R&D Investment and Output Competition by Supply-Managed Producer Associations Zoe Campbell James Vercammen University of British Columbia CAES/AAEA Annual Meetings Portland (July 30, 2007)

Producer-Funded R&D  Public sector agricultural R&D is gradually being replaced by private sector R&D in many countries (Alston, Pardey, and Roseboom 1998)  As well, farmers are increasingly active in R&D through producer association check-off schemes (Alston, Pardey, and Smith 1998)  Return to agricultural R&D is generally high, both for producers and for society, so R&D investment is typically inefficiently low (Alston, Marra, Pardey and Watt 1998, Brinkman 2004)

Producer Associations in Supply-Managed Industries  Canada utilizes supply management for the production of dairy, poultry, eggs and other select commodities  Producers in supply-managed industries are required to contribute a portion of their sales to their association (i.e., a mandatory levy)  A sizeable fraction of the total levy is ear-tagged for R&D  Dairy Farmers of Canada invests annually up to $1.7 million in health and nutrition research, and dairy production research

R&D Incentives with & without SM  SM schemes are often criticized because of non-competitive domestic pricing, restricted imports and a constrained operating environment for processors  Can SM schemes also be criticized on the basis of inefficient R&D incentives?  Specifically, do producers in SM industries contribute less to R&D because of restricted domestic production and import controls?  Would Canadian producers participate more actively in R&D if a future WTO agreement eliminates SM and allows for free-trade and competition?

Theoretical Context  Theoretical analysis of R&D incentives generally assume a small set of imperfectly competitive firms and R&D spillovers  Agricultural firms are perfectly competitive, but the association making the R&D decisions has monopoly power and faces no spillovers  There are no models which compare R&D incentives when both R&D and production are monopolized (current SM) with R&D incentives when R&D is monopolized and production is competitive (dismantled SM)

Paper Objectives  Theoretically compare R&D investment incentives with SM versus a competitive closed economy (R&D decisions are still monopolized)  Expand comparison by allowing for an open border with the U.S. (now producer association competes for market share) Initially assume identical demand and production costs prior to R&D selection to isolate pure competition effects Then assume Canada is a net importer prior to R&D to account for “size of the market” effects of SM reform  Assume R&D reduces cost rather than creates new products

Review of Theoretical Issues  Schumpeter (1942) argues that monopoly and large scale promote R&D investment because more benefits can be captured and the economic environment is more stable  Others argue that competition promotes R&D investment because firms that fail to innovate operate at higher relative cost and lose market share  In an oligopoly environment, spillovers reduce a firm’s R&D incentives because of impact on rival firm’s cost (d’Aspermont and Jacquemin 1988)  Firms have an incentive to set up research joint ventures and/or R&D cartels, and these are typically socially efficient (Kamien, Muller and Zang 1992)

Closed Economy Result 1: In a closed economy, R&D incentives are stronger with versus without SM  In a competitive environment with relatively elastic demand, consumers capture large share of R&D surplus  SM retains higher fraction of R&D surplus for producers  Suppose supply is linear with slope  and intercept c, and suppose demand function is P(Q)  Assume R&D decreases c  SM: Competition:

Closed Economy Illustrated SM Competitive Gain is small or negativeGain is positive R&D Induced Shift

Open Economy  In the closed economy model, the SM producer association faces no competition  Competition in the form of free trade should induce the producer association to invest more in R&D

Open Economy Model  Demand: P = H – Q for home P = F – Q for foreign  Supply: MC = h + Q for home MC = f + Q for foreign Where: h = h 0 – x h -  x F f = f 0 – x F -  x H   (0, 1) is the spillover parameter  Cost of R&D is quadratric  Let x SM, x C and x T denote optimal R&D levels for H with SM, closed competition and open competition

Pure Competition Effects: No Spillover Two Countries are identical prior to R&D Decision Becomes net importer due to lower R&D Becomes net exporter due to higher R&D Country HCountry F Excess Supply Excess Demand

Result 2: Pure Competition Effect  Suppose trading countries are identical prior to R&D, and suppose spillovers are zero. In two-stage game equilibrium: x C < x SM < x T  The concern over market share lost to imports induces the producer association to invest relatively more aggressively

Result 3: Impact of Spillover  Suppose trading countries are identical prior to R&D An increase in the spillover parameter, , reduces optimal R&D For a low to moderate value of  x C < x T < x SM For a relatively high value of  x T < x C < x SM

Intuition for Result 3  As H increases x, F also becomes more competitive due to the spillover  H will therefore choose a smaller value of x to account for this externality  There exists a critical value for  which ensures R&D expenditures are equal with SM and with open borders  If R&D spillover is high (i.e., above critical value), then dismantling SM will result in a lower level of producer contributions to R&D

R&D Joint Ventures  R&D joint ventures (RJV) are common in industries such as biotechnology and telecommunications  In our model, RJV implies agreeing to share R&D results (  = 1) while still choosing x non-cooperatively  Kamien, Muller and Zang (1992) show that with imperfect competition, RJV result in lower R&D levels but higher profits for each firm  Similar results are obtained in this competitive model of R&D: raising  increases surplus for producers and society, but reduces R&D spending  Considerable evidence of R&D cooperation in agriculture

Net Importer Scenario  The assumption of equal-sized trading partners is now relaxed  Assume that with open borders, H is a net importer prior to choosing R&D  Opening the border therefore reduces the size of H’s market (refer to this as the “market scale” effect)  Walk through the two alternative scenarios of: (a) no spillovers; (b) positive spillovers

Result 4: Market Scale Effects  Suppose H is a net importer after SM is dismantled but prior to R&D choice. Suppose the spillover is zero. If pre-R&D imports are small, then the competition effect dominates and x T > x SM If pre-R&D imports are relatively large, then the market scale effect dominates and x T < x SM  One of these two scenarios corresponds to the Canadian case

Result 5: Market Scale and Spillovers  Suppose H is a net importer after SM is dismantled but prior to R&D choice. Suppose the spillover is positive. An increase in the spillover induces F to invest less heavily in R&D An increase in the spillover initially induces H to invest more heavily in R&D but eventually induces H to invest less heavily in R&D  In other words, for small values of β, R&D choices for H and F are strategic substitutes and for larger values of β, the choices are strategic complements

Conclusions  Despite a large literature on R&D incentives, no obvious implications for SM  Considerable theoretical ambiguity regarding whether R&D incentives will improve or worsen with a dismantling of SM  Framework is highly simplistic  Additional theoretical and empirical work warranted Financial support from Canadian Agricultural Innovation Research Network (CAIRN gratefully acknowldged