Joint Research Project

Joint Research Project

Working Paper Series

Work Package 4, Working Paper 2/..,November/2000

AGRICULTURAL DIVERSIFICATION: A REVIEW OF METHODOLOGICAL APPROACHES AND EMPIRICAL EVIDENCE

Hannah Chaplin

Department of Agricultural Economics

and Business Management, Wye College, University of London

This Research Project is Financed by the EU Commission's 5th Framework Programme (QLRT-1526)

Contents

1. Diversification4

1.1. Introduction4

1.2. Definition of Diversification4

1.3. Part-time Farming6

1.4. Pluriactivity8

1.5. Types of Diversification Activities8

1.6. Diversification versus Specialisation9

1.7. Who Diversifies?12

2. Factors Affecting Diversification13

2.1. Risk14

2.1.1. Price Risk14

2.1.2. Production Risk14

2.1.3. Attitudes to Risk15

2.1.4. Methods of Measuring Risk17

2.1.4.1. Econometric Method17

2.1.4.2. Experimental Method18

2.2. Other Factors20

2.2.1. Farm Characteristics20

2.2.2. Household Characteristics23

3. Models28

3.1. Agricultural Household Models28

3.2. Models of Entrance and Exit Decisions33

3.2.1. Satisfaction of Risk Aversion and Viability

Constraints33

3.2.2. Sunk Costs35

3.2.3. The “q” Theory38

3.2.4. Considering Exit and Entry Decisions at Call

Options38

3.2.5. Entry Barriers40

3.3. Panel Data Modelling45

3.4. Appropriateness of the Models48

3.4.1. Agricultural Household Models48

3.4.2. Entry Models49

3.4.3. Panel Data Models50

4. Conclusions51

References53

1. Diversification

1.1. Introduction

This paper seeks to review diversification literature. In the first section, diversification will be defined, types of diversification outlined and factors affecting diversification discussed. This will lead on to the next section where possible models, which may be used to explain diversification, will be reviewed. These models include household models, entry and investment models, and finally panel data models.

1.2. Definition of Diversification

Diversification may be defined as “the production of a variety of different articles, services, etc. Often as a safeguard against the effects of fall in demand for a particular product” (Oxford English Dictionary, 1972). The concept may be explained further by considering minimum diversity as being the practice of a single system and maximum diversity as an equal distribution of all enterprises (Zandstra, 1993). With regard to agriculture, diversification may be viewed as a process with four stages. Initially, diversification is at the cropping level where there has been a shift away from monoculture. This is the stage at which many developing countries are currently lying (Petit and Bargouti, 1993). At the second stage, the farm has more than one enterprise and may produce and sell crops at different times of year (Metcalf, 1969). At the subsequent stage, diversification is understood as being mixed farming (Shucksmith et al., 1989). Finally, activities beyond agriculture are incorporated into the meaning of diversification (Newby, 1988). The concept of diversification is often taken to mean a shift away from the production of surplus commodities to those which may be expanded (Newby, 1988).

At the final stage, diversification may be considered as unconventionality with respect to traditional farm family agricultural activities (Evans and Ilbery, 1993). In addition, it incorporates the use of farm resources for non-agricultural activities (Shucksmith and Winter, 1990). Such activities could include on-farm processing, the provision of non-agricultural products and services on- farm (Evans and Ilbery, 1993). This is consistent with non-agricultural literature, which explains diversification as a strategy of utilising excess capacity of production factors, which are subject to market failure (Montgomery and Wernerfelt, 1988). Thus, if there is no market for surplus factors of agricultural production such as land or capital, output may be generated from them by utilising these factors in an on-farm non-agricultural enterprise. This may be of interest for Central and Eastern European Countries (CEECs) where land and capital markets are still in the process of development. The farm household labour resources are not implicitly included within the bounds of diversification, but capital and land resources are. A Ministry of Agriculture, Fisheries and Food (MAFF) study of diversification in 1989 excluded employment of labour but included contracting (Shucksmith and Winter, 1990). Thus, diversification is a narrow concept restricted to farm-centred activities in Britain. By and large, this narrow definition of diversification is policy-driven where the circumstances of smaller producers are neglected and emphasis is placed on large farms. For larger farms, the surplus factors of production are largely capital and land, whereas for the smaller farms, it is labour which is most often in surplus (Shucksmith et al., 1989). A baseline survey of Western Europe indicated that off-farm employment is the most common form of non-agricultural involvement of farm households. Farm-based diversification was of little significance (MacKinnon et al., 1991).

