SUPPLY RESPONSE WITHIN THE FARMING SYSTEM CONTEXT PRICE AND NON-PRICE FACTORS AND AGRICULTURAL SUPPLY RESPONSE

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1 SUPPLY RESPONSE WITHIN THE FARMING SYSTEM CONTEXT WEEK 1: DAY 1 PRICE AND NON-PRICE FACTORS AND AGRICULTURAL SUPPLY RESPONSE by Bruno Henry de Frahan, Catholic University of Louvain CONTENTS 1. THE DIFFERENCE BETWEEN AGGREGATE AND INDIVIDUAL COMMODITY SUPPLY RESPONSES 2. AN ANALYTICAL FRAMEWORK TO IDENTIFY DETERMINANTS OF AGGREGATE AGRICULTURAL SUPPLY 3. THE EMPIRICAL EVIDENCE 3.1. The responsiveness of public programmes and private services to agro-climatic potential 3.2. On-farm responses to public programmes 3.3. Short- and long-run supply responses to prices 4. THE IMPACT OF STRUCTURAL ADJUSTMENT ON AGRICULTURAL SUPPLY RESPONSE REFERENCES LIST OF TABLES Table 1. Principal policies used for structural adjustment LIST OF FIGURES Figure 1. Determinants of Agricultural Supply 1

2 This module is about the role of price and non-price factors and the impact of policy reforms on agricultural supply response. The first section of the module introduces the farm household concept commonly used in development literature (Benoit-Cattin), which places emphasis on the analysis of farm households' attitudes towards risk and uncertainty (Kanafani). This first section also presents an analytical framework to identify the different price and non-price factors that influence first aggregate agricultural supply (Henry de Frahan) and second individual commodity supply (Kjeldsen-Kragh). The second section examines non-price factors that may influence agricultural supply: natural resource constraints (Ruben), property rights distribution (Degand), credit access (Heidhues and Schrieder), input and output market performances (Tollens) and policy (Henry de Frahan). The third section outlines different quantitative methods commonly used to assess supply response, such as time series analysis (Thirtle and Townsend), duality theory (Thirtle and Khatri), econometrics (Upton) and mathematical programming (Benoit-Cattin), and concludes with a review of empirical studies (Tollens). The fourth section presents and discusses case studies from Cameroon (Kamajou, Heidhues and Fadani), Senegal (Benoit-Cattin), Zimbabwe (Thirtle, Townsend and Kharti), Ghana (Fosu) and Morocco (Akesbi) that empirically illustrate the impact of policy on agricultural supply response. The last part concludes with policy and research implications (Kamajou). As an introduction to the topics presented and discussed in this module, this chapter is organised into four sections. The first section examines an important difference between aggregate and individual commodity supply responses. This is particularly important since in assessing policy reforms we are specifically interested in the aggregate supply response while textbooks and available empirical studies measure more frequently individual commodity supply responses. The second section suggests an analytical framework borrowed from Binswanger (1994) that is useful in identifying determinants of aggregate agricultural supply. The third section uses empirical studies reported in Binswanger (1994) that reveal the critical links among determinants of aggregate agricultural supply. The last section puts the analysis of agricultural response in the context of structural adjustment programmes with a strong agricultural component, using policy categories from Norton (1992). This introductory chapter has been kept short to leave time for students to raise questions and issues that they would like to study as well as to allow the time for students to read the first chapters. It is strongly recommended that chapters be read in advance of lectures. 1. THE DIFFERENCE BETWEEN AGGREGATE AND INDIVIDUAL COMMODITY SUPPLY RESPONSES It is the supply response of broad agricultural aggregates rather than of specific commodities that is of interest when analysing the supply response to macroeconomic and agricultural policy reforms, since these reforms have a significant impact on the entire economy. One of the most important results of these reforms is the improvement of terms of trade in favour of agricultural commodities (Binswanger 1994). The supply response literature, however, has mainly focused on the short- and long-run supply response of individual commodities to changes in relative output and input prices for example while little empirical work has been done on the short- and long-term response of aggregate agricultural output, such as agricultural exports or domestic food production, to these changes. Similarly, the response of individual commodities to farm subsidies and taxes, research, extension, road infrastructure and marketing and credit services has been widely studied but not the response of aggregate output to these factors. Yet adjustment policies often require large cuts in public 2

