Category Archives: Agriculture

320 – Fixed costs and input rates

Optimal input rates (e.g. of fertilizer to a crop) are not affected by fixed costs. I had an interesting discussion with a Canadian poultry farmer last month, who needed to be convinced of this fact.

In Canada last month I gave a seminar at the Ontario Ministry of Agriculture, Food and Rural Affairs on water pollution from agricultural fertilizers, and how an understanding of the economics of fertilizer application can help identify cost-effective policy strategies for reducing pollution.

One thing I talked about was the economics of applying too much fertilizer (more than would be in the farmer’s own financial interests).

One attendee at the seminar was a poultry farmer (who was also a scientist) who later wanted to talk to me about a reason for increasing input rates that I had not mentioned. The reason he suggested was that, by increasing input rates a farmer can increase his or her production, and even if the resulting increase in revenue is not enough to cover the additional input costs, it helps to dilute the fixed costs of production over a larger value of outputs, making the farmer better off overall.

He said that this is an idea that is common amongst poultry farmers, at least in Ontario. The problem is that it’s completely wrong. There is no way that increasing input rates above the level that maximises the difference between revenue and input costs can make a farmer better off, even if it does mean that the average fixed costs per unit of output is lower.

A simple numerical example will make this clear.

Fixed costs ($/ha)Fertilizer cost ($/ha)Yield (tonne/ha)Revenue ($/ha)Net revenue ($/ha)Average fixed cost ($/tonne)
5001.122017045.45
50201.530023033.33
50401.836027027.77
50602.040029025.00
50802.0541028024.39
501002.0841626624.04
501202.142025023.81

In this example, there is a production cost of $50/ha which is not affected by the rate of fertilizer used. In this sense it is “fixed”.

As the rate of fertilizer applied increases, the input cost goes up, and so does the crop yield, although it increases at a decreasing rate.

The net revenue is the difference between the revenue and the total costs (fixed costs plus fertilizer costs). Given this pattern of revenue and costs, the fertilizer rate that maximises net revenue is the rate corresponding to a cost of $60/ha (the fourth row of numbers in the table), giving a net revenue of $290/ha. This is the fertilizer rate that maximises profit to the farmer.

The last column shows the fixed cost per unit of production. Because the yield keeps increasing at fertilizer rates above the economic optimum, the fixed cost per unit of production keeps falling. The lowest fixed cost per unit of production is in the last row of the table, but this clearly doesn’t have the highest profit.

When you are considering the optimal level of an input, the only costs that matter are the costs that vary as you vary the level of the input. Fixed costs cannot possibly affect the optimal rate of an input because they are fixed. They stay the same at all input rates. The fact that average fixed costs per unit of output might fall at higher input rates is completely irrelevant.

I think I convinced the Canadian poultry farmer. He said he was going to talk to his other farmer friends about it.

Although boosting an input rate loses a farmer money, in many cases the amount lost will be quite small unless the input rate is especially high (due to “flat payoff functions” – see Pannell 2006). That may be why the error has not been detected by the farmer or his friends. The loss may be too small to be noticeable.

To the extent that farmers think that diluting fixed costs is a good idea, explaining to them that it is pointless may help to reduce some farmers’ tendency to apply too much fertilizer. If successful, this may contribute to reducing water pollution.

Further reading

Pannell, D.J. (2006). Flat-earth economics: The far-reaching consequences of flat payoff functions in economic decision making, Review of Agricultural Economics 28(4), 553-566. Journal web page * Prepublication version here (44K). * IDEAS page

Pannell, D.J. (2017). Economic perspectives on nitrogen in farming systems: managing trade-offs between production, risk and the environment, Soil Research 55, 473-478. Journal web page

319 – Reducing water pollution from agricultural fertilizers

I gave a talk to the Ontario Ministry of Agriculture, Food and Rural Affairs (OMAFRA) on July 16, 2019, exploring ways to reduce water pollution from agricultural fertilizers.

Many methods have been proposed to reduce water pollution from agricultural fertilizers. The list includes use of nitrification inhibitors, land retirement, vegetation buffer strips along waterways, flood-plain restoration, constructed wetlands, bioreactors, cover crops, zero till and getting farmers to reduce their fertilizer application rates.

Last year, while I was at the University of Minnesota for several months, I reviewed the literature on these options and came to the conclusion that the option with the best prospects for success is reducing fertilizer application rates. It’s the only one of these options that is likely to be both effective and cheap.

In my talk, I made the case for agencies who are trying to reduce pollution to focus on reducing fertilizer rates.

