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Rural Industry Adjustment to Trade Related Policy Reform

by David Harris

December 2005

RIRDC Publication No 05/173  RIRDC Project No DAH-1A

Executive Summary
The domestic impact of trade related policy reform is an important issue for many countries.

Governments are often reluctant to reduce support for highly protected industries because of concerns about the ability of farmers to adjust to the change in market conditions.

In 2003 around a third of farm income in OECD countries was obtained from subsidies and market support arrangements. A number of industries in the major developed economies received high levels of assistance through policy interventions. These support measures impose costs on other parts of economy and have a distorting effect on world trade.

There has been very little reform aimed at reducing support for the most heavily protected industries. Some policy change has occurred involving reduced price support in conjunction with income support payments. But this type of reform is unlikely to stimulate the resource adjustments that will remove the distortions in world trade.

Over the past 10-15 years a number of agricultural policy reforms have been implemented in Australia. While recognising there can be a social dimension to the effects of reform there is considerable interest in the economic aspects of the industry response. This report examines the economic dimensions of industry adjustment to policy change in four case studies.

Adjustment to policy reform
Industry commentators often paint a bleak picture of the effects of reform by presenting a negative perspective based on a pre-existing situation. Concerns are raised about the risk of a long term industry contraction. This perspective ignores the fact that past experiences have shown farmers to be highly resilient and dynamic respondents to economic change:
 

• one of the important aspects of reform is that farmers are encouraged to focus on new income earning opportunities and/or farm performance improvements.


Concerns about the longer term effects of reform often prove to be overly pessimistic. There is widespread evidence that farmers are responsive to changes in net returns caused by market related developments. They are equally responsive to the adjustment pressures driven by policy reforms. A reduction in support will lead to farm level changes. But after a period of adjustment there is often an improvement in the industry’s performance.

The way policy reforms are implemented is an important issue in the context of the WTO trade negotiations. Several developing countries have expressed concerns about the domestic consequences of a new WTO trade agreement. The major developed economies are resisting reforms to a number of highly protected industries for similar reasons.

The primary issue is the adjustment pressures that flow from trade liberalisation. Effective reductions in support will deliver substantial benefits to world economies including the countries that introduce the reforms. But these benefits can only be obtained if the resource adjustments are allowed to occur after the reforms are implemented.

From an economic welfare perspective the best response to the adjustment pressures is often to do nothing. Farmers will respond to the market prices and resource movements will occur in two ways. Some farmers will elect to leave the industry or diversify into other products.

Others will remain in the industry and make changes to improve their financial position.

 However, policy reform often generates political pressures for government assistance. For various economic, social and political reasons the government may decide that some form intervention is warranted. As policy advisers are dealing with a ‘second best’ solution in these situations it is important to consider the unintended consequences that could arise.

There may be a social dimension to the industry adjustment to the reform. Governments have to balance their response against the costs imposed on other parts of society. Invariably the reform will involve the removal or reduction of a ‘hidden’ tax which creates wider economic benefits. The government response may erode these benefits:
 

• for many food products low income earners elsewhere in the economy are an important group of beneficiaries.


Adjustment to policy reform in Australia
It is an accepted principle in Australia that agricultural adjustment is a continuous process caused by changes in economic conditions. Farmers enter an industry after considering the potential risks and returns. The adjustment process involves farmers leaving or entering the industry. It also involves farmers expanding or reducing their involvement in the industry.

Australian experiences with autonomous adjustment indicate that farmers have shown considerable resilience and capacity to adapt to changing market conditions. Fluctuations in world prices and exchange rates affect farm returns in most industries. Farmers react to these developments by making changes to maintain the profitability of their farm business.

In general Australia does not provide long term compensation to the ‘losers’ of policy reform.

But shorter term transitional assistance has been provided for particular circumstances. An important principle in the policy response is that assistance should be designed to encourage change and the transition of resources – it should not try to stop the adjustment process.

Australian policy reforms of the past 10-15 years have mostly involved reductions in import protection or domestic support. This report looked at four case studies of industry adjustment to a major policy change:
 

• the dairy reform was the overnight elimination of all market support measures;
• the citrus reform was a phased reduction in tariff protection for processing fruit;
• the pig meat reform was a change in quarantine trade access conditions;
• the SA lobster reform was the removal of open access rights to a natural resource.


