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### Abstract

Introduction In recent years in Canada, direct support provided by governments to the agricultural sector has been decreasing due to international obligations under the General Agreement on Tariff and Trade/World Trade Organization (GATT/WTO) and the North American Free Trade Agreement (NAFTA). Consequently, governments and the agriculture industry are exploring ways of generating and sustaining farmers' revenue from the marketplace. In Western Canada, there is a renewed interest in the concept of "post-harvest value adding" and substantial investment has been made by the federal / provincial governments and the agriculture industry in value-added initiatives in the post-farm-gate sector. A greater part of farm products from western Canada is shipped and marketed as raw, bulky and unprocessed farm commodities. The value of processed food and beverages is low relative to the value of unprocessed farm commodities, reflecting a relatively lower level of value added to primary agricultural products in the prairies compared to Ontario. The annual rate of growth in processed food and beverages in the prairies is less than 5%. From 1988 to 1997, the average annual growth rate of processed food and beverages is calculated as 4.9% for Alberta, 4.4% for Saskatchewan, and 2.9% for Manitoba. Consequently, the potential for increased value-added processing has attracted much attention by both the federal and the prairie governments. In 1996, the Alberta government provided $35 million in seed money towards the establishment of a new, not-for-profit Alberta institution, the Alberta Value Added Corporation (AVAC). This corporation was created to foster research and development into the commercialization of value-added products with a focus on the agriculture and food sector. In 1996, the Saskatchewan government instituted an Agri-Value Program (AVP). The purpose of the program is to encourage the development of agriculture-related, value-added industries in that province. In 1997, Manitoba Agriculture and Agriculture and Agri-Food Canada introduced the Agri-Food Research and Development Initiative (ARDI). This initiative was meant to encourage, promote, and conduct innovative research and development projects that contribute to economic development, sustained prosperity, and successful adaptation in the changing agricultural trading environments. Post-harvest value-added activities are part of a continuous, complex economic development process within the food system. Assessing the effectiveness of value-added initiatives in the farm sector requires an understanding of the whole economic process. This includes an understanding of: 1. the growth in effective demand for value-added products and production of agricultural raw materials, 2. the multi-stage system of the food production process, 3. the structure of the food production technology, and 4. the payoffs of value-added investments to enable better policy decisions regarding alternative uses for these public funds. Objectives of the Study The primary objective of the study was to simulate the likely impact of value adding on commodity prices, quantities, and welfare of farmers. However, given the complex process within the food system, this study also examined the linkages between processors and grain and livestock farmers in the prairie region using econometric modelling methods. Specifically, the objectives of the study were: 1. to examine the interrelationships in commodity production at the farm level in the prairies, 2. to evaluate food supply and farm commodity demand relationships in the processing sector in Canada, 3. to evaluate the existence of any oligopsony power in the domestic market for primary farm commodities, and 4. to simulate the likely impact of value adding on commodity prices, quantities, and welfare of farmers. Three crops and two livestock commodities were considered in this study, namely wheat, feed barley, canola, slaughter cattle and slaughter hogs. These are major farm commodities produced in western Canada. Methodology The procedure adopted to achieve the objectives of the project was first, model the farm sector and the processing sector separately and second, use parameter measures from those sectors to simulate the likely impact of value adding on commodity prices, quantities and producer welfare. The functional forms used allow the evaluation of cross commodity effects. The supply and demand relationships are then used to build a synthetic model that is used for the simulation exercises. For comparison purposes, the Canadian Regional Agricultural Model (CRAM) is also used to examine the potential impact of value adding on agricultural production and producer welfare. CRAM is a spatial equilibrium mathematical programming model of the Canadian agricultural sector, developed and maintained by Agriculture and Agri-Food Canada. It has been used extensively for various policy analyses related to Canadian agriculture. Policy runs are conducted using CRAM to examine any changes in the relevant variables due to increased value added activities in the prairies. Analysis of the Farm Sector It is believed that long-term growth in post-harvest value-adding activities depends not only on growth in effective retail demand, but also on the supply of agricultural raw materials. The supply of agricultural products depends on expected price and other exogenous factors including technology, weather and government policy. There are production interrelationships in the farm sector. Some major livestock feed inputs (e.g., barley) are obtained from crop production so that production decisions in the crop sector are directly associated with production decisions in the livestock sector. Moreover, major government policy decisions may change the economic environment affecting the crop sector and this may have an impact on the livestock sector. Even within the crops sector, changes in the economic factors affecting one crop may have an impact on other crops. Changes in the economic environment affecting the agricultural sector can be expected to affect farm commodity prices. Often