AAMP Training Materials

1. AAMP Training Materials Shahidur Rashid and Nick Minot (IFPRI) s.rashid@cgiar.org, n.minot@cgiar.org Module 1.3: Profitability of Fertilizer

2. Module Outline • Objectives • Background Materials • Fertilizer Profitability, Case Studies and Exercises • Fertilizer Crop Model Exercises • Conclusions

3. Objectives • Assess farm-level profitability of fertilizer use • Fertilizer cost components • Output response of fertilizer applications • Profitability of fertilizer use • Risk and the value/cost ratio (VCR) • Use Fertilizer Response Model • Evaluate the impact of price and policy changes on fertilizer use, crop output, and consumer and producer benefits

4. Background Material • Review of markets & prices • From cost curves to the supply curve

5. Markets and Prices Market Price Process of exchange Outcome Q: What determines the process of exchange?

6. Demand & Supply Consumers maximize satisfaction from what they buy given their income Producers maximize their profits given certain technology DEMAND SUPPLY PRICE

7. From Cost Curves to the Supply Curve Average Total Cost (ATC) is a firm’s total cost divided by the quantity produced. Marginal Cost (MC) is the change in total cost for a change in output, or the cost of the “next” unit produced. A firm’s MC also acts as its supply curve.

8. The Individual Firm and the Market

9. Fertilizer Profitability • Fertilizer cost • Crop response to fertilizer application • Profitability of fertilizer use • Risk and the value/cost ratio • Exercises on fertilizer profitability

10. Fertilizer cost build ups

11. Case study of maize profitability

12. Fertilizer responsiveness on maize (maize yields (qt/ha)

13. Ethiopia Fertilizer – Yield Response Elasticities

14. Key Factors Behind Fertilizer Profitability Fertilizer Price Highly Variable RISK Output Price Current Yield Weather Uncertain Level of Use Lack of Public Goods Transaction Costs High Prices

15. Value/cost ratio (VCR) VCR = value of increased crop output cost of fertilizer applied = P(crop)*Q(additional crop production) P(fert)*Q(fertilizer applied)

16. Risk and fertilizer use • Fertilizer use is highly risky in Africa because of highly variable weather • Drought  crop losses • Drought  heavy financial losses when purchased inputs (like fertilizer) applied

17. Risk and VCR • Rule of thumb: given normal risks, VCR > 2 necessary for farmers to use fertilizer • High risk production environments: VCR > 3-4 necessary for farmers to use fertilizer

18. Fertilizer Profitability Example • Elasticity estimate for fertilizer response = 2.6 • Therefore, a 10% increase in fertilizer use  2.6% increase in yield response • Average fertilizer use is 80kg/ha, so… • 10% increase in fertilizer use  8kg/ha additional use of fertilizer • Cost of additional fertilizer = 8kg * 4 Birr/kg = 32 Birr • Average yield is 1700 kg/ha. Using our elasticity estimate, • Expect a 2.6% increase in additional output  44.2 kg/ha • Additional value of extra production  44.2 kg/ha * 2.5 Birr/kg = 110 Birr/ha • Extra revenue due to fertilizer  110.5 – 32 = 78.5 Birr

19. Profitability Exercise 1 • Question 1: Given the data above, will it be profitable for a farmer to increase fertilizer use by 10%

20. Profitability Exercise 2 • Question 2: Suppose the country increases fertilizer use by 20%, which leads to a 6% increase in maize supply. If the price elasticity of supply is 0.5, what will happen to maize price? What will happen to profitability?

21. Using a Fertilizer Crop Model • Review • What is a model? • Example of a simple model • Comparative Statics • Understand fertilizer response curve • Discuss crop supply and demand

22. What is a model? • A model is a set of equations that represents some aspect of reality and converts data and assumptions into useful results. Data Assumptions Model Results

23. Example of a simple model Data: Distance from Livingstone to Lusaka is 472 km Assumption: Can drive at 60 kph on that route MODEL: Time = Distance/speed Results: Time=7.9 hours

24. Comparative statics • Running a model repeatedly with some difference and comparing results Alternative data Alternative assumptions Base data Base assumptions Model Model Alternative results Base results Example: If we could increase our speed from 60 to 70 kph, it would take us 15% less time or 6.7 hours.

