AAMP Training Materials Module 2.2: Modeling Smallholder Commercialization Nicholas Minot (IFPRI) n.minot@ifpri.org This is the second section of the Smallholder Commercialization Unit which is part of the AAMP Training Materials. Exercises in this presentation are found in the Excel spreadsheet entitled: Module 2.2 – Modeling Smallholder Commercialization.xls

Contents Agricultural commercialization conceptual framework Agricultural household models before and after 1985 Separable vs Non-Separable household models Household modeling exercises Conclusions Resources

Agricultural Commercialization Conceptual Framework Food and cash crop production Food demand - Marketed surplus = The figure above is the simplest form of a market model: Food and Cash Crop Production - Food Demand = Marketed Surplus

Agricultural Commercialization Conceptual Framework Land Labor, mgt Inputs Weather Population Preferences Income Food and cash crop production Food demand Food prices International markets & trade Infrastructure and market efficiency - Marketed surplus = Food crop production and demand are influenced by a number of factors. Food prices influence both production and demand. Low Prices  Lower Production & Low Prices  Higher Consumption International trade affects food prices, which in turn affects production and consumption. Trade imposes a price band

Agricultural household models – Before 1985 “Separable household models” Maximize household income Allocate income among consumption goods to maximize utility “Separable” in that production decisions are not affected by consumption decisions Marketed surplus is difference between optimal quantity of production and optimal quantity of consumption They could only be equal by coincidence so this should only occur rarely Separable household models are problematic for analyzing smallholder farm household behavior. They assume that production decisions are separate from consumption decisions, but this often does not hold true since smallholders make planting decisions based on their predicted consumption needs.

Agricultural household models – Before 1985 Model doesn’t explain several important patterns Prediction of separable model Patterns in developing countries Farmers specialize in few commodities according to comparative advantage Many farms are diversified, producing many food and cash crops Farmers allocate most land to commercial crops Small share of land allocated to cash crop production Farmers either buy or sell each crop (only rarely does optimal production = optimal consumption) Many household grow and consume staple crops, without buying or selling Separable models make assumptions about smallholders that often do not hold true. It is not uncommon to find smallholders who produce a variety of crops, most of which are food crops, and they consume what they produce.

Agricultural household models – Before 1985 Attempts to explain differences between model and actual farmer behavior Food first: Farmers first produce enough food for consumption needs and only if they have extra land do they produce for the market Problem: Overly simplified view since many farmers do produce cash crops even though they have not produces all their food requirements. 40-60% of smallholders in many countries are net buyers of staple food crops Risk aversion: Farmers maximize income and minimize risk Problem: Better explanation, but still doesn’t explain the fact that farmers do not participate in markets (neither buyer nor seller) for many commodities

Agricultural household models – After 1985 Non-separable household models Singh, Squire, & Strauss (1986) Agricultural Household Models Models incorporating transaction costs, ie cost of buying or selling a commodity Creates a gap between a) price household can buy at and b) price it can sell at Example: Suppose market price of maize is 300, but it costs 50 to transport it to the market or to transport from market to household Farmer can pay 350 to purchase maize or he can earn 250 from selling maize If maize is worth 290 to household, it is not worth buying or selling maize, so household does not participate in market

Agricultural household models – After 1985 Why do transaction costs make models non-separable? Cannot calculate profit-maximizing production without knowing consumption preferences Consumption preferences  whether household is buyer or seller  price of commodity for household  profit maximization Thus, consumption preferences and profit maximizing income must be solve simultaneously Spatial arbitrage between household & market Shadow price (Ph) for household Ph = Pm +t if household is buying commodity Ph = Pm – t if household is selling commodity Pm+t > Ph > Pm-t if household neither sells nor buys The larger is t, the more likely household neither sells nor buys

Agricultural household models – After 1985 Implications of non-separable agricultural household models Prediction of NON-separable model Patterns in developing countries If transaction costs are high, diversified food consumption needs  diversified food production patterns Many farms are diversified, producing many food and cash crops If transaction costs high, farmers forced to self-supply with food, meaning small share of land allocated to cash crop production Small share of land allocated to cash crop production If transaction costs high, many households do not participate in market (Pm+t > Ph > Pm-t ) Many household neither buy nor sell staple foods