3 expenditures, which may affect the supply of public services such as research, extension, credit or infrastructure. The impact of these changes on aggregate output is, therefore, of major importance. The analytical framework from Binswanger (1994) outlined below identifies how this impact can be measured. The response of an individual crop to, for example, price changes differs fundamentally from the overall response of the agricultural sector. Individual crop production can increase by taking resources (e.g., land, labour, fertiliser, irrigation water) previously used in other crop production, leaving total agricultural output unchanged. Aggregate agricultural production can increase only if more resources are devoted to agriculture or if technical change is introduced. The difference between individual commodity and aggregate supply responses will be again emphasised by Kjeldsen-Kragh in week 1, day AN ANALYTICAL FRAMEWORK TO IDENTIFY DETERMINANTS OF AGGREGATE AGRICULTURAL SUPPLY The analytical framework in Figure 1 classifies the determinants of aggregate agricultural output into four categories (Binswanger 1994): 1. Factors exogenous to the country or the decision process, including the agroclimatic environment, external opportunities and shocks (e.g., world prices), technology and population Public programmes, including sectoral interventions, and policies affecting macroeconomic variables, which depend to some extent on exogenous factors (links 2, 3, 4 and 6). 3. Responses of the private agro-service sector to exogenous factors, public programmes and policies (links 2, 3, 5 and 6). 4. The on-farm response, in terms of investment, technology adoption and migration, with respect to the three previous categories of determinants. On-farm responses associated with the agroclimatic potential are in turn transformed into output via the production function (link 1). The main focus is not on the structural parameters of the production function (link 1) for policy analysis, but rather on the effects of public programmes (e.g., public investments in roads, irrigation, research, extension, land tenure) and policy (e.g., price and trade policy) on private off-farm and farm response and, consequently, on aggregate agricultural output (links 5, 6 7 and 8). Estimations of input demand, investment, adoption and supply functions are therefore the relevant measures to carry out. Note that on-farm responses may depend either directly or indirectly on public programmes. 2 For example, a better road infrastructure increases farm profits and reduces the costs of consumer goods directly (link 5) but also indirectly via improved agro-services (link 8). 3 It is important, therefore, that the total effect 1 Following the induced innovation paradigm, technological options can be seen as being endogeneised in the long run. Family planning policy can also have an impact on demography. 2 This also applies to policies 3 A total effect combining direct and indirect effects can be regarded as a move on and a shift of the supply curve. 3

4 of infrastructure on on-farm responses should combine the direct and indirect effects. Note also that on-farm responses to public programmes may depend on agroclimatic conditions, world prices and technology availability, factors which, in turn, may have influenced the decision to implement these programmes. This complicates the correct estimation of the onfarm effects of public programmes. Panel data combining cross-section with time-series data may be used to overcome these problems (Binswanger 1994). A distinction between short and long run aggregate output responses to price, for example, must also be made. While the short-run price response only captures the direct price effect on output via changes in variable input use (link 1), the long-run price response captures the total price effect which includes the direct price effects on factor use, adoption and investment (link 7), as well as the indirect price effects (link 6). Issues concerning aggregation and time frame will be covered in more detail by Kjeldsen- Kragh in week 1, day 4 and by Tollens in week 3, day 4, while methodological issues will be addressed by Thirtle and Townsend in week 2, day 5 and by Thirtle and Khatri in week 3, day 1. 4

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6 3. THE EMPIRICAL EVIDENCE 3.1. The responsiveness of public programmes and private services to agroclimatic potential (link 2) As many empirical studies show, farmers, governments and service providers strongly respond to agroclimatic variables. Farmers invest more heavily where agroclimatic conditions are less risky (see Kanafani in week 1, day 2) and more suitable, while farm workers migrate to higher potential agricultural areas. Public infrastructure and services are also targeted to the more favourable agroclimatic areas. Private providers of services, such as input suppliers and bankers, respond to the better business opportunities associated with better agroclimatic conditions and infrastructure. Ignoring agroclimatic conditions can be costly, as shown by the failure of many development projects targeted at arid and semi-arid areas (Binswanger 1994). The constraints posed by natural resource endowment and management on agricultural supply response will be specifically covered by Ruben in week 1, day 5 and by Degand in week 2, day On-farm responses to public programmes (link 5) As shown by empirical studies using panel data reported in Binswanger (1994), the effects of infrastructure (e.g., roads and irrigation), services (e.g., banking and extension) and human capital (e.g., education, adult literacy and health) on aggregate agricultural output (including fertiliser demand and draft power investment) can be important, even more greater than the effects of prices. Constraints in input and product markets will be covered in more detail by Tollens in week 2, day On-farm responses to public research and extension (link 5) There is no doubt that in stimulating technical change, agricultural research and extension have a positive impact on factor productivity and agricultural output. The long-run increase in world agricultural production associated with the secular decline in agricultural commodity prices mainly results from a decline in agricultural production costs, which occurs primarily with technical change. Empirical studies reported in Binswanger (1994) actually show a positive impact of public research and extension on aggregate agricultural output. This aggregate impact is, however, lower than the impact on individual commodities. As a commodity's technology changes, its profitability increases and its production may expand at the expense of other commodities whose relative profitability has declined. The aggregate response to research and extension is smaller than the response of individual commodities to research and extension. On-farm responses to public programmes will be covered in more detail by Henry de Frahan in week 2, day 4. This topic will be examined in the context of policy and institutional reforms On-farm response to credit access (link 8) 6