A plethora of terms have emerged alongside diversification to describe non- agricultural activity by farm households such as pluriactivity and part-time farming. These terms are often used interchangeably. The precise meaning of these terms will be discussed below.

1.3. Part-time Farming

Part-time farming may be defined with respect to the farm or the farmer and different elements of each. These may be how the farmer divides his time, the existence of other paid work or in terms of the holding itself (Robson et al., 1987). Thus, the definition is fairly loose and is often chosen for convenience. This is frequently due to changing policy issues which create different information requirements (Gasson, 1991). Examples of this are outlined as follows. In the 1941-3 National Farm Survey of the UK, the existence of other paid work was used in order that identification of wartime farmers who were not completely devoted to food production could be carried out. The Small Farm Scheme denoted holdings below 275 standard man-days (smds) as non-viable part-time farm businesses. Since 1970, the agricultural census defined a part-time farmer as one who devoted less than 40 hours per week to farm work. This was appropriate for labour productivity policy objectives (Robson et al., 1987). Part-time farms may be defined as those where either the farmer or spouse combines non-agricultural work with work on the holding. The farmer or spouse is then a part-time farmer (Gassson, 1986).

Where part-time farming is defined in relation to the existence of other paid work, there is no distinction between a farm household where only a few days a year are devoted to off-farm work, and one in which one member has full-time off-farm employment. Furthermore, there is no distinction offered between those who regard farming as their primary employment and those who regard it as a secondary occupation. A number of countries do make this distinction by classifying the former type as class I and the latter as class II (Robson et al., 1987). Several criteria have been put forward as a means of identifying part-time farmers as distinct from those who are full-time, which help to address some of the problems outlined above. These are:

a)Spending less than a stipulated length of time working on the farm.

b)Having some other gainful occupation(s).

c)Having some other gainful occupation(s), the principal one not being farming in terms of criteria such as time spent working or income gained (Lund, 1991).

These three definitions all have limitations. The first provides no information about time use beyond the farm. Thus, it does not differentiate between a pensioner or unemployed individual who requires the farm for subsistence production or a hobby farmer. The existence of another gainful occupation as a definition as outlined above shows no distinction between time committed to this occupation. Thus, in such a case, the classifications of class I and class II may be of use. The third classification only identifies those for whom farming is a secondary occupation and thus eliminates those for whom a secondary occupation may provide an important source of income.

Where the main point of interest is to see how the holding contributes to farm families’ income and employment, the income-generating activities of the whole household who contribute to the household budget should be included in the definition (Robson et al., 1987). The definition of part-time farming is related to personnel, i.e. the farmer and the farm household, as opposed to the capital and land resources in the case of diversification. However, if farm-centred activities such as a restaurant constitute paid work, then the distinction between farm-based and off-farm work becomes blurred and there is little distinction between part-time farming and diversification (Evans and Ilbery, 1993).

1.4. Pluriactivity

The term pluriactivity originates from the French pluriactivité (Fuller, 1990). It is utilised to describe the combination of farming and other gainful activity, which may be on-farm or off-farm (MacKinnon et al., 1991). Fuller (p367, 1990) states that pluriactivity is a term which “describes a multidimensional landholding unit in which farming and other activities are undertaken, both on- and off-the farm, for which different kinds of remuneration are received (earnings, incomes in kind, and transfers).” Thus, pluriactivity incorporates the terms diversification and part-time farming through the usage of labour, land and capital resources (Evans and Ilbery, 1993).

