The basic model
For reasons of exposition, we start with a simple model of the agricultural sector, in which we consider two factors used to produce one agricultural good Q = f (A, K). Land (A) and the composite of labour and capital (K) are combined in a constant-returns- to-scale production function. Output market clearing and input market-clearing conditions determine the output and input prices. We begin with the assumption of constant elasticities of factor supply and the elasticity of demand.
The capitalisation of agricultural support payments into land values depends largely on the land supply, input substitution elasticities, and whether subsidies are linked to land or not (for more details, see Ciaian et al., 2010). The more inelastic is land supply, the more subsidies are capitalised into land values. Everything else being equal, subsidies linked to land (area payments) are more capitalised into land values than other coupled subsidies (Floyd, 1965; Alston and James, 2002).
If land supply is fixed, then area payments are fully capitalised into land value. Coupled production subsidies are fully capitalised into land value if, additionally to zero land supply elasticity, either the supply elasticity of other inputs is perfectly elastic or if factor proportions are fixed. In other situations, the benefits from coupled subsidies are shared between land and other production factors. If demand elasticity is not perfectly elastic, then consumers also benefit from coupled subsidies. Theoretically, agricultural policy’s impact on land values may be very large (e.g. fully capturing the subsidies).
In empirical studies, the land supply elasticity is usually found to be rather low, mostly due to natural constraints. For example, based on an extensive literature review, Salhofer (2001) concludes that a plausible range of land supply elasticity for the European Union is between 0.1 and 0.4. Similarly, Abler (2001) finds a plausible range between 0.2 and 0.6 for the United States, Canada and Mexico.
Input substitution elasticities are a further crucial factor determining the distributional consequences of agricultural policies. With area payments, farms have an incentive to substitute other inputs for land, which increases land demand and leads to the capitalisation of subsidies into land values. A high elasticity of substitution between land and other inputs will induce a high impact of an area subsidy on land value, as high elasticity of substitution indicates strong substitutability between land and other farm inputs in the production process. Subsidies which are not targeted at land have the opposite effect. A high elasticity of substitution between land and other farm inputs reduces the impact of these subsidies on land value (Floyd, 1965; Gardner, 1983; Alston and James, 2002). Based on 32 studies, Salhofer (2001) reports average elasticities of substitution between land and labour of 0.5, between land and capital of 0.2, and between land and variable inputs of 1.4 for Europe. Similar values are reported in Abler (2001) for the United States and Canada.