In brief, I identified three key reasons why there are untapped opportunities to reduce fertilizer rates.

1. Some farmers apply more fertilizer than is in their own best interests. Surveys in the US suggest that something like 20 to 30% of American farmers could make more profit if they reduced their rates. If it was possible to identify these farmers and convince them of this, it would be a rare win-win for farmers and the environment.

2. Even those farmers who currently apply fertilizer close to the rates that would maximize their profits could cut their rates without sacrificing much profit. Within the region of the economically optimal rate, the relationship between fertilizer rate and profit is remarkably flat. New estimates by Yaun Chai (University of Minnesota) of this relationship for corn after corn in Iowa indicate that farmers could cut their rates by 30% below the profit-maximizing rate and only lose 5% of their profits from that crop. For corn after soybeans, the equivalent opportunity is for a 45% cut!

3. Some farmers believe that applying an extra-high rate of fertilizer provides them with a level of insurance. They think it reduces their risk of getting a low yield. However, the empirical evidence indicates exactly the opposite. When you weigh up the chances of an above-average yield and a below-average yield, higher fertilizer rates are actually more risky than lower rates. In addition, price risk interacts with yield risk to further increase the riskiness of high rates.

I think there is a real opportunity to explore these three factors in more depth and try to come up with policy approaches that could deliver reduced fertilizer usage in a highly cost-effective way. Some of it would just be about effective communication (e.g. the design of “nudges”, as popularised in behavioural economics) while some might require a modest financial commitment from government or industry. One idea is to offer something like a money-back guarantee to those farmers who agree to reduce their rates by a specified amount. If they lose money as a result, they get compensation. Because of the flatness of the fertilizer-profit relationship, the payments required would usually be very small.

I recorded the presentation to OMAFRA, and it’s available here.

Further reading

Pannell, D.J. (2006). Flat-earth economics: The far-reaching consequences of flat payoff functions in economic decision making, Review of Agricultural Economics 28(4), 553-566. Journal web page * Prepublication version here (44K). * IDEAS page

Pannell, D.J. (2017). Economic perspectives on nitrogen in farming systems: managing trade-offs between production, risk and the environment, Soil Research 55, 473-478. Journal web page

316 – Resources for agri-environmental schemes

I’ve been asked to present a talk in Ireland in two weeks, on the topic “The Design of Effective Agri-Environment Schemes”. In putting the talk together, it struck me that I (with help from colleagues) have developed quite a few resources in this space, so I’ve collected them on a new web site to make them easily accessible.

Agri-environmental schemes (or programs or policies) aim to reduce the adverse impacts of agriculture on the environment. There are many such schemes around the world, but often they are not very efficient or effective. We could often do a lot better if we did a smarter job of designing and implementing these schemes.

Not that it’s easy. There are so many aspects to consider: the effectiveness of different practices at reducing environmental damage, their attractiveness (or otherwise) to farmers, the mechanisms to be used to promote the best practices, the costs and risks of different approaches, which environmental issues are the priorities, and so on. In my view, most designers of agri-environmental schemes don’t appreciate what a difficult task they are trying to do, and make do with relatively quick and dirty approaches to the design.

The resources I’ve included on the web site address a wide range of relevant issues, including:

  • Lessons from past agri-environmental schemes
  • The selection of appropriate policy mechanisms
  • Measuring environmental values
  • Ranking projects, including the choice of an appropriate metric
  • Additionality
  • Understanding and predicting farmers’ adoption of new practices
  • Dealing with uncertainty and including systems for learning from experience
  • The need to pull off that together in a coherent framework

It includes journal articles, books, reports, frameworks, computer tools, web sites, and blog posts, plus links to my free online course on “Agriculture, Economics and Nature”.

Overall, if an organisation wanted to design and deliver an agri-environmental scheme that would really deliver outcomes, they could benefit greatly from the material on this site. The URL is www.resources4aes.net.

Further reading

Pannell, D.J. (2008). Public benefits, private benefits, and policy intervention for land-use change for environmental benefits, Land Economics 84(2): 225-240. Full paper (140K) * IDEAS page

312 – The economics of nitrogen in agriculture

The global challenge of feeding seven billion people would be more difficult without nitrogen fertilizer, but it causes pollution of rivers, lakes and coastal waters around the world, and it contributes to emissions of greenhouse gases. It increases the profitability of individual farmers, but it is over-applied in many cases, wasting money and needlessly worsening environmental problems.

These are, in large part, economic issues. In a recent paper I attempted to summarise the large and diverse research literatures on the economics of nitrogen in agriculture. Here are some of the key points.

