4. Are Farms Different?

"Most New Zealand farmers and commentators rate adequacy of financial profitability as the key driver of environmental and social sustainability" (Underwood 1999 in Rhodes, Willis and Smith 2000 p13)

4.1 Characteristics of farming

It is interesting to note the possible differences between farming and other economic activities. This is because if there are substantial differences in the institutional arrangements and characteristics relating to farming (and how farmers interact with markets) these would determine optimal policy choices, which would be specific to agriculture. Furthermore, in that circumstance, the direction of policy may not be established a priori by theory, since farmers may react in a way that is completely unexpected or unintended. This section examines the characteristics: of farming, New Zealand farming, and the issues thrown up by environmental degradation.

The major test of an environmental policy is how farmers react to an economic shock relative to other parts of the economy, i.e., what does a farmer do when prices of commodity products reduce sharply? The short answer is; anything they can to maintain their farming lifestyle, but not to the long term detriment of their farming resource.

4.2 Why does any difference matter?

Are there any specific points of difference between farming and other forms of economic activity? At an individual impact level there is no clear-cut difference between activities undertaken on the farm and those in urban settings. For example, you could, on an individual level, compare attempts to foster environmental extension activity on farms to attempts by urban authorities to encourage people to recycle.

Two issues are important. Firstly, what is different about agriculture, in the New Zealand context, is the scale of the activities. For example, the approximate 4 million cows contribute the equivalent effluent waste of over 40 million people. What happens in farming collectively, as a land based activity, can have a significant impact on the environment.

This differentiates itself from the environmental effects of other activity in the New Zealand economy (such as a corner store). The primary sector is a major user of natural resources especially land and water. The treatment of natural resources whether owned privately or publicly has significance locally, regionally, and nationally.

Secondly, it has major significance of off-site effects or externalities on the rest of society. Since land management practices have the potential to "spillover", impacting on other parts of the economy, if farmers can be persuaded to farm in a sustainable way then there can be significant social benefit from these actions. These actions can take a number of forms such as aesthetic and practical. For example:

it is widely believed that one of the driving forces behind farm subsidies in Europe is the willing cross subsidisation from urban to rural areas for aesthetic reasons. Urban taxpayers like to see a countryside that is aesthetically pleasing. Subsidies equals pleasant looking countryside. ⁶
in countries such as New Zealand, where unsubsidised agriculture is the major export earner, preservation of productive land over the long term is a priority.

Farmers may be unwilling to follow sound practices such as soil erosion control through poplar planting or improved tillage practices, and controlling effluent discharge into streams. Specifically, a number of reasons combine to dampen down farmer concerns about long term environmental sustainability:

a lack of education or appreciation of environmentally sustainable practices.
a short term commodity price view of the world.
a lack of trust of all levels of government (see public Vs private goods).

This leads farmers to gamble that:

a fifty year "event" will not inundate their property.
effluent from their property is not traced to them.
short to medium term profits are more important than long term sustainable development objectives.

So because of the scale and externality issues associated with environmental sustainability, environmental extension activity could be important in agriculture. This will depend crucially upon whether or not outcomes "on farm" depart significantly from what is deemed to be environmentally sustainable management.

4.3 Institutional arrangements

Turning to the institutional arrangements in farming, a useful approach to understanding farm behaviour is through the lens of institutional economic theory. This leads directly to the fundamental work of Coase (1937) and latterly Allen and Lueck (1998).

Coase (1937) asked the question: how big should the firm be? This is particularly interesting in farming because casual observation suggests that farms are small in terms of labour employed (although getting bigger) and predominately family owned. To further investigate this issue Allen and Lueck (1998) devised an approach, which connects observations of seasonal production stages, crop cycles, task specialisation, and random weather events to the modern theory of the firm.

The smallness of farms has a major impact on how environmental technology is transferred. Part II of this report illustrates that previous models of extension fail to address the problems faced by landowners particularly when new skills are required, motivation levels need to be maintained, and issues of increasing complexity addressed.

By its nature, a sustainable environmental strategy is long term. For an environmental policy process to work will require a good deal of education and understanding. It will involve farmers, those involved "on the ground" in the process, and policy designers, as to what is an environmentally sustainable approach and what is not, to weather the situations when farmers are under financial stress.

