Recent trends in the developments of the Common Agricultural Policy suggest an increasing attention towards rural development issues. On-farm processing may offer an alternative for diversification, income generation and rural development in the event of increasingly deregulated agricultural markets. In this study, the economics of on-farm processing for the case of the Swedish potato industry is examined. An interregional partial equilibrium model is developed. Various stages of the potato marketing chain are explicitly mbdelled. It is empirically demonstrated that, in some regions, on-farm processing is a part of a socially optimal industry structure. Furthermore, it is shown that on-fmm processors are more robust towards import competition than bulk product producers. Hence, the results support the notion that small scale processing may contribute towards satisfying some of the objectives of an effective rural development agenda. Published by Elsevier Science B.V.