At the farm level

The production function for nitrogen (N) fertilizer (the relationship between yield and the rate of nitrogen fertilizer) always exhibits diminishing marginal returns – it flattens out at higher fertilizer rates. In dry conditions, yield may even fall at high N rates.

The rate of nitrogen fertilizer that maximises expected profit is less than the rate that maximises expected yield, sometimes much less.

Here’s a really neat tool that shows the relationships between N, yield and profit for corn in the US. http://cnrc.agron.iastate.edu/

Visual effect of nitrogen fertilizer on corn

Risk

N fertilizer affects the riskiness of cropping. For two reasons, higher N rates are more risky (i.e. profits are more variable at higher N rates). One reason is that the grain price is itself risky. Since profit depends on grain price times yield, and yield usually increases with increasing N rate, the more N you apply, the more variable your profit will be. In addition, yield also tends to be slightly more variable at higher N rates.

Flat payoff functions

There always exists a range of fertilizer rates that are only slightly less profitable than the profit-maximising rate (i.e. a range where the payoff function is relatively flat), and in most cases, that flat range is wide. This means that the farmer has flexibility in choosing the fertilizer rate. If a lower rate would better satisfy another objective (e.g. risk reduction), the farmer can choose that rate with little sacrifice of profit. If regulators require a moderate reduction in fertilizer rate below the farmer’s economic optimum, the cost to the farmer will be small. Flat payoff functions also mean that the benefits of precision-agriculture technologies that spatially adjust fertilizer rates within a field will usually be small.

Nitrogen pollution

Typically, the marginal cost to farmers of nitrogen emissions abatement is low for low levels of abatement but increases at an increasing rate as the required level of abatement increases. As a result, modest targets for abatement can often be achieved at low cost, but ambitious targets can be extremely costly.

Spatial targeting of abatement effort (both at the regional and international scales) can generate much larger benefits than untargeted policies, although these additional benefits are likely to be offset to some degree by increased costs required to run a targeted program (costs of information and administration).

Policies intended to increase farmers’ incomes can have the unintended consequence of increasing nitrogen pollution by increasing the incentive to apply fertilizer.

Further reading

Pannell, D.J. (2017). Economic perspectives on nitrogen in farming systems: managing trade-offs between production, risk and the environment, Soil Research 55, 473-478. Journal web page

Gandorfer, M., Pannell, D.J. and Meyer-Aurich, A. (2011). Analyzing the Effects of Risk and Uncertainty on Optimal Tillage and Nitrogen Fertilizer Intensity for field crops in Germany, Agricultural Systems 104(8), 615-622. Journal web page ♦ IDEAS page

Schilizzi, S. and Pannell, D.J. (2001). The economics of nitrogen fixation, Agronomie 21(6/7), 527-538.

Pannell, D.J. and Falconer, D.A. (1988). The relative contributions to profit of fixed and applied nitrogen in a crop‑livestock farm system, Agricultural Systems 26(1), 1‑17. Journal web page ♦ IDEAS page

Pannell, D.J. (2006). Flat-earth economics: The far-reaching consequences of flat payoff functions in economic decision making, Review of Agricultural Economics 28(4), 553-566. Journal web page ♦ IDEAS page

310 – Additionality can be tricky to assess

Many environmental policies and programs pay public money to people or businesses (or give them tax breaks or discounts) to encourage them to adopt more environmentally friendly practices and behaviours. A seemingly common-sense rule for these sorts of programs is that we shouldn’t pay people to do things that they were going to do anyway, without payment. But it can be quite a hard rule to apply in practice.

The idea that we shouldn’t pay people to do things that they were going to do anyway goes under the name of “additionality”. (It is also related to the with-versus-without principle in Benefit: Cost Analysis, and the concept of market failure – see PD272).

The idea behind “additionality” is that, when a program pays money to people to change their behaviours, the environmental benefits that result should be additional to the environmental benefits that would have occurred anyway, in the absence of the payments.

The reason this matters is that, if we are able to target payments to those behaviours that do result in additional environmental benefits, we’ll end up with greater environmental benefits overall, compared to paying for non-additional benefits – we’ll get better value for taxpayers’ money.

Some environmental programs do a poor job of checking for additionality. As I noted in PD272, much of the money given to farmers in US agri-environmental programs is not additional. In Australia, the Direct Action program for climate change doesn’t consider additionality well when selecting the winning bids in their reverse auctions (it compares practices before vs after signing up to the program, not with versus without).

So, environmental programs that allocate money to people or businesses should worry about additionality, but how? It can be harder than it sounds. It’s all very well to say, “only pay people if they would not have done it anyway”, but how do we know what they would have done anyway?