25. A fertilizer-crop model Assumptions: relationship between fertilizer use and crop yield, farmer behavior and elasticity of demand. Data: current crop production, crop consumption, crop price, fertilizer price (before subsidy), subsidy rate, & fertilizer use. Model Results: fertilizer use, crop production, crop consumption, & crop price, given a change in data or assumptions

26. Fertilizer response curve • Yield is positive even with no fertilizer • Yield rises with more fertilizer, but the rate of increase declines • Too much fertilizer will reduce yield

27. Fertilizer response curve • a is the yield with no fertilizer (a>0) • b determines the steepness of the curve at the beginning (b>0) • c determines how quickly it turns down (c<0) Yield = a + b*F + c*F2

28. Fertilizer response curve (in value terms) • If we multiply yield by crop price, we get the curve of the value of production per hectare • It has the same shape • We can add cost of fertilizer per hectare (red line) • Profit from using fertilizer is vertical distance Profit

29. Fertilizer response curve (in value terms) • Black box maximizes yield • Blue box maximizes profit • Red box is where a risk-averse farmer might choose to produce

30. Fertilizer response curve (in value terms) • Fertilizer subsidy lowers the angle of the red line (dashed red line) • This increases optimum amount of fertilizer and increases yield

31. Fertilizer supply and demand • Fertilizer subsidy lowers the retail price (red lines) • This increases fertilizer use from 25 to 33 kg/ha

32. Crop supply and demand • Fertilizer subsidy increases crop supply (shift to right) • This lowers price if non-tradable

33. Crop supply and demand • Benefit to consumers is reduction in price multiplied by quantity consumed • Benefit to farmers: is area between supply curves (red) below equilibrium price

34. Fertilizer Response Exercises (Notes) • Only yellow cells should be changed • Generally we want to change the “after” cells so we can compare “before” and “after” results • Don’t forget to return changed numbers to their original values before doing the next exercise. • The model does not account for rationing, late delivery, targeting, leakage, rent seeking, or differences between farmers and regions etc. Nor has it been calibrated using real-world data. Therefore, it should be considered a training tool, nothing more.

35. Fertilizer Response Exercises • Evaluate the effect of a new seed variety that is more responsive to fertilizer. • Change the “b” coefficient (cell E14) from 25 to 30. • What is the effect of a new seed variety that gives a higher yield without fertilizer, but gives same response to fertilizer? • Change the “a” coefficient to 900, but leave “b” and “c” as is. • What is the effect of an increase in the crop price on fertilizer use? • Change the crop price from US $250 to US $300.

36. Fertilizer Response Exercises • What would be the effect of a program that made farmers less risk averse? • Reduce the VCR (Cell E11) from 2 to 1.5 • What is the effect of a 40% subsidy on fertilizer utilization? Do farmers use more or less than the economic optimum? What about 50%? And 60%? Which gives the largest net impact on the country? • Suppose farmers were not risk averse and were economically rational. What is the net impact of a fertilizer subsidy? • Hint: set VCR=1 in before and after columns.

37. Fertilizer Response Exercises • What is the net effect of a 50% fertilizer subsidy if the administrative costs are 40% of the direct subsidy costs? How about 50% or 60%? • What is the distribution of gains from a fertilizer subsidy between farmers and consumers? Why is one larger than the other? What would be the distribution be if the demand for the crop were highly elastic (e.g. elasticity of demand=-20)? What kind of crops have a highly elastic demand?

38. Conclusions • In order to simulate impact of fertilizer policies, one needs: • Data on current use by crop and yield responsiveness • Estimates of supply and demand elasticities for fertilizer & crop • Assumptions about farmer decision making process (what is minimum VCR?) • Fertilizer demand can be affected by: • Yield response of crop (maize & rice respond more than cassava) • Yield response of variety (modern varieties respond more) • Price of fertilizer (subsidy or lower price  higher demand) • Risk aversion of farmers (lower risk aversion higher demand) • Crop price (higher price makes fertilizer more profitable)

39. Conclusions • Increased fertilizer use causes: • Increase in supply of crop with benefits to farmers • Reduced price of crop (if non-tradable) with benefits to consumers • Distribution of benefits of higher fertilizer use depends on elasticity of demand for the final output (maize, cotton, etc) • Inelastic crop demand means price falls more, larger benefits for consumers, smaller benefits for farmers • More elastic crop demand means price falls less, smaller benefits for consumers, larger benefit for farmers • If tradable crop, price fixed by world markets and no benefits for consumers, all benefits to farmers

40. References • Kelly, V. 2006. Factors affecting the demand for fertilizer in sub-Saharan Africa.” ARD Discussion Paper No. 23. The World Bank. Washington, DC. http://siteresources.worldbank.org/INTARD/Resources/ARD_DP23_FINAL.pdf • Morris, M. et al. 2007. Fertilizer use in Africa. The World Bank. Washington, DC. http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2007/03/15/000310607_20070315153201/Rendered/PDF/390370AFR0Fert101OFFICIAL0USE0ONLY1.pdf