle. In these cases, the lease rate for the entire farm was essentially a rate for the allotment. Another practice was to cash rent the allotment in place;;in this case the rental rate included the land and sometimes barn space and sticks. sSee Shuffett and Hoskins, op.cit., and Maier, et al:, op.cit.

34 cents per pound of tobacco and in the burley areas around 20 cents.6 Since average market prices for both tobaccos are in the range of 70 to 75 cents per pound, this suggests that the short-run supply prices for current quantities of both are in the neighborhood of 50 to 55 cents per pound. This price, coupled with aggregate controlled production, is a point on the short-run supply curve for tobacco-the particular curve being the one resulting from current levels of technology, factor supply relationships, and uncertainty. Diminishing returns to fixed inputs renders this curve less elastic than the corresponding long-run supply curve with all inputs variable. The "most fixed" inputs are barn space, some equipment, and resident labor. The short-run supply price will be lower than the long-run supply price when output levels are low and there is excess capacity in the fixed inputs, especially since the opportunity costs of these inputs are probably quite low. The short-run supply price will be above the long-run price at high output levels, when the fixed inputs are being used intensively and additional output is more difficult to attain. Casual observation indicates that there is little in the way of excess capacity with the exception of~some resident labor on farms with small allot- ments. Thus, a price in the 50 to 55 cent range is probably not far below the long-run supply price. It might, in fact, be taken as a lower limit for the long-run, free market supply price for the current levels of output. Returning to a free market would probably increase the degree of price uncertainty and further increase the free market supply price since farmers will require some payment for bearing this additional uncertainty. Moreover, it appears that the long-run supply curves for both flue-cured 'and burley are very elastic. Economies or diseconomies to size of operation~do nof' appear to be significant. Nonlabor inputs are in abundant supply or can be made so at little or no increase in cost. There seems to be no reason to believe that contraction of output would result in reduced nonlabor costs or that long-run expansion of output would lead to significant increases. Thus, as far as these inputs 'There is considerable variation in the lease rate among counties for flue-cured types as shown by' Dale M. Hoover in Lease and'Transfer of Flire•Ctrred' Tobacco Marketing Quotas Anzong Farmers for the 1966 arrd 1967 Crop Year: A Prelimi- nary Report, Economic Information Report No. 6, Department' of' Economics, N.C. State University. The analysis by Shuffett and Hoskins„ "Capitalization of Burley Tobacco Allotment Rights into Pannland Values," indicates that burley lease rates wlll also vary a great deal. i :Y'. ~. .. . ~ 1 . 1 ~. ~ _. _ . . . . .. ~ 4*4•+y.1 . . ':y. .

35 cents.6 0 of 70 to rices for 55 cents ation, is ar curve r supply 0 inputs supply n space, 0 supply in the puts are ove the 0 e being . Casual apacity il allot- not far a lower evels of degree y price ditional 0 both mies to s are in cost. output sion of inputs ue-cured Tobacco Prelrini= nomics, 0 tion of burlev 1 2 0 4 a are concerned, the long•run supply curves could probably be taken as perfectly elastic. It appears, however, that the labor supply curve to the tobacco industry has a positive slope, and since labor is the most important component of total cost this would impart a positive slope to the long-run supply function. Yet, most of the tobacco areas are charac- terized by continuing migration from farms and the wage increases necessary to retaim enough labor to make sizeable expansions in tobacco production would probably be moderate. In summary, the long-run supply functions for both, burley and flue-cured tobacco could be expected to fall either within the range of 50 to 55 cents per pound or slightly higher over a wide range of produc- tion levels.' Thus, the free market price would also fall in or close to this range with the quantity of production being determined by the location of the demand curve. Factors Affecting Demand. There is no auxiliary market yielding much useful data on the demand for tcbacco. We do know, however, what the market has been taking within reeent price ranges, and that the elasticities of both domestic and foreign demand are almost certain- ly quite low. It also seems likely that lower prices should be associated with a rather low domestic demand elasticity. However. the foreign demand elasticity would probably be considerably higher at prices near those at which comparable tobacco from other countries moves in world trade. This is especially true in the case of flue-cured. Other exporting countries seemingly can come closer to duplicating the Amer- ican flue-cured' product tham in the case of burley. Besides, the world market for flue-cured is much larger than that for burley. In other words, even if the export demand elasticity for burley is considerably higher at low prices than at current prices, this elasticity would apply to a much smaller fraction of the market than in the case of flue-cured and the elasticity of total demand for burley could be expected to remain quite low. Tariffs levied on tobacco by importing countries also ten& to reduce the elasticities. Thus, for burley, one might expect that the market would absorb. an output not substantially larger than at present at a price in the 50 to 55 cent range. The quantity of flue-cured could be expected to rise significantly at these prices, but it is not possible to say by how much. °This range implicitly assumes no appreciable changes in production technology and is in terms of real (constant) dollars. It is fairly close to an estimate made by Ilartman and Tolley for nue-curedleaf alone. See Hartman and Tolley, op:cil. 4

