R&D Investment and Output Competition by Supply-Managed Producer Associations

1. R&D Investment and Output Competition by Supply-Managed Producer Associations Zoe Campbell James Vercammen University of British Columbia CAES/AAEA Annual Meetings Portland (July 30, 2007)

2. Producer-Funded R&D • Public sector agricultural R&D is gradually being replaced by private sector R&D in many countries (Alston, Pardey, and Roseboom 1998) • As well, farmers are increasingly active in R&D through producer association check-off schemes (Alston, Pardey, and Smith 1998) • Return to agricultural R&D is generally high, both for producers and for society, so R&D investment is typically inefficiently low (Alston, Marra, Pardey and Watt 1998, Brinkman 2004)

3. Producer Associations in Supply-Managed Industries • Canada utilizes supply management for the production of dairy, poultry, eggs and other select commodities • Producers in supply-managed industries are required to contribute a portion of their sales to their association (i.e., a mandatory levy) • A sizeable fraction of the total levy is ear-tagged for R&D • Dairy Farmers of Canada invests annually up to $1.7 million in health and nutrition research, and dairy production research

4. R&D Incentives with & without SM • SM schemes are often criticized because of non-competitive domestic pricing, restricted imports and a constrained operating environment for processors • Can SM schemes also be criticized on the basis of inefficient R&D incentives? • Specifically, do producers in SM industries contribute less to R&D because of restricted domestic production and import controls? • Would Canadian producers participate more actively in R&D if a future WTO agreement eliminates SM and allows for free-trade and competition?

5. Theoretical Context • Theoretical analysis of R&D incentives generally assume a small set of imperfectly competitive firms and R&D spillovers • Agricultural firms are perfectly competitive, but the association making the R&D decisions has monopoly power and faces no spillovers • There are no models which compare R&D incentives when both R&D and production are monopolized (current SM) with R&D incentives when R&D is monopolized and production is competitive (dismantled SM)

6. Paper Objectives • Theoretically compare R&D investment incentives with SM versus a competitive closed economy (R&D decisions are still monopolized) • Expand comparison by allowing for an open border with the U.S. (now producer association competes for market share) • Initially assume identical demand and production costs prior to R&D selection to isolate pure competition effects • Then assume Canada is a net importer prior to R&D to account for “size of the market” effects of SM reform • Assume R&D reduces cost rather than creates new products

7. Review of Theoretical Issues • Schumpeter (1942) argues that monopoly and large scale promote R&D investment because more benefits can be captured and the economic environment is more stable • Others argue that competition promotes R&D investment because firms that fail to innovate operate at higher relative cost and lose market share • In an oligopoly environment, spillovers reduce a firm’s R&D incentives because of impact on rival firm’s cost (d’Aspermont and Jacquemin 1988) • Firms have an incentive to set up research joint ventures and/or R&D cartels, and these are typically socially efficient (Kamien, Muller and Zang 1992)

8. Closed Economy Result 1: In a closed economy, R&D incentives are stronger with versus without SM • In a competitive environment with relatively elastic demand, consumers capture large share of R&D surplus • SM retains higher fraction of R&D surplus for producers • Suppose supply is linear with slope  and intercept c, and suppose demand function is P(Q) • Assume R&D decreases c • SM: Competition:

9. Closed Economy Illustrated R&D Induced Shift SM Competitive Gain is positive Gain is small or negative

10. Open Economy • In the closed economy model, the SM producer association faces no competition • Competition in the form of free trade should induce the producer association to invest more in R&D

11. Open Economy Model • Demand: P = H – Q for home P = F – Q for foreign • Supply: MC = h + Q for home MC = f + Q for foreign Where: h = h0 – xh - xF f = f0 – xF - xH  (0, 1) is the spillover parameter • Cost of R&D is quadratric • Let xSM, xC and xT denote optimal R&D levels for H with SM, closed competition and open competition

12. Pure Competition Effects: No SpilloverTwo Countries are identical prior to R&D Decision Country H Country F Excess Supply Excess Demand Becomes net importer due to lower R&D Becomes net exporter due to higher R&D

13. Result 2: Pure Competition Effect • Suppose trading countries are identical prior to R&D, and suppose spillovers are zero. In two-stage game equilibrium: xC < xSM < xT • The concern over market share lost to imports induces the producer association to invest relatively more aggressively

14. Result 3: Impact of Spillover • Suppose trading countries are identical prior to R&D • An increase in the spillover parameter, , reduces optimal R&D • For a low to moderate value of  xC < xT < xSM • For a relatively high value of  xT < xC < xSM

15. Intuition for Result 3 • As H increases x, F also becomes more competitive due to the spillover • H will therefore choose a smaller value of x to account for this externality • There exists a critical value for  which ensures R&D expenditures are equal with SM and with open borders • If R&D spillover is high (i.e., above critical value), then dismantling SM will result in a lower level of producer contributions to R&D

16. R&D Joint Ventures • R&D joint ventures (RJV) are common in industries such as biotechnology and telecommunications • In our model, RJV implies agreeing to share R&D results ( = 1) while still choosing x non-cooperatively • Kamien, Muller and Zang (1992) show that with imperfect competition, RJV result in lower R&D levels but higher profits for each firm • Similar results are obtained in this competitive model of R&D: raising  increases surplus for producers and society, but reduces R&D spending • Considerable evidence of R&D cooperation in agriculture

17. Net Importer Scenario • The assumption of equal-sized trading partners is now relaxed • Assume that with open borders, H is a net importer prior to choosing R&D • Opening the border therefore reduces the size of H’s market (refer to this as the “market scale” effect) • Walk through the two alternative scenarios of: (a) no spillovers; (b) positive spillovers

18. Result 4: Market Scale Effects • Suppose H is a net importer after SM is dismantled but prior to R&D choice. Suppose the spillover is zero. • If pre-R&D imports are small, then the competition effect dominates and xT > xSM • If pre-R&D imports are relatively large, then the market scale effect dominates and xT < xSM • One of these two scenarios corresponds to the Canadian case

19. Result 5: Market Scale and Spillovers • Suppose H is a net importer after SM is dismantled but prior to R&D choice. Suppose the spillover is positive. • An increase in the spillover induces F to invest less heavily in R&D • An increase in the spillover initially induces H to invest more heavily in R&D but eventually induces H to invest less heavily in R&D • In other words, for small values of β, R&D choices for H and F are strategic substitutes and for larger values of β, the choices are strategic complements

20. Conclusions • Despite a large literature on R&D incentives, no obvious implications for SM • Considerable theoretical ambiguity regarding whether R&D incentives will improve or worsen with a dismantling of SM • Framework is highly simplistic • Additional theoretical and empirical work warranted Financial support from Canadian Agricultural Innovation Research Network (CAIRN gratefully acknowldged