farmers' responses to changes in the agricultural economic environment are assessed in terms of the response of commodity supply to changes in prices. However, in the short run, some factors of production (e.g., land) may be irreversibly committed to particular uses. It is important, then, to examine farmers' ability to make long run structural adjustments in response to any broad-based changes that may confront the farm sector from increased value-added activities in the processing sector. This study examined a model of three crops (wheat, barley and canola) and two livestock activities (cattle and hogs) which incorporated farmland allocation in the production of wheat, barley, canola and tame hay, as well as land allocation to summer-fallow. Supply functions derived from the Generalized Leontief profit function were specified and estimated simultaneously for the crops and livestock sectors using annual data from 1960 to 1997. The study assessed the extent of substitution/complementarity in production among the five commodities and the effects of price changes on production resulting directly from changes in price as well as indirectly from farmland reallocation. The statistical and economic implications of the models were assessed. The results indicate the existence of significant economic interrelationships in the western Canadian agricultural sector. The partial and total effects of price changes on production were examined and the results show that the quantity supplied for each of the commodities examined is positively related to its own price (Tables 2.4, 2.5 and 2.6). Hog production is the most price-elastic among the five commodities examined suggesting that the inventory of animals can be reduced readily for slaughter with high market prices. Canola production is the least price-elastic. Wheat production and barley production appear as complements but canola production appears to be a substitute to wheat production. Hog production is positively related to the prices of wheat, barley and canola. Cattle production is positively related to the price of barley. A chi-square test of non-jointness in production indicates jointness in the production of grains and oilseeds, non-jointness in the production of cattle and hogs and jointness in the production of hogs and barley. These findings of complementarity and substitution provide insights into the potential effect of increased value added activities in the processing sector on the farm sector as well as the potential effects that changes in the economic conditions of one commodity may have on other commodities. More specifically hog production is the most price-elastic among the five commodities with an own price elasticity of 0.83 when estimating short-run sensitivities. In other words, hog production is the most sensitive of the commodities included in the study to changes in it own price. A one percent increase in hog price will increase market supply by 0.83% in the short run. This appears to be a reasonable finding, since annual data are used and the hog cycle (from birth to market) is about 12 to 18 months. Consequently, inventory of animals can be reduced readily with high market prices within this time frame. Cattle production has a longer cycle (approximately 3 to 3 1/2 years) and inventory reduction may not be readily accomplished as with hogs. Thus, the much lower estimated elasticity of cattle supply of 0.123 appears reasonable. Cattle supply in the short run is much less sensitive to changes in slaughter cattle prices than hogs. Cattle production also appears positively related to acreage allocated to tame hay acreage but negatively related to acreage allocated to wheat, barley, canola, and summer-fallow. In the longer run, hog and cattle production are more responsive to price changes than in the short run. The non-jointness in production between the cattle and hog sector indicates that Alberta can expand both the cattle sector and the hog sector at the same time with minimal economic conflict between the two sectors. The jointness in the hogs and barley sector indicates that any major increase in the hog sector will require adjustments in the barley sector. Key crop production constraints are highlighted by the results. Wheat and barley are complementary with each other. Increasing wheat acreage tends to increase barley acreage. However increases in wheat and barley production tend to come at the expense of decreasing canola acres. The effect of interest rate (the price of capital) on commodity production is quite low for all commodities. Policies encouraging the livestock industry, a key value-added industry in Alberta, need to consider the following points. *The model estimates indicate that changes in the livestock sector impact on the grain and oilseed sector. *A policy pursuing increases in hog and beef production will have little conflict between the cattle and hogs for resources. *Increases in the livestock sector will have an impact on the barley sector and thus indirectly on wheat and oilseeds. This suggests that any models need to consider the interactions between the different sectors considered here. Furthermore, the supply response changes with the length of time. The models used here do not account for livestock waste by-products. Analysis of the Processing Sector: Initiatives taken by the government in value adding activities are likely to encourage and promote projects that contribute to the economic development of the agricultural industry. Government initiatives in value adding include funding programs that encourage research and development into the commercialization of value-added products. With such programs, it is hoped that the food-processing sector will undertake structural adjustments that may eventually result in increased utilization of primary agricultural commodities. Agricultural and food-processing industries in Canada and the United States have become increasingly concentrated, often resulting from mergers and acquisitions (Green 1985). The trend toward fewer and larger firms has raised concerns about potential market power and its exploitation. In particular, if increasing concentration