7 As with agricultural research and extension, investment is a major source of agricultural growth. Credit supply is influenced by public policies and programmes such as regulation, interest rate policy and the Central Bank's allocation of reserves to agricultural credit institutions. To what extent does credit supply facilitate private investment and influence aggregate agricultural growth? The results of an empirical study reported in Binswanger (1994) indicate that co-operative credit, commercial credit and overall rural credit expansion increase aggregate output, fertiliser use and investment in equipment and livestock but reduce agricultural employment in India. 4 The study concludes that the main impact on agriculture of credit expansion is a substitution of capital for labour rather than an increase in aggregate agricultural output. The development of rural financial markets and their impact will be covered in more detail by Heidhues and Schrieder in week 2, day Short- and long-run supply responses to prices (links 6 and 7) Empirical studies reported in Binswanger (1994) show that, across developing and developed countries, the short-run (one year) price elasticity of aggregate agricultural supply is very low even if the short-run price elasticity of individual commodities is fairly high. The short-run price elasticity of aggregate agricultural supply in sub-saharan African countries is no lower than in other areas. As expected, long-run price elasticities tend to be higher than short-run price elasticities. Short-run price elasticities of aggregate agricultural supply are low because most factors of agricultural production are fixed in the short term. Land, capital and labour account for 70 to 85% of the cost of agricultural production. More of these resources must be devoted to agriculture in order to obtain a large aggregate agricultural response. This is difficult in the short term considering the relative fixity of these resources. In the short-run, land availability cannot be altered without considerable investment; supplies of capital cannot increase rapidly; labour availability cannot change without population growth or migration among sectors or regions. Variable inputs, such as fertilisers and pesticides, are the only factors whose quantities can be quickly adjusted to changing incentives, but they account for less than 15 to 30% of the cost of agricultural production (Binswanger 1994). In contrast to the short-run aggregate supply response of agriculture to price changes, the long-run aggregate supply response is large. It ultimately is a result of an expansion of labour and capital following private decisions to migrate, invest and adopt technology. It is well documented that the speed of intersectoral labour migration depends on intersectoral income differences, which are a function of aggregate agricultural prices. Similarly, the intersectoral capital allocation between agriculture and non-agricultural sectors depends on the intersectoral differences in the returns to investment, which in turn depend on not only the relative differences in sectoral prices but also the relative differences in sectoral efficiency gains from technical change. The long-run aggregate supply response depends also on the time frame, since the translation of capital and labour (re)allocation into output growth takes time. The speed of resource transfer across sectors appears to be more a reflection of the specific characteristics of factor supply than an adjustment in response to price or non-price 4 It is, however, argued that the net effect on rural employment must be positive since the estimates show positive elasticities of rural wage with respect to credit. 7

8 changes. This observation is often overlooked in policy discussions (Coeymans and Mundlak 1992 cited in Binswanger 1994). Short- and long-run supply responses to prices will be further explored by Kjeldsen-Kragh in week 1, day 4, Thirtle and Townsend in week 2, day 5 and Tollens in week 3, day AGRICULTURAL RESPONSES TO STRUCTURAL ADJUSTMENT The agricultural sector has figured prominently in the structural adjustment programmes of many countries not only because of its dominant share in most developing economies but also because of extensive government interventions in the sector. These interventions have in many instances resulted in large transfers of resources out of the agricultural sector and slow economic growth. The major policy components of structural adjustment that affect agricultural response must be identified to understand the multiple consequences of the elimination of government interventions on agricultural response,. These policies are integrated into the analytical framework presented in Figure 1. 5 Most of the policies implemented to carry out structural adjustment programmes have both a macroeconomic and a sectoral expression (Norton 1992). For example, pricing policy at the macroeconomic level is primarily exchange rate policy and wage policy. At the level of the agricultural sector, pricing policy includes an array of specific measures such as administered input and output prices, agricultural import tariffs, rural wages and interest rates on agricultural credit. Following Norton (1992), the policies that make up structural adjustment programmes can be grouped into seven categories (Table 1): pricing policy, fiscal policy, monetary and financial policy, trade policy, institutional measures, land policy, 6 studies to define future policies. Some specific measures may be placed in more than one category: interest rates and tariffs fall under both pricing policy and trade policy. Likewise, pricing decisions imposed on state agro-industrial enterprises fall under both pricing policy and fiscal policy, since such decisions define the implicit taxation of these enterprises. Table 1 lists seven policy categories and gives examples of their expression at the macro-economic and sectoral level. According to Norton (1992), the most commonly used structural adjustment policy measures that affect the agricultural sector are: raising real producer prices of agricultural products, reducing subsidies on inputs (e.g., fertiliser), irrigation and credit, 5 Norton (1992, pp 33-43) presents more formal analytical frameworks to describe the main types of responses in the agricultural sector, with a particular emphasis on the adjustment policies that deal with trade and foreign exchange rates. 6 Because of its important role in agricultural development, land policy is included in the list. 8