36 K Over the years a number of technological changes in tobacco utilization have substantially reduced the tobacco requiredi for a given output of cigarettes. Perhaps the development an& use of these new techniques would not have been profitable had tobacco been priced lower. If this is the case, the long-run demand for tobacco may actually be quite elastic. Prices in the 50 to 55 cent range would make future developments of the same kind less profitable and might result in the market taking substantially larger quantities thamat current prices. Factors Affecting Supply. Some observers contend that lack of excess barn curing space and shortages of seasonal laborers should significantly suppress production increases, at least during the first year or two following program termination. This hypothesis appears reason- able for both flue-cured and burley types, but especially so for burley where the seasonal labor pool may be extremely limited and construc- tion costs of new curing,space are high.8 Obviously, there would be considerable uncertainty among producers about strategies which might be followed in disposing of leaf owned by grower cooperatives (CCC loan stocks). In general, such be supported with evidence. On the other hand, a forecast which is too general is not useful as a basis for policy. In this section we opt for something,of a "middle ground". The analysis is necessarily abstract. but some numbers are attached for illustrative (and preliminary predictive) purposes. Certainly if a reason- ably accurate forecast of-the short-to-intermediate-run price pattern could be made, problems in analyzing expected changes in resource adjustments and income distribution would be eased considerably. in the elasticities. In our opinion, any very specific forecast could not Price variability will be influenced by both supply and demand phenomena, viz., changes in~ supply and deman& magnitudes as well as Price and Output Changes in Initial Years Forecasts of free market prices for the first three to five years following program elimination are obviously hazardous in the extreme. 'Conventional-type curing facilities require a new investment of around S.60 per pound for burley and S.25 per pound for flue-cured. Many flue producers are now adding, bulk curing barns which require an initial investment of around S.50 per pound. Such nonconventionali facilities for burley are stiU in the experimental stages of development. L0 9e+:,:.,;k; • -.. .- f

bacco given new jpriced ctually future in the S. ack of should st year reason- Iburley rtstruc- iamong of leaf I, such 15.60 per lare now 50 per ~imental stocks would act as a supply-increasing, thus price•depressing factor; however, they may be disposed of in such a manner as to dampen price variability and thus tend to eliminate producers'price uncertainty. It is doubtful, though6 that producers would be able to anticipate any particular loan disposition policy, especially during the first year or two following program~ termination. Thus, loan stocks of appreciable size should serve to create price uncertainty, and consequently, decrease elasticity of supply by producers.9 Whatever the source, product price uncertainty should persuade many producers to at least defer commitments for increasing their labor resources devoted to tobacco production. It is possible, also, that the supply of seasonal labor, so necessary with present technology to harvest burley and flue-cured, is quite inelastic.' ° We do not know of any studies which have teste& this hypothesis. But, lacking any other plausible explanation, for the time being, we accept it as the most credible. In short, on the supply side, there are three major factors to be considered!: lack of excess curing space, uncertainty about disposition of government loan stocks, and an inelastic supply of seasonal labor. When combined these factors should give rise to a quite inelastic short- to-intermediate-run supply function. Moreover, these same factors should suppress any outward shifts in this supply function. Factors Affecting Demarrd. We have already discussed demand elasticity (both domestic and foreign~ for both burley and flue types). Year-to-year demand shou:d be equally as inelastic and relatively stable, if not more so, because of the unlikely possibility of sudden sharp consumer-preference changes or the sudden emergence of "good" tobacco substitutes. Demand elasticity for cigarettes is quite low and 9Currently, government loan stocks of both burley and ituecured types constitute relatively large proportions of total stocks-around 25 per cent of total burley stocks and 26 per cent of total flue-cured stocks. 10Burley producers currently are paying at least $2 per hour for seasonal harvesting labor, flue-cured farmers around S1..30 per hour. Both groups, in general, contend that any significant increase in tlris rate would attract„perhaps, only negligible increases in the offerings of labor services. The key phrase here seems to be "significant increase". Obviously, if the increase were large enough the supply function may exhibit some more elasticity, but this could be quite high-say in the range of $3 to $5 per hour, rates that manufacturing laborers in these geographic areas currently receive.