allows firms to exploit the domestic market for farm commodities, then farmers will be affected if the food processing firms are able to use their power to hold commodity prices at low levels. However, previous studies have documented the efficiency of increasingly large plants in the food-processing industries when plant size is determined by production structure characteristics such as cost economies and technical change (Hazeldine 1991; Goodwin and Brester 1995; Holloway and Goddard 1988; 1999b). In these circumstances increased import and export competition may modify market power. In Canada, a significant proportion of primary agricultural products, particularly grains and oilseeds is exported. This suggests that, with export competition, food-processing firms may not be able to exercise any market power in the domestic market for farm outputs. This portion of the project examined aggregate demand of the processing sector for wheat, barley, canola, slaughter cattle and hogs in order to: *evaluate the interaction between the primary sector and the processing sector, *assess potential market power exploitation between the primary agriculture sector and the processing sector. The resulting model estimates between the primary sector and the processing sector were used to understand the interactions between the primary and processing sector. A measure of market power was used to determine whom, if anyone would receive any "extra" profits from increased production in the processing and primary sector. An alternative index for measuring industry-wide market power was developed for use in the study. The procedure used here differed from previous studies in that conjectural marginal input cost was explicitly incorporated into a profit function allowing a system of factor demand and output supply equations to be estimated. Conjectural marginal input cost is a method of measuring market power. With this procedure and sufficient data, policy analyses were conducted by assessing the conduct of the industry over time in response to certain changes. This framework was applied to four Standard Industrial Classification (SIC) food-processing industries in Canada; the meat and meat products industry (excluding poultry), the cereal grain flour industry, the livestock feed industry and the vegetable oil industry (excluding corn oil). These are the major food processing industries for Western Canadian agricultural outputs. The profit function for each industry was specified as a translog functional form and one output supply and two factor demand models were estimated for each industry. The results suggest that the supply curves for meat and meat products, cereal grain flour, livestock feed and vegetable oil are upward sloping (Table 3.3). Increased output prices result in an increased supply of these products. The results also indicate that the processing industry demand curves for slaughter cattle, wheat, feed barley, canola and labour are downward sloping. Increases in commodity prices reduce the demand for farm commodities. Own-price elasticity measures evaluated at the mean of the period 1991-1996 are larger in absolute value than estimates that are based on the sample mean which covers the period from 1974-1996 (Table 3.4). The results portray labour and farm commodities as complements in the food production process. Not all of the increase in processing occurs through acquisition of more capital. For example, increases in post-farm gate processing result in increased amounts of labour being used in the processing sector. The elasticity measures have signs that make economic sense and may be of interest for policy analysis. Supply quantities of meats, flour and vegetable oil are sensitive to output price. Specifically, a one percent increase in output prices leads to a greater than one percent increase in output. Regarding the issue of market power held by processors, there is no evidence of non-competitive behaviour in any of the commodity markets examined. The absence of non-competitive behaviour may be attributed to the structure of the commodity markets as well as other factors such as the increased competition from world trade that has accompanied technical change, and increased scale of food processing operations. Based on historical relationships, increases in processing of farm commodities in Alberta will not lead to any significant exercising of market power by these firms. The sectors are competitive in their pricing. In conclusion, it should be pointed out that the approach employed in the study may be useful in other empirical evaluations of potential imperfections and distortions in the domestic market for farm commodities. These model estimates for the processing sector provide further information of use when modelling the overall impact of increased value-added activities on primary agriculture. Simulation of the Impact of Value-Adding on the Farm Sector using Dual Models Agricultural economists have expended much effort toward evaluating the economic benefits from cost-reducing research in agriculture. Economic research in this area has focused on the multi-stage production system in a partial-equilibrium framework. Studies have examined the distribution of economic benefits from government policy such as investment in research and development. Other studies have examined the benefits from investments in commodity promotion and advertising. The literature provides important insights into the effects of different types of exogenous factors on commodity prices and quantities as well as the effects on welfare of particular groups in the food production system. The effects of promotion and/or advertising are evaluated under the assumption that promotion and/or advertising shift the retail demand curve while for research, the effects are evaluated under the assumption that research shifts the farm input supply curves. While this multi-stage approach is equally applicable to estimating the effects of value adding investment, no attention as yet has been given to economic research on this particular issue. This portion of the project extended the literature on distribution of gains in a multi-stage