4.3.1 Farming characteristics

In general, a number of points can be made about farming and the observed behaviour of farmers⁷. These include:

The impact of seasonality and number of random shocks that impact on production has a major bearing on farm organisation. This essentially comes down to a trade off between specialisation and moral hazard⁸. Farms are characterised by family ownership because the costs (including risks) of expanding production and employing further labour are outweighed by the opportunities for moral hazard that seasonality and random shocks present. As Allen and Lueck (1998) p346 suggest:

"The simplest family farm avoids moral hazard because the farmer is the complete residual claimant. But the simplest family farm sacrifices gains from specialised labour available in more complex agricultural factories."

When farm systems are able to lessen the impact of seasonality or random production shocks they are able to mimic factory like processes, with large scale co-operative or corporate organisations similar to other organisational forms found elsewhere in the economy.

Agriculture is characterised by different, almost separate stages of production. These include, for example, preparing soil, planting crops, applying pesticides, harvesting, packing, processing, and marketing. In a specialised business there is no reason why each of these stages could not be done by a different set of contractors.

It is usual, however, for farmers to control all stages of production and some cases processing and marketing. In Coase’s words they "make" these products themselves rather than "buy" in services. In the case of the New Zealand dairy industry, farmers have integrated forward into processing and (with statutory) help into marketing. Co-operatives, in this regard, can be seen as a risk management device to ensure that the product is sold in a timely fashion. Ownership of the processing facilities and marketing operations is the firmest sort of contract.

Another variation on the "make" or "buy" issue is that farms are usually characterised by ownership of land, not renting or short-term leasing. This is a particular characteristic not only of New Zealand farming but most farming operations in the industrialised world. To complicate matters further, these two businesses (owning and producing) have an inherent tension between longer-term land holding and its returns, and the short-term fixation on the price. Why is this strange? Owning land and farming the land are two different businesses. The first business reflects the value of the land and return, which can be earned in the way of rent. Some of the factors that are important in valuing land are gradient, soil, location, available services, and property condition. These situational advantages or disadvantages will have a great bearing on the farmer’s attitudes towards any policy directed at environmental improvement activity. The other business (farming) reflects the returns from production. When the value of production falls, the ability to continue an on-farm environmental improvement process becomes more difficult since available funds dry up.

The specific characteristics of farming that need to be considered by policy makers include:

The smallness of farms. Even though technology has allowed the management of an increased area of land (and the trend is set to continue), the basic farm unit is still the family farm. This means that there is limited cash injected from outside sources into the business, so improvements to the property will happen over time as cash flow permits.
The number of farmers. The scale of farms and their normal ownership by the farmer means there are large numbers of farmers doing different things on the land with varying degrees of skill and technology up-take.
The people who run the farm own the farm. Contracts are internalised within the family unit – so if farm returns fall, contracts do not need to be re-drawn (they are informal and between family members.) It also means that as a residual claimant the landowner is responsible for the long term health of the property so there is a strong incentive to maintain the property in a sustainable way and take care of those hard to monitor issues such as water quality or soil fertility.

This adds complexity and underlines the need for flexibility in policies directed at farming. An effective environmental policy requires the "buy in" from all farmers, who learn at differing rates, and have different ideas about the worth of environmental programmes. It also highlights the need for support from various agencies of government for a co-ordinated a policy approach, once farmer "buy in" is achieved. In a recent MAF report Rhodes, Willis and Smith (2000) p18-19 highlighted farmer concerns: "that their own reserve or potential reserve [would not be] fitted… into any wider regional or national plan". Therefore, their motivation to carry out further environmental improvements diminished. This illustrates the importance of interaction between farmers and government agencies (see Figure 1) and how that interaction occurs. Part II of this report suggests that this is complex, requires a long term investment, and involves the systematic development and use of social capital.

4.4 New Zealand farming

The type of farming practised in New Zealand relative to the rest of the world is somewhat unique. It is not as intensive as the farming processes undertaken in other OECD nations and other agricultural exporting nations, nor is it similar to the traditional subsistence farming practised in less developed nations. New Zealand’s endowment is a warm temperate climate, which is the major contributor to phenomenal grass growth. Coupling this with the rapid adoption of technology gives New Zealand a competitive edge on world agricultural markets.

