Agricultural Policy, Gravity, and Welfare

For most poor countries agricultural is a critical industry in that it is both an important source of income and accounts for a substantial share of household expenditures. Despite the fact that 90% of the world’s farmers live in developing countries, world agricultural markets are often shaped by the policies of a few rich countries. While it is clear that the existing system of subsidies and trade barriers has significant effects on prices of agricultural commodities there is no consensus on whether these effects have a positive or a negative impact on the poor nations.1 Such disagreements and lack of clarity about the possible effects of cuts in tariffs and trade-distorting subsidies may explain the long modalities” phase (since July 2004) for the framework agreement on agriculture reached at the Doha Round of trade negotiations.

This paper examines the impact of reductions in tariffs and subsidies on the location of production, trade flows, and prices for the world’s most important grains. Quantifying these effects enables us to estimate the welfare implications of various policy scenarios. To accomplish this goal, we build on recent developments in the gravity literature to extend the most successful empirical trade model (the gravity equation) to a full general equilibrium framework that allows us to estimate country-specific welfare effects caused by trade liberalization and removal of various direct and indirect support measures for agricultural products and to decompose the incidence of these effects on grains consumers and farmers in the world.

We improve on existing partial and conditional general equilibrium studies3 in two ways: First, we extend the standard conditional general equilibrium gravity setting, where output and expenditure shares are exogenously given, to a full general equilibrium framework. This allows us to model and quantify the effects of direct domestic farm support measures. Second, we capture the general equilibrium effects of bilateral trade policies and we decompose their incidence on consumers and producers in each country via multilateral resistance indices. The outward multilateral resistance (OMR) indices consistently aggregate the incidence of bilateral trade costs across all export markets and thus OMRs are well suited for estimating the general equilibrium effects of policy changes on producers. The inward multilateral resistance (IMR) terms are used to evaluate effects on consumers. IMRs aggregate the incidence of bilateral trade cost on consumers of each product as if they are consuming from a united world market. Decomposing the incidence of trade policies and production support on sellers and buyers at the commodity-level is particularly important in the case of agriculture, as many studies show that these effects depend crucially on the net exporter status of each country and aggregation may produce misleading results.

Our general equilibrium gravity (GEG) framework is an attractive alternative to the complex computable general equilibrium (CGE) models, because it is tractable and significantly simpler. Furthermore, we use detailed commodity-level data to estimate (rather than calibrate) the parameters needed to describe the world economy and the potential changes caused by the removal of trade barriers and farm supports. Our model will allow us to calculate the effects of the removal or modification of specific policies that are already in place, as well to simulate the impact of potential new policies. In addition, with a focus on the developing nations, we will be able to compare the effectiveness of alternative scenarios in order to identify the (combination of) policy changes that will be most beneficial for the poorest nations in the world.