production system to include gains/losses from investment in value adding in the post-farm-gate sector. The study followed and adapted the work of other researchers who have measured the impact of a technological change in the supply curve for farm commodities. This study was concerned with the impact of investment in value added processing that may shift the derived demand curve for farm commodities. Five commodities were examined; wheat, feed barley, canola, slaughter cattle and slaughter hogs. Functional equations representing the supply and demand for the commodities were applied in experiments based on the assumption of increased demand for the commodities. The sector models were built using estimated coefficients from the primary farm sector and the processing sector models. Model results provide insights into the effects of investment in value adding on prices, quantities and farmers' welfare. Overall, the various simulation results suggest that farmers would be better off with increased prices of grains/oilseed. However, the results indicate that increases in commodity prices cannot be realized in the short term from increased domestic demand for commodities. Effects of a 20% Increase in Domestic Demand for Wheat With an increase in domestic wheat demand, the price of wheat declined by 9.04% and barley by 2.81%. There is however an increase in canola price. With the decline in prices, wheat and barley production experienced some decline in production. Canola production declined as well. The decline in barley price did not result in an increase in domestic demand for this grain. The increase in the price of canola caused the domestic demand for this oilseed to fall by 4.19%. Canola exports increased by 60%, which probably explains the increase in canola price. Wheat exports also increased by 10.78%. However, this change in export volume was not enough to result in a rise in wheat price. The changes in wheat and canola exports appear to be more pronounced than the changes in production of the commodities. The effects on barley were quite minimal. Although the price of barley declined by 2.81%, domestic demand declined and production did not increase. This solution may appear counter-intuitive but considering the fact that barley is used as feed for the livestock industry, we observe that the production of cattle and hogs does not increase. Changes in the hog industry were modest and it appears that the cattle industry was not affected by the increase in domestic wheat demand. In terms of welfare, producer profits declined by 5.77%, which may be attributed to the unrealized increase in farm prices, particularly for the grains. Effects of a 20% Increase in Domestic Demand for Canola A 20% increase in the domestic demand for canola caused an increase in the price of canola by 5.45% but a decline in the price of wheat and barley. With an increase in price, canola production increased by 21.06%. The production of wheat and barley declined which may be attributed to the decline in price and to substitution effects in production with canola. Exports of canola increased by 50%. The decline in wheat price, however, caused an increase in domestic demand for wheat by 21.69%. The effect on barley was not significant. Unlike wheat, a significant amount of canola is processed locally. Thus, the finding of an increase in canola price and production with an increase in domestic demand may be in order. An increase in the domestic demand for canola resulted in an increase in hog price but a decrease in cattle price. Nonetheless, the production of both cattle and hogs decreased by 0.32 and 11.11 percent, respectively. The domestic demand for the two commodities also declined and for exports, hogs exported increased by 3.25% while export of cattle decreased by 5.88%. Effects of a 20% Increase in Domestic Demand for Cattle With a 20% increase in domestic cattle demand, the price of cattle declines by 1.14%. The price decline is contrary to what would be expected. Nevertheless there is an increase in cattle production by 16.9% suggesting a positive net effect for the cattle industry. Export of cattle decreased by 64.71%. The price of hogs fell by 0.18% but hog production increased by 4.86%. However, the decrease in hog price resulted in a 42.86% increase in the domestic demand for hogs. Export of hogs decreased by 1.63%. Changes in the prices and production of the crops were modest but adjustments in the quantities exported were significant. The price of barley was unchanged yet production and domestic demand decreased. This solution appears counter-intuitive when assessed relative to the increased production of both cattle and hogs, as it was expected that an increase in the production of cattle and hogs would result in an increase in domestic demand for barley. In terms of producer welfare, total profits increased by 5.09%. The significant increase in the production of cattle and hogs coupled with the relatively stable livestock prices, may have contributed to the increase in farmers' welfare. This solution may suggest that farmers would be better off with increased investments and capacity-expansions in the domestic cattle slaughtering industry. Effects of a 20% Increase in Domestic Demand for Hogs Generally, a 20% increase in domestic demand for slaughter hogs resulted in price increases for all five commodities, ranging from 0.09% to 1.13%. The price rise did not cause significant change in commodity supply except for hog production. The production of hogs increased by 2.78%. There was no change in hog exports. With a price increase, the domestic demand for wheat, canola and cattle decreased. The export quantities for canola and cattle increased by 20 and 2.94%, respectively. The effects on barley were minimal. In terms of producer welfare, total profits increased by 4.72%, which may be attributed to the resulting increases in commodity prices. This solution is consistent with the solution from the cattle scenario above, in which farmers may be better off with capacity expansions in the domestic meat processing industry. Simulation of the Impact of Value-Adding on the Farm Sector using the Canadian