If the type of farming activities undertaken in New Zealand relative to the rest of the world are considered, it could be characterised by ‘intensive grassland management.’ Figure 2 illustrates where New Zealand "fits" in a stylised spectrum of intensity of world agriculture.

Figure 2: Stylised view of the intensity of world agriculture

Source: NZIER

Figure 2: Stylised view of the intensity of world agriculture

Feedlots and other factory farming methods are not common in New Zealand (apart from poultry and egg production), therefore seasonal variations dramatically impact on the volume of product produced. However, if feedlots and factory farming methods become more cost effective in the New Zealand setting, farming would be treated more like manufacturing firms and the regulatory environment should reflect this shift away from traditional farming methods.

The changing nature of New Zealand farming is driven by:

The relatively new geological structures in New Zealand. Soils, personal interest, weather, export orientation, and micro-climates, mean that there is diversity of agricultural activities taking place in New Zealand.
The prices received for the commodities produced on world markets are also volatile, and to a large extent, producers are price takers. On average the net wealth position of any of our agricultural industries can change dramatically in a short space of time as prices rise and fall, favourable or unfavourable weather conditions prevail, or random shocks occur.
The use of land in the New Zealand context. There are no subsidies given to New Zealand farmers to produce product, therefore overseas market prices are major determinant of what is grown on the land. So if the land is suitable to be converted from one activity to another more profitable activity, farmers will do so. Not only is there a diversity of agricultural uses, but land use changes over time.

This means that delivery techniques will vary from region to region because of the different farming practices. Therefore flexibility of policy initiatives and increased interaction between the various stakeholders becomes an important part of any effective process.

4.5 Uniqueness of environmental issues

It has been customary, for economists, to catogorise effects of environmental degradation (or environmental improvements) as principally on-farm or off-farm effects. This categorisation is often regarded as closely conforming to the division between privately appropriable effects and external effects, but the situation is more complex. For instance, environmental degradation caused by one farmer may impact on all users downstream.

4.5.1 On-site impacts

On-site impacts are more easily identified and managed and quantified relatively easily in a cost-benefit framework⁹. For example, on-site environmental damage effects could include:

Reduced vegetative production, e.g. loss of pasture, lower crop yields, and slower regeneration of grazed land.
Reduced animal performance, e.g. lowered lambing percentages, reduced feed conversion, increased animal stress, and veterinary complaints.
Damage to fixed structures on site, e.g. buildings, fences, and farm roads.
Disruption to site operations e.g. non-optimal stock rotations, pasture utilisation loses, transport costs in detouring major slips, clean-up activities in aftermath of major adverse events.

There are also cases where farmers are "expected" to carry out environmentally sustainable farming practices when the economic benefits to farmers are, at best, marginal. For example, a forthcoming paper by Parminter (2001) concludes that:

"The private monetary incentives for planting poplars for erosion control are marginal at best. At all discount rates, the farmer would be better off doing nothing to control erosion, rather than plant poplars and not harvest them, unless there are very strong non-monetary incentives."

For short term production purposes the cost benefit analysis carried out by Parminter suggests, given normal conditions, that: "farmers may be better off investing in pines rather than poplars." However, risk adverse farmers may be motivated to plant poplars as "insurance" against a one-off on-site erosion event.

This illustration raises questions about the different risk profiles farmers have and how that translates into on-farm behaviour. This increases the complexity of the issue facing farmers as the economic signals counteract what are considered to be sustainable farming practices. The complexity and the need to change behaviour underlines the importance of long term solutions as the lines between the on-site and off-site impacts are blurred. Part II explores the linkages between research, extension, and effective interaction with users in more detail.

4.5.2 Off-site impacts

Off-site effects can be divided into a number of different categories. By listing the various bundles of effects, by way of example, it can demonstrate the complexity and difficulty of the issues involved in developing a long-term environmentally sustainable programme and measuring the costs and benefits.

Off-site production effects: These are effects, which impact on production processes, but not necessarily on the properties where the erosion originates. Such external effects are principally:

Reductions in adjoining site outputs where degradation on one property generates any of the on-site effects on another property (e.g. downstream deposition of sediment).
Losses imposed on processing facilities for land-based primary produce, which may be either lost scale economics on lower throughput; or lost value added on lower throughput.