Although the three terms can be taken to carry slightly different meanings, generally they are utilised interchangeably. In this study, the term diversification will be used. It will include farming in conjunction with other gainful activities, which may be off-farm employment (income diversification) or on-farm non-agricultural enterprises. The term non-agricultural in this definition includes activity beyond the primary production of food, fibre and fuel, such that on-farm processing and marketing of produce are included. The definition of the farm household will have an important bearing on the extent of income diversification.

1.5. Types of Diversification Activities

The income earned by a farmer will be diversified if activities beyond those of core agriculture (the primary production of food and fibre [Slee, 1986]) are participated in. The nature of such activities are categorised and outlined below

Off-farm non-agricultural activities

These are any forms of employment which are non-agricultural and occur off the holding. This covers a broad range of possibilities such as manual, white collar, professional or business activities (Gasson, 1987).

On-farm diversification activities

Within this category lie home businesses which are managed from the holding and are independent of the farm base and farm-based enterprises, typically using land, farm produce or the farm setting, i.e. are dependent on the farm base e.g. bed and breakfast (Gasson, 1986).

Non-earned income

This is income which does not require the human resources of the receiver in order to be obtained. Examples of these monies are interest from savings, dividends, remittances, pensions and other state benefits, insurance claims and the like (Shucksmith et al., 1989).

1.6. Diversification versus Specialisation

Within agriculture there are a variety of reasons why a producer may specialise or diversify. The most extreme form of specialism is monoculture. Most monoculture literature relates to the developing world, although monoculture does occur in the developed world (e.g. in the corn belts of America). Specialisation on large farms may achieve economies of scale. There are other reasons why a producer may decide to specialise. Kim (1981) identified five groups: i) Available factor resources such as land (i.e. its typology, soil type, local climate, etc.) which will affect the potential cropping or livestock rearing. The available human resources will carry with them knowledge and expertise about specific crops or livestock. The cultivation of crops/livestock beyond this knowledge will carry risk. Thus, in an area where there has been a history of monoculture there will be a tendency to specialise. ii) The extent of diversification in domestic and world markets will influence the production mix. A poorly-diversified market will propagate monoculture. Where there is government intervention such as subsidies, these will influence a producer’s production mix. Where a narrow range of commodities are subsidised, this may lead to specialisation in these commodities. iii) Market access restrictions will reduce the range of commodities produced, increasing the propensity for monoculture. iv) The infrastructure in agricultural and rural areas will affect the availability of inputs and market access. Thus, poor infrastructure may limit the production mix and increase the tendency towards monoculture. v) Historical factors such as colonisation, which created plantations and left an infrastructure and resources biased towards monoculture, will increase the propensity to specialism. There may also be traditional attachments to certain crops which may endow the producer with prestige or status.

A shift from monoculture into diversification reduces both production and price risk (Rosegrant et al., 1995). However, this is rejected by Quiroz and Valdés (1995) who argue that production diversification does not reduce price risk. This is because commodity prices demonstrate similar reaction patterns to aggregate, worldwide and macroeconomic shocks, indicating that they are highly correlated. An increase in the diversity of commodities produced augments the diversity of diets, so that there is an increase in substitution of commodities by the consumer, increasing correlation further. On the supply side, diversification-led improvements in infrastructure and market integration increase production substitution, thereby increasing price correlations. Thus “ the more each unit of production is diversified, the more positive the correlation between prices and the lower the gains to diversification” (Quiroz and Valdés, 1995).

This argument is only applicable where diversification occurs within the primary production of food and fibre. Where diversification combines non-agricultural activities with agricultural, there is little or no price correlation between the activities. Thus, there are gains to diversification through risk reduction. This is particularly so in the case of diversification by holding off-farm employment which stabilises fluctuating agricultural income ((Barlett, 1991; Kimhi and Bollman, 1999).