9 reducing the operating costs of parastatal enterprises or divesting them, implementing programmes such as land surveys, land titling, and public land sales to small farmers. International and domestic trade liberalisation measures have become an important component of more recent structural adjustment programmes affecting the agricultural sector. To what extent should trade policy as well as exchange rate policy determine domestic agricultural price levels is, however, still debated in many developing countries. At the same time, there is an increasing recognition of the need for well-designed targeted food subsidies to assist lower income groups who experience significant decreases in their economic welfare as a consequence of the new pricing policy.. Norton (1992) cites many conflicts and trade-offs among various policies. Trade liberalisation may facilitate a more efficient allocation of resources across sectors in the long run, but in the short run it may aggravate the imbalance of payments. Other trade-offs include devaluation versus a reduction in inflation, credit contraction versus output expansion and tariff reductions versus trade deficit reductions. Because these trade-offs are so important, the design of structural adjustment programmes should be based on a careful analysis of the multiple consequences of each policy instrument as well as a well-articulated structure of priorities.. Tollens in week 3, day 4 shows the impact of structural adjustment programmes on the shortand long-run agricultural supply responses of agricultural exports, aggregate output and domestic food production and discusses the agricultural aspects of the trade-offs mentioned above. 9

10 Table 1. Principal policies used for structural adjustment Type of Policy Macroeconomic Instruments 1. Pricing Policy Tariffs and quotas (foreign exchange rationing or trade liberalisation) Export subsidies 2. Fiscal Policy Expenditure reduction Tax changes Tariffs Subsidy changes 3. Monetary Policy Money supply targets Interest rates Credit allocation 4. Trade Policy Exchange rate Wage policy Interest rates 5. Institutional Reform Monetary management rules Management of parastatals Divestiture of public enterprises Improving capabilities of ministry staffs Education and training programs Other regulatory measures 6. Land Policy Cadastral surveys Land taxes Zoning Agricultural Instruments Administered output prices a Implicit tariffs on government imported goods Rural wage policy Irrigation fees Other administered input prices Agricultural interest rates Current expenditure reduction Public investment reduction Increased taxes and fees Agricultural tariffs Changes in subsidies Limits (upper and lower) on agricultural credit availability Agricultural interest rates Tariffs and quotas (foreign exchange rationing or trade liberalisation) Export subsidies Marketing board reform Divestiture Improvement of grading standards Plants and animal hygiene regulations Upgrading ministry staffs Improved agricultural research Agricultural education Improved parastatal management and cooperative management Formation of water user s groups Cadastral surveys Land taxes Leasing policy on public lands Sale policy on public lands Land titling Consolidation of scattered parcels 7. Studies for Future Policy Various studies Various studies a Includes consumer subsidies resulting from price policy 10

11 Source: Norton,

12 REFERENCES Binswanger, Hans P. (1994). Determinants of Agricultural Supply and Adjustment Policies. In Franz Heidhues and Béatrice Knerr (eds.), Food and Agricultural Policies under Structural Adjustment. Frankfurt am Main: Lang, Coeymans, Juan Eduardo and Mundak, Yair. (1992). Sectoral Growth in Chile: Research Report Manuscript. Washington, D.C.: International Food Policy Research Institute. Norton, Roger D. (1991). Agricultural issues in structural adjustment programmes. FAO Economic and Social Development Paper No 66. Rome: FAO. by Bruno Henry de Frahan Research Unit of Agricultural Economics Catholic University of Louvain Place Croix du Sud, 2/15 B-1348 Louvain-la-Neuve Belgium 12