Sometimes it’s reasonably easy. There are cases where we can be pretty confident that people would not have done the environmental action, and will not start doing it in future, without a payment or regulation. I suspect that most of the work on Australian farms to fence off waterways to exclude livestock would not have happened without payments to cover the cost of fencing materials.

In the US, the Conservation Reserve Program pays farmers to remove agricultural land from production and plant environmentally beneficial species. This is probably mostly buying actions that lead to additional outcomes.

The nature of these additional activities is that they are things that are not normally done by farmers. This is largely because they cost the farmer money.

Judging additionality can be much trickier for environmental actions that also generate enough private benefits to be potentially worth doing by the private individuals or businesses. Zero tillage is a good example. Widespread adoption by farmers of zero tillage in Australia, Canada, the US and some other countries has substantially reduced soil erosion, with a range of off-farm benefits. But the reason this practice has been adopted so widely is that it can be very beneficial to the farmers who adopt it. Paying Australian farmers as a reward for doing zero tillage would be pointless, because most of them are already doing it. The public benefits would not be additional.

But imagine how it was in the early days of zero tillage. From the time when it was first developed, it took several decades for zero tillage to be taken up by most farmers. For the first decade, there were very few adopters. A program looking at subsidising zero tillage in 1990 would probably have judged that the payments would lead to additional benefits, and I would not have blamed them.

In fact, at that time, before the systems and technologies to make zero tillage work as well as it does now had been fully developed, payments in many cases would have satisfied the additionality condition. But only temporarily. At some point, the payments would have needed to be switched off, but judging when to switch them off would have been incredibly difficult. Most likely the payments would have continued for quite a while after additionality was lost.

For some practices, additionality comes and goes. For example, planting perennial pastures sequesters more carbon in soils than is found under annual crops, so it might be worth paying crop farmers to convert. But only if they would not otherwise have done so. The area of perennial pastures in Australia rises and falls over time in response to the prices of livestock products, the performance of available perennial pasture varieties, and the economic performance of cropping. If an agency started to pay farmers to plant perennial pastures, ideally they would keep a close eye on the economics of perennial pastures relative to cropping, in case additionality was lost. If it was lost for a period, then payments for that period are achieving nothing, and could be cut without losing the sequestered carbon.

But how would the agency know? The economics of a mixed farming system are very complex, and highly context specific. I worked on nothing but the economics of mixed farming systems for about 15 years, and it would take me quite a bit of effort to assess the additionality of perennial pastures on a particular farm. It would likely vary from paddock to paddock within the farm. The agency could potentially pay consultants to regularly assess the economics, but the costs of doing so on an individual farm would probably outweigh the value of the additional stored carbon.

What the Australian Government’s Emissions Reduction Fund does instead is a before-vs-after comparison of soil carbon, and it assumes that all of the increase is additional for the life of the agreement. This works initially, but the longer the agreement goes on, the larger the chance that additionality will be lost. If it is lost, then the public money allocated for converting to perennial pastures will just be a gift to farmers who would have done it anyway. The gifts could be small and short term or large and long-term; it’s impossible to know in advance. If it turns out to be large and long term, it is the farmer’s good luck – there is no mechanism in the program to turn the payments off.

Should the program have been designed differently? As I said earlier, rigorously assessing additionality on each farm over time is probably not feasible for this practice. It would cost so much that the investment in soil carbon sequestration was not worthwhile.

Additionality could be assessed for a region, rather than for many individual farms. That would make it more affordable, but given the high heterogeneity of the economics of perennial pastures within a region, or even within a farm, the assessment would be wrong in many cases. Still it might be judged to be acceptable as a compromise.

The other alternative is not to provide payments for soil carbon sequestration at all. Personally, that would be my recommendation. There are other problems with paying for soil carbon as well – leakage and permanence, not just additionality (Thamo and Pannell 2017) – and I don’t believe it’s possible to develop a sound policy that is worth the transaction costs.

Although assessing additionality can be difficult, I’m not saying that it is irrelevant. It is always worth thinking it through carefully when setting up an environmental program, and sometimes it is feasible to do a reasonably reliable assessment of it at reasonable cost. But not always. If not, then the program managers have to judge whether the risk of non-additionality is so high that it is not worth proceeding with the program. That’s a difficult judgement that should not be made lightly.

Further reading

Thamo, T. and Pannell, D.J. (2016). Challenges in developing effective policy for soil carbon sequestration: perspectives on additionality, leakage, and permanence, Climate Policy 16, 973–992. Journal web page