Agricultural household models – After 1985 Implications of non-separable agricultural household models Price Price Demand Supply Price range over which household does not react to price changes The figure on the left is a graphic representation of one household’s response to market price changes. If the market price is high, it is profitable for the farmer sell his crop, even with transactions costs. If the price is very low, then the farmer will want to purchase the crop. However, the vertical section describes the price range for which it is neither beneficial to buy or sell. Within that range, this individual household is not responsive to price changes in either production or consumption. The larger the transactions costs, the larger that range in which autarky takes place. There are many households in the economy, all with different production levels, preferences etc. The figure on the right shows that while the pattern is similar, not all households are the same. Demand Supply Quantity Quantity One household Several households

Agricultural household models – After 1985 Implications of non-separable agricultural household models Price Quantity Price Price range over which many households are self-sufficient & do not respond Price range over which most households are buyers & respond Price range where most households are sellers & respond Many households aggregated If the thousands of households in the economy, all with different production levels, preferences etc. are aggregated, the figure on the right emerges. The top portion of the curve indicates the price range at which almost all households sell their crop, and the bottom section is the price range at which almost all households buy. The section in the middle, which is nearly vertical, indicates that the supply response is highly inelastic. Many households will not respond to the price in this band, choosing instead to neither buy nor sell their crop. The demand curve (not drawn) displays a similar, backwards S pattern. One implication of this inelastic section in S and D is that a relatively small change in production can have a dramatic influence on market price which in turn affects demand. However, this pattern only exists for crops that are both produced and consumed. Quantity Several households

Agricultural household models – After 1985 Estimating non-separable household models Need data on production technology, market prices, transaction costs, and consumption preferences Use simultaneous equations for supply and demand Econometric software such as Stata Simulation based on existing parameters Need info on current production and consumption patterns, prices and transaction costs, and elasticities of supply and demand Use mixed complementarity programming (MCP), which allows inequalities (Ph <= Pm + t) Modeling software such as GAMS Very similar to modeling spatial equilibrium between markets

Agricultural household model in Excel Characteristics of Excel worksheet [Exercise – Ag HH Model] Two commodities: maize and coffee Area of maize & coffee depend on prices of both commodities Yield of maize & coffee depend on fertilizer price Maize demand depends on exogenous income Can change: productivity (yield), world prices, exchange rate, income, and distance (marketing costs) How to use the Excel model BLUE represents cells you can change to calibrate model YELLOW represents cells you can change to simulate a shock GREEN shows the output cells, which should not be changed Table shows “before” and “after” simulated shock Solid lines represent “before”, dashed lines “after” Open the [Exercise – Ag HH Model] worksheet in the AAMP Module 2.2 – Farm Household Modeling Excel workbook. Ensure that the values in the yellow cells are zero. This is the baseline case.

Agricultural household model – Exercises Increase household income by 20% (Cell E23) What happens to maize consumption? Does the household start to buy maize? Why? Why does coffee production decline? What happens to marketed surplus? Increase household income by 40% Does the household start to buy maize? Explain why the household does or doesn’t start to buy maize 1a) Rises due to higher demand. 1b) No. Production also rises. 1c) Maize partly displaces coffee. 1d) No change in maize marketed surplus (still 0%), no change in coffee marketed survey (still 100%), but overall marketed surplus declines from 54% to 50% because maize (which is not marketed) expands, reducing production of coffee (which is marketed). 2a) Rises due to higher demand. 2b) Yes. 2c) An increase in income of 40% shifts the demand curve outward far enough that the household is able to afford maize purchase.

Agricultural household model – Exercises Increase exchange rate by 20% (Cell E14) Increase the exchange rate from 85 KSh/US$ to 102 KSh/US$ (this implies a devaluation of the shilling devaluation) Why does maize production decline? Why does the fertilizer price increase? What happens to coffee yield? And coffee area? Explain the contradictory effects on coffee. Increase exchange rate by 40% (Cell E14 = 119) What happens to maize purchases? Why does devaluation cause farmers to shift from maize to coffee production? Increase world fertilizer price by 20% (Cell E25 = 20%) How is the effect different than 20% devaluation? Note: Return cell E23 to zero before continuing. 3a) With a weaker shilling, imported inputs are more expensive and therefore less used. Production drops. 3b) Fertilizer price increases due to the weaker shilling. It now takes more shillings to purchase the same amount of fertilizer. 3c) Coffee Yield and area remain the same. This is because coffee is exported. So, while inputs cost the farmer more, she also receives more money when selling her output. 4a) Maize purchases increase. 4b) Devaluation increases the profits from the exported crop, coffee. This puts more cash in the pockets of farmers, who choose to buy maize (which has become relatively cheap). Note: Return Cell E14 to 85 5a) Higher fertilizer prices shift back (to the left) the supply of maize and supply of coffee, reducing maize production and coffee production. It is different from a 20% devaluation in that the devaluation also raises the local-currency price of coffee, offsetting the effect of higher fertilizer price in the coffee market.