 In each case the impact of the policy reform on producer returns was mixed in with the effects of market related developments. It either amplified or reduced the adjustment pressures from the reform. Different forms of transitional assistance were provided to help farmers adjust and the widespread industry contractions that some had feared did not occur.

The key point that emerges from these case studies is that farmers were able to adjust to the change in market conditions. Some older farmers retired and others moved into vocations outside agriculture. Those that remained took steps to improve the physical and financial performance of their farm by diversifying, increasing output or making efficiency gains.

Deregulation of the dairy industry involved a sudden, substantial reduction in income for farmers that focused on fluid milk sales. In the first year of a deregulated market average milk prices declined by up to 18% in the states that primarily supplied fluid milk. But the industry adjusted rapidly to the effects of the reform.

A number of dairy farmers retired from the industry – farm number declined by more than 17% during the first three years of a deregulated market. Other farmers reacted to the decline in returns by expanding farm output. After a short period of adjustment there was a recovery in milk production and the industry’s export performance has been maintained.

The citrus reform involved a phased reduction in import protection for processing fruit over an eight year period. The effect of the reform on average returns was amplified by a declining trend in the world price for frozen concentrated orange juice. Market prices for processing fruit declined by 45% over the period the policy reform was implemented.

Some citrus growers left the industry or diversified into other products. Others made changes in fruit varieties to reduce their dependence on sales of processing fruit. There is no evidence of a long term decline in output and after a period of adjustment there was a significant improvement in the industry’s export performance.

The pig meat industry had to adjust to a relaxation of the SPS requirements for imports. Pig farmers were exposed to import competition for the first time. The alignment of market conditions to import parity pricing coincided with a period of cyclical growth in production.

Pig prices declined by more than 25% during the immediate post reform period.

The number of pig farms fell by a third in the five years that followed the change in market conditions. Some non-specialist, small scale farmers left the industry. Those that remained increased the scale of their pig enterprise and improved herd management to strengthen their financial position. After a short period of adjustment industry output recovered and a specialised export trade has developed.

Policy reform in the South Australian lobster industry involved the removal of open access rights to a natural resource. The economic performance of boat owners had declined because of over exploitation of the lobster stocks. Transferable access rights and restrictions on fishing effort were introduced to establish a sustainable resource base.

After a short period of adjustment there was a rise in fishing yields. Boat numbers declined marginally but the improved performance of the fishery allowed a higher catch quota. Strong export returns and higher catch rates improved the financial position of boat owners. The industry adjustment occurred without any transitional assistance.

In each case study the impact of the reform was not as severe as the views expressed by many commentators and industry performance improved after a short period of adjustment. In three cases transitional assistance was provided as a component of the reform. The key principles were assistance was provided for a limited period and market prices directed the adjustment: • it demonstrates that long term income supplements are not required to sustain an industry after the removal of industry support measures.

Transitional assistance for policy reform
The way policy reforms are implemented is an important issue. The approach used in these Australian case studies may not be directly applicable to situations in other countries. But the general approach should interest policy advisers faced with similar situations:
 

• transitional assistance was used to facilitate change;
• this involved political judgements about the relative merits of the welfare, equity and economic efficiency issues associated with the reform.


Individuals’ acting in their own self interest in response to undistorted price signals is the best way for adjustment to occur. If transitional assistance is provided in conjunction with a policy reform it can affect the way farmers adjust. This raises the question of the objective of the assistance and what form it should take.

The objective of transitional assistance is to facilitate adjustment but it can have unintended consequences in the affected industry. For example, some forms of assistance create financial incentives that encourage industry participation and the adoption of a particular adjustment strategy. This can create a production distortion because output will be higher than would be the case if no assistance was provided.

It is possible to rank the options for transitional assistance according to how strongly they will introduce a production distortion. The following table indicates that short term transitional assistance is a better way to manage adjustment pressures from WTO related policy reforms than long term income support:
 

•  it facilitates the resource adjustments that generate benefits for the domestic economy and reduces distortions in world trade.