Regional Agricultural Model (CRAM): The Canadian Agricultural Regional Model (CRAM) is a spatial equilibrium policy analysis model developed and maintained by Agriculture and Agri-Food Canada. It provides significant regional and commodity detail of the Canadian agricultural sector and is an important instrument for the analysis of policy changes on the Canadian agriculture industry at a disaggregated level, in terms of the impacts on production (i.e., supply) and demand. In this study, two case situations were analyzed using CRAM: (a) the domestic demand for each of the commodities, wheat (high quality), beef (high quality), and pork was increased by 5% and by 10% and (b) the domestic demand for all three commodities was increased simultaneously by 5% and by 10%. The results obtained generally confirmed those from the dual model. An increase in the domestic demand for individual commodities did not result in any change in the relevant variables compared to a simultaneous increase in all commodities. In the latter scenario, results suggest that, in each case, producer and consumer welfare declined but by less than 1%. In the model, increases in domestic demand were all accounted for from export demand by the rest of the world. This may have contributed to the decline in welfare. Specifically, with a simultaneous 10% increase in production, we observe a 1.79% decline in world demand for high quality wheat, 14.46% decline in world demand for Heifers & steers, a 3.1% increase in world demand for low quality dressed beef, and a 3.77% decline in export demand for pork. There was no significant change in production for any of the commodities. Any changes in production were less than 1% from the base results. However, for beef, a simultaneous increase in domestic demand resulted in an increased in beef slaughter in Alberta. In the case of a simultaneous 5% increase in domestic demand, there was a 2% increase in Alberta beef slaughter. With a simultaneous 10% increase in domestic demand, there was a 4% increase in Alberta beef slaughter. Other minor changes that are observed, particularly with a simultaneous 10% increase in domestic demand, are changes in production and input use (i.e., fertilizer, chemicals and fuel). Overall the impact of increased domestic demand for primary agricultural products on farm incomes was minimal. Conclusions It is clear from the results that the volume of Canadian agricultural commodities traded on the world market is too small to permit Canada to influence world price. On an individual commodity basis, however, Canada may be able to influence prices received by farmers. The results from the simulation exercises indicate that farmers' welfare is increased with increased commodity price. Prices are determined by the market. Therefore, there is the need for strategies directed at specific markets to effect an increase in price. In foreign markets, strategies could be directed at increasing market share. Canada's average market shares in the world market for wheat and barley from 1988 to 1997 are approximately 18% and 19%, respectively (Canadian Wheat Board 1999; Food and Agriculture Organization 1999; International Grains Council 1999). Canada's share of the world market for canola is approximately 48%. However this would not lead to a larger economic sector devoted to further processing. Canada's potential to influence prices on the world market depends critically on the world demand for commodities, which is erratic. Consequently, domestic value-added processing has been seen as an opportunity for guaranteed markets that would facilitate high prices of commodities. Adding value to enhance the price of commodities will be effective when an appreciable proportion of domestic production is processed domestically and a smaller proportion of the commodity is exported. The current development of new value-added processing opportunities on the prairies (e.g., canola crushing plants and livestock slaughter facilities) will provide some economic activity in the prairies. However, these activities will not enhance the price of commodities at the farm gate, which will continue to be set by the world price, net of transportation costs. The loss of direct support from the government means that farmers will continue to face the full impact of downturns in agricultural commodity prices. Increasing the value of processing and related activities to$20 billion will have minimal direct impact on the welfare of primary agriculture producers who are engaged in producing the typical commodities such as wheat or beef. The domestic market will replace some of the export demand for Alberta commodities. If primary agricultural producers are to benefit directly from increased processing in Alberta and Canada, then these producers will have to participate directly in value-adding industries, through direct ownership or through cooperatives. Alternative structures may be alliances between various players in the sectors or primary agricultural producers may have to move into niche markets where current demand exceeds the supply. However, typically, niche markets, unless consumer demand is growing rapidly, are often rapidly saturated and any "excess profits" at the farm gate removed. Although farmer involvement in processing can take many forms, the formation of new structures of co-operation and vertical co-ordination in the food chain must be given special attention. New management structures are required to meet the challenges of the new agricultural economy. The "New Generation Co-operatives" (NGCs) initiated in the US in North Dakota and Minnesota provide a potential model that may be followed. "New Generation Co-operatives" integrate farmers into domestic processing activities, with focus on vertical integration between these levels. Such arrangements provide farmers with a set price for their primary commodities as well as earnings from the processing and value adding activities. Thus, NGCs may have the potential with respect to first, their inherent ability to compete in value-added products market and second, providing ways of generating and sustaining producers' revenues from the marketplace.