Agricultural household model – Exercises Increase the marketing costs for fertilizer, maize, & coffee by 30% This simulates a household that lives farther from roads and markets What happens to the cost of fertilizer? What happens to the buying and selling price of maize? What are the two factors causing coffee production to decline? What happens to the marketed surplus percentage? Increase the base maize consumption (Cell C7) from 1000 to 1400, then increase maize market cost by 50% This represents a net maize buyer and raises cost of purchasing maize What happens to coffee production and sales? Why do higher maize marketing costs reduce cash crop marketing 6a) Fertilizer price rises due to transport costs. 6b) The selling price drops and the buying price rises. 6c) Coffee production declines because the cost of inputs rises and the cost of outputs falls. 6d) The marketed surplus percentage declines. Note: Return cells C27, D27 and E26 to 0 7a) Coffee production declines. 7b) The higher maize marketing costs raises the buying price of maize, causing the household to grow more maize, which reduces land and labor available for coffee production.

Agricultural household model – Exercises Increase maize productivity by 30% (Cell C28) This simulates a 30% increase in maize productivity due to, for example, an improved maize variety What happens to maize yields? What happens to maize area? Explain this change. Why does coffee area and production increase? What is the effect on the value of sales and the marketed surplus? Increase coffee productivity by 30% (Cell D28) What happens to coffee yield and production? Why does an increase in maize productivity have almost the same effect on marketed surplus as an increase in coffee productivity? Note: Return Cell C7 to 1000 8a) Maize yields increase. 8b) Maize area decreases. With higher yielding seeds, less area is needed to produce the same output. 8c) Because less area is needed for maize, coffee area can be expanded. Expanding coffee area also increases production. 8d) The value of sales (row 47) increases substantially due to the extra output of coffee, and the marketed share increases moderately, reflecting the fact that the family still retains all of its maize. Note: Return Cell C28 to 0 9a) Yield and production increase. 9b) Value of sales and marketed surplus rise. 9c) Both scenarios produce the same effect: The family can produce enough maize for home consumption while increasing the output of coffee. Whether the output increase in coffee is due to area expansion (Ex 8) or increased coffee yields (as in Ex 9), the result is the same: revenue from coffee sales increase.

Agricultural household model – Exercises Increase maize market price by 30% (Cell C11 = 36.4) This simulates a 30% increase in maize prices in the market due to, for example, a bad harvest in another part of the country What happens to maize area and yields? What happens to coffee production? Decrease maize market price by 10% What is the effect on maize and coffee production? Why do these price changes have so little effect on the agricultural household? Increase world coffee price by 20% What happens to coffee yield and production? Why? What is the effect on the value of sales and the marketed surplus? Note: Return Cell D28 to 0 10a) Maize area and yield are unchanged 10b) Coffee production is unchanged Note: Return Cell C11 to 28 11a) There is no change. 11b) The changes are not large enough to compensate for the transactions costs faced by the farm households. Maize is still to expensive to buy, but not enough to sell. 12a) Yield and production stay the same. Although price has risen, the household is constrained by limited land area and can not increase output. 12b) Value of sales and marketed surplus rise.

Conclusions Rising income dampens commercialization if household is self-sufficient Devaluation (or depreciation) increases commercialization by shifting incentives toward export crops Distance to market and high marketing costs reduce commercialization by reducing fertilizer use & yields and lowering farm gate price of commercial crops More…

Conclusions If household is net buyer of food, high marketing costs reduce commercialization by diverting land from commercial crops to food crops Higher productivity in staple food crop contributes to commercialization by making land available Higher maize prices have no effect on self-sufficient households, which explains inelasticity of supply of staple foods

Resources Singh, I., L. Squire, & J. Strauss. 1986. Agricultural household models: Extension, application and policy. Baltimore: Johns Hopkins University Press. de Janvry, A., M. Fafchamps ,and E. Sadoulet. 1991. Peasant household behavior with missing markets: some paradoxes explained. Economic Journal 101 (409): 1400-17, November. Taylor, J. 2003. Agricultural Household Models: Genesis, Evolution, and Extensions . Review of Economics of the Household, Vol. 1, No. 1. http://www.reap.ucdavis.edu/research/Agricultural.pdf Renkow, M. Agricultural household models. Lecture notes. http://www.ag-econ.ncsu.edu/faculty/renkow/ECG_540/05_household.pdf