f K 38 every relevant consideration indicates that the elasticity for unpro- cessed tobacco is even lower-especially in the short run.' ~ " Jt is doubtful that low demand elasticity would contribute to year-to-year tobacco price variability nearly so much as year-to-year variability in the quality of domestic tobacco crops. We cannot docu- ment that sharp variability occurs, but the surface evidence certainly is not inconsistent with such a cont'ention.t 2 The deman& for burley (and ,most certainly for flue-cured types) is in actuality not a demand for a homogeneous product. Domestic and foreign buyers differ in their raww product needs, by tobacco grades, even though there may be a rather large degree of grade and type substitution.13 Thus, in any particular marketing season there appears to be varying degrees of how weil'that season's production fits such needs. For example, a particular crop may (as a whole) be described by buying firms as being, very desirable in some ways an& not so desirable in other ways. In any event, if the totality of a givem crop is deemed to be generally undesirable, companies appear to adopt the. strategy of deferring buying until another season and/or purchasing substitute materials including govern- ment loam stocks. The net result is the same as am intermittent shifting of the relatively inelastic demand curve. Price Patterns. Production and price could move in a modified cobweb pattern. We will assume, for simplicity, that demand sh-ifts are : minimal' or nil an& government loan stocks act as an overall price- depressing factor rather than as a supply-shifting factor. The resultant modified cobweb patrtern which contains short-run supply and deman& curves of the inelastic nature previously discussed (Figure 1). Production and price in the last year of price supports is indicated "The fact that tobacco accounts for a very small percentage of the costs of a package of cigarettes is very important. For a discussion of demand elasticities see Herbert L. Lyon and Julian L. Simon, "Price Elasticity of the Demand of Cigarettes in the United States", American Journal of Agricultural Economics. Vol. 50: 4, 1968, pp. 888-895. _ . , r. '"For example, the 1970 burley crop sold higher than most economists had expected-given the large amounts already in total supply and especially in loan stocks. One explanation for this good market was simply that' the crop was "usable" by tobacco companies. P "Thcse rules are dictated by differing blends in cigarettes and other tobacco products. Public observers, in general„have only limited knowledge about these btend6. 11 b) h) o1 to OI pr a fo Pt p1 P3 Q2

39 by OQo and OPo, respectively. Subsequent production decisions are hypothesized to adhere to a classic cobweb pattern, with the exception of year tr when the barn space and labor constraints are hypothesize& to dampen the cobweb response and limit production to, say OQ, -thus, price would be OPI. In- year t2, with~ the influence of a previous year's good price, production should increase substantially to OQ2 and price would drop sharply to OPz. This, presumably, would' force some producers to (temporarily at least) cease production and Price p0 p1 p3 P2 I -------1- -------~--1- ~ 1~ ~------- T -LtJ~' Qo Q1Q3 Q2 Quantit)' Figure 1. Hypothetical Supply and Demand Curves

others to heavily'curtail it. Thus, in year t3, productiom would be less, OQ3, and price would increase to OP3.' ° Any effort to assign numbers to the prices and production levels in Figure 1 is obviously open, to criticism. However, the following suggested patterm may shed some light on the type of price variability which would be associated with such a model for burley leaf: Production Demand Price Arc Demand Elasticity (mil. lbs.) (cents per lb. Qo = 530 Po = 70 .70 Q, = 610 Pt = 59 .28 Q2 = 740 P2 = 43 .27 Q3 = 650 P3 = 52 Disposition of Government Loan Stocks. In thee above example, units) exceeds supply elasticity, and such would seem to be feasible in the length stable cobweb pattern, of course, occurs only when demand elasticity (in absolute which is consistent with our earlier discussion under the long-run section. The I ' Note that this analysis eventually leads to a reasonably stable equilibrium price other reason, to dispose of considerable portions of existing loan stocks losses it might become necessary, because of the tobacco's age or some lessened by a loan stock disposition policy designed to minimize CCC (OP3) which, in year t2, would give rise to somewhat more production and a somewhat lower price, etc. Even though price variability could be OQ3) by disposal of some loan stocks. This would lead to a lower price altered by such a policy. In year ti, OQt could be increased (to, say, Consider how' the analysis accompanying Figµre 1 could be loan-stocks-pricing policy designed to minimize CCC losses. alter the basic cobweb pattern of Figure 1. One might still expect considerable price variability, but variability could be reduced by a program termination. Such a disposition policy would not substantively selling of sizeable amounts of leaf during years immediately following losses on these loan stocks, and this might be accomplished by selective Presumably the grower cooperatives would prefer to minimize higher prices in years when free market production is lower. woul& be much less harmful (thus much more politically feasible) at prices are lowered. This suggests that disposition of CCC' loan stocks lower demand elasticities are associated with lower prices and this is consistent with what we might expect. That is, tobacco dealers and manufacturers would expand purchases less than proportionately as of run we have described. i I