Within economic literature there are a variety of arguments for and against diversification. During the late 1960s and early 1970s, much was written to express the benefits of diversification; more recently this trend has reversed. This is partly due to the fact that diversification may have both value-enhancing and value-reducing effects, so that one outweighs the other. It has been argued that diversification results in a more efficient allocation of resources since it creates an internal capital market, thereby reducing the problem of under-investment (Berger and Ofek, 1995). Factors of production which are in surplus will create loss in efficiency and lower competitive advantage, if they are not utilised through diversified activities (Montgomery and Wernerfelt, 1988). Downsides of diversification occur through cross-subsidisation between segments, where resources of the better performing segments are utilised to support those which are ailing (Berger and Ofek, 1995). It is indicated that diversification into related markets has a more positive effect than entering unrelated markets, since skills and resources can be used in related markets and benefits from a positive reputation may be transferred (Berger and Ofek, 1995). Financial literature cites the benefits of diversification as risk-reducing. The reduction in risk is inversely related to the correlation between asset returns (Tarbert, 1998). This concept can be used in a farming context with risk reduction being inversely related to the correlation between enterprise returns.

1.7. Who Diversifies?

The driving forces for diversification can be broadly identified as accumulation and survival. Accumulation is generally part of a business strategy. Farmers in this category are usually more commercially aware than their counterparts and view farming as a business (Gasson, 1986). In a study by Marsden et al. (1986), such farmers regarded diversification as a method of increasing returns on agricultural capital or had entered the agricultural industry with the intention of utilising capital generated from non-agricultural activities. This was because agriculture was perceived to be a low-risk investment, which could lessen taxation burdens. Within the study, another group of accumulators was identified as businesses with corporate or institutional capitals. For this group, farming was a minor constituent of total business activities.

Survival is closely linked to household strategy (Marsden et al., 1986). The income earned from non-agricultural activity may be utilised in order to purchase machinery for the farm and other inputs and for capital repayments. Thus, the motivation is one of financial need in order to remain farming. Households in this category tend to be attached to the lifestyle provided by farming (Gasson, 1986). This strategy indicates that a relative fall in agricultural incomes will tend to result in farmers seeking other income sources to survive. This can be explained by the push-pull hypothesis. Diversification occurs because household members are ‘pushed’ by the level of farm income and ‘pulled’ by off-farm opportunities (Efstratoglou-Todoulou, 1990). A Greek study carried out indicated a negative relationship between diversification and farm opportunities and incomes. Pull factors appeared to carry a stronger influence than push factors (Efstratoglou-Todoulou, 1990).

Diversification of income by holding off-farm employment may occur as part of a strategy to exit farming. In such a case, the employment is usually full-time. It has been indicated that this occurs in Canada but not Israel (Kimhi and Bollman, 1999). However, whether the time commitment to the off-farm job becomes the force behind exit, has not been ascertained. Participation can be regarded from another point of view: as a means to gain sufficient capital to establish a viable farm, therefore being a method of overcoming entry barriers to farming. Farmers in this group will have up-to-date off-farm work skills and therefore are readily employable in the off-farm work market (Simpson and Kapitany, 1983). In a study by Shucksmith and Smith (1991), it was observed that new entrants to farming from non-farming backgrounds were numerous among those who earnt most of their income from outside agriculture.

In the case of CEECs, some diversification may occur into agriculture via land reforms. In this case, people with non-agricultural employment who have gained land in the process of land reform have entered agriculture.

2. Factors Affecting Diversification

There are several factors which can influence the decision to diversify. Many of these are socio-economic characteristics of the farm household. These affect the choice of farm and non-farm activities either via a farmer, or farm family’s indifference map or by influencing attitude to risk (Feinerman and Finkelshtain, 1996). Risk will be discussed separately to the socio-economic factors.