Long term income support payments will not facilitate adjustment and is the least preferred form of assistance after production linked subsidies. If farmers receive an industry based, income supplement there will be extra resources in the industry. Farmers will be less responsive to the market price signals.

In general income support payments will have an off-setting effect on the way the reform affects the income situation of farmers. A payment that fully compensates for the initial loss of support will weaken the incentive for enterprise restructuring, diversification and farm exit decisions. It also fosters a reliance on government assistance funded by taxpayers.

Adjustment occurs because of a change in the income situation of the farmer which amongst other things can be caused by a change in price. If the farm income situation is unchanged there is very little incentive to fundamentally alter production decisions. To a large extent the pre-existing production distortions are likely to continue.


Temporary border protection is also not a good way of providing transitional assistance and it may be counter-productive. It is a shorter term measure but it could increase a pre-existing production distortion and introduce a new distortion though higher prices for consumers. A further disadvantage is that it provides the assistance through market prices:

• farmers do not get clear price signals on the effects of the reform;
• the assistance gets mixed in with the fluctuations in market returns; and
• the size and purpose of the financial transfer is not transparent to farmers.


Implicit assistance provided through a phased approach to reform may be a better way of facilitating change. It is a shorter term measure that declines in value. A disadvantage with this approach is that it also uses market prices to deliver the assistance. It also delays the removal of the pre-existing production distortion as farmers are not immediately exposed to the full effects of the reform:
 

• the purpose of the implicit assistance is not clearly communicated – it is often viewed as a component of farm income;
• farmers are often unaware of the amount of assistance they are receiving and the scale of the impact of the policy reform.


The best way to facilitate adjustment is for farmers to get immediate, undistorted price signals on the full effects of the policy reform. This would suggest a preferable way to proceed is to adopt the full impact (overnight) approach to policy reform. It creates a strong incentive for farmers to immediately assess their future prospects and consider their options for change.

This approach can lead to requests for assistance, especially if it involves a large reduction in support. A one-off, untied grant has some appeal if the government decides some transitional assistance is warranted. The purpose is clearly communicated and it is more likely to be used for farm restructuring than implicit assistance obtained through market prices.

The full impact approach was used to deregulate the Australian dairy market. Farmers were able to see the full extent of the impact on net returns and the transitional assistance was not tied to remaining in the industry. It did not encourage a particular adjustment strategy or delay the farm level adjustment which was a relatively short process:
 

• a sizeable number of farmers choose to leave the industry for alternative activities;
• those that remained mostly used the assistance for restructuring purposes.


An untied payment does not limit consideration of the options for adjustment. This can be an unintended consequence of specific purpose grants. A tied payment influences the way the adjustment occurs by encouraging farmers to remain in the industry:
 

• it can distort decision making if farmers do not give enough consideration to diversification or farm exit decisions.


A one-off, untied payment separate from net farm returns is like receiving a wind-fall gain. It requires a decision on how to use the assistance. Some farmers will remain in the industry and use the assistance for restructuring purposes. Others will decide to exit the industry and use the assistance to reduce the costs of switching into other industries or other vocations.

Transitional measures that introduce the smallest production distortion are indirect assistance programs. This form of assistance does not create financial incentives that can distort decision making. It can facilitate adjustment provided the funds are used for meaningful initiatives.

Some forms of indirect assistance can influence farmer adjustment decisions if they strongly advocate industry participation with a particular adjustment strategy. However, the production distortion will be smaller because adoption of the strategy is self-funded. Programs that advocate a course of action can limit the consideration of other adjustment options.

Targeted exit assistance does not generate a production distortion in the affected industry. It helps farmers in severe financial difficulties to leave the industry by reducing the costs of transition. Exit programs can be a useful compliment to other assistance measures because it raises the profile of industry retirement as an option for consideration by farmers.

The best way to facilitate farmer adjustment decisions is to make the full impact of the reform transparent. Similarly, transitional assistance will be most effective at facilitating adjustment if it is received as a transparent payment. This suggests the full impact approach is the best way to implement policy reform either with or without adjustment assistance:
 

• an untied, one-off grant in conjunction with targeted exit assistance is the best form of direct assistance if it is deemed to be necessary;
• a targeted exit program in conjunction with indirect assistance is the least distorting way of facilitating change.
 

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