Lost scale economies on lower throughput imply reduced output:input ratios for processing and hence a real efficiency reduction, but lost value added on lower throughput need not imply an efficiency loss. For instance, if reduced farm output results in shorter shifts in processing plant operation, with a consequent reduction in labour input, power used and so on, there may be no reduction on resource utilisation except for capital equipment – much of which can be regarded as a sunk cost with no bearing on any quantification of the costs and benefit.

When analysing the costs and benefits it is common to exclude processing losses from consideration on the grounds that resources "released" will be redeployed in other industries. In the medium term to long term this may be appropriate. But in the short term the loss of productive output from processing resources is a real cost. This is particularly so if such resources (especially labour) perceived as more important for local or regional concerns, where the outcome of the adjustment is likely to lead to depopulation and the undermining of the district’s capacity to support both public services and private trading activity.

A further question is whether these losses need be regarded as true externalities requiring government intervention, or whether they could be overcome through private negotiations. Processors can and do enter contractual arrangements with suppliers to remove the qualitative variation in their stock intake; could they do the same for quantity changes? They also protect themselves against loss by insurance. To some extent such arrangements simply transfer risk between parties, but they could have real resource effects. For instance, if processing losses caused by interrupted supply were insurable from a nationwide pool, the threat of plant closures and consequent dislocation in regions struck by adverse events could be reduced. As long as the pool is large enough to handle accumulated claims, and all contributors are better off with the cover than they would have be without it, there can be efficiency gains because there will be less incentive for overly-cautious behaviour.

Off-site community/environment effects: These may be characterised as consumption losses, detracting from well-being derived from current use of the natural environment and community amenities. Many of them impact on changes in probabilities – increased risk of flood, – reduced likelihood of catching fish – so they represent a small yet persistent "expected value" loss if analysed in a cost benefit framework. Few generalisations can be made about the scale of these effects since this depends on the nature and extent of the communities in downstream areas. Among the possible effects are increased sediment load leading to: increased flood risk, increased erosion, increase cost of water filtration, and reduced aesthetic amenity.

For some of these effects, potential damage costs avoided may be a reasonable proxy for value, but for those which are not explicitly traded in a market context some form of non-market valuation procedure is required. Such techniques are data intensive, costly to administer, yield values which can not be extrapolated beyond the context in which compared with other costs used in a national accounting context. Obtaining values for such off-site effects remains one of the major problem areas for evaluating environmental changes.

Off-site transitory effects: These relate principally to disruption of infrastructure and national network facilities. The main item is likely to be disruption to transport infrastructure which has two components:

Additional road repair and maintenance costs caused by adverse events damage; and
The delay and diversion costs imposed by such damage on all who use the infrastructure, directly or indirectly.

These costs would be measured as an expected value of damage, comprising cost of disruption times the probability of disruption occurring; so conservation techniques which alter that probability or the likely extent of damage could critically affect analysis results. Such effects may not be a major component in an analysis, but neither would they be zero.

4.6 Summary

The question that is asked is what, if anything, is "special" about the setting for sustainability of our farming activities? If there are no differences between rural industries and other forms of economic activity, government has very little economic justification for different types of interventions – farms can be treated the same way as factories.

The special characteristics of rural industries have been teased out both in terms of the unique characteristics of farming in the New Zealand setting and the problems associated with measuring the costs and benefits of environmental damage. The next section will use this information, combined with the previous two sections to demonstrate the possible interventions that would be effective.

6 Whether this is true or not is beside the point.

^{7 This work closely follows the Allen & Lueck
(1998) paper, whose approach brings together earlier work on organisations done by Alchian
and Demsetz (1972), Holmstrom and Milgrom (1994), and Becker and Murphy (1992).}

8 Moral hazard occurs when: (a) one party to a contract can exploit an opportunity and benefit at the expense of the another party, and (b) the contract can not be monitored or enforced in a satisfactory way.

9 To understand why a cost benefit framework is seen as the most appropriate tool to measure on and off site impacts, see Appendix A.

Contact for Enquiries

Rural Affairs Coordinator
Sector Performance Policy
MAF Policy
Ministry of Agriculture and Forestry
PO Box 2526
Wellington
NEW ZEALAND

Phone: +64 4 894 0675
Fax: +64 4 4 894 0745
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