jan-henning feil

18.02.2011

The Effects of Different Political Schemes on the Willingness to Invest, Firm Profitability and Economic

Efficiency in the Dairy Sector

- An Agent-Based Real Options Approach -

Jan-Henning Feil

Jan-Henning Feil The Effects of Different Political Schemes on the Willingness to Invest in the Dairy Sector

1. Motivation / Objective

2. Theoretical Background

3. The Agent-Based Real Options Market Model

4. Results

5. Conclusion

2

Overview


• currently strong changes in general conditions (e.g. abolishment of EU milk quota system by 2015)

• extreme milk price fluctuations globally in 2007, 2008 and 2009

higher level of (dis)investments in the dairy sector can be expected

farmers and lobbyists are calling for additional market regulation (e.g. cf. EUROPEAN MILK BOARD, 2009; NATIONAL MILK PRODUCERS FEDERATION, 2009)

3

MotivationThe Dairy Sector


• Real Options Approach (ROA) more advantageous for analyzing

investments in the dairy sector than Net Present Value (NPV) rule

(e.g. PURVIS et al., 1995; ENGEL AND HYDE, 2003; TAUER,

2006)

• However: no real options model yet that allows the analysis of

investments in competitive markets under consideration of different

political schemes

4

MotivationAnalyzing Investments in the Dairy Sector


1. Development of an agent-based real options market model which

allows the analysis of different political schemes in competitive

markets in general, and in the dairy sector in specific.

2. Comparative analysis of the effects of

a. lower price limits for milk products maintained by governmental purchases of excess supply

b. subsidies for investments in milk production

on investment triggers, firm profitability and economic efficiency.

Objective

5


• ROA exploits the analogy between a financial option and an investment

project (cf. e.g. ABEL AND EBERLY, 1994; DIXIT AND PINDYCK, 1994)

• An irreversible investment under uncertainty should only be made, if the

present value of its expected returns exceeds the investment costs by an

amount equal to the value of the option to invest at a later point in time

with possibly more profit.

in comparison to the NPV rule the investment trigger price is shifted

upwards

6

Theoretical BackgroundROA vs. NPV Rule


Theoretical BackgroundStochastic Price Process without Competition

7

Source: own elaboration

time

investment trigger

sample path of prices without competition (unregulated price process)

price

Geometric Brownian Motion (GBM)

Jan-Henning Feil The Effects of Different Political Schemes on the Willingness to Invest in the Dairy Sector 8

numerical model allows endogenous derivation of price process and investment triggers


Theoretical BackgroundStochastic Price Process with Competition

time

investment trigger = reflecting barrier

sample path of prices without competition (unregulated price process)

price

Geometric Brownian Motion (GBM)

sample path of prices with competition (regulated price process)


The Agent-Based Real Options Market ModelBasic Assumptions

9

• N homogenous competing risk-neutral firms

• can make investments up to a given maximum output capacity

• step-by-step investment possible over T years

• production capacity can be adjusted via investments just once a year

• irreversible investment

• no depreciation

production output:

nXt+∆t = nXt + nxt+∆t

investment size in t = additional production output in t+∆t


The Agent-Based Real Options Market ModelInvestment Behavior of the Firms

10

• perfect competition

rational expectations and complete information

• firms with lower trigger prices have a stronger tendency to invest

firms are sorted according to their trigger price level, nP* ≤ n+1P*

firm n +1 does not invest, if firm n is not already completely invested

• in every year a “last“ firm invests such that its trigger price is equal to

the expected product price of the next period


• Maximization of Expected NPV = Option Value:

The Agent-Based Real Options Market ModelObjective Function for Determination of the Optimal Trigger Prices P*

11

P* is derived by use of Genetic Algorithms


• Maximization of Expected NPV = Option Value:

• implementation of lower price limit PMIN :• Implementation of investment subsidy s :

The Agent-Based Real Options Market ModelObjective Function for Determination of the Optimal Trigger Prices P*

12

P* is derived by use of Genetic Algorithms


The Agent-Based Real Options Market ModelDetermination of the Economic Efficiency

13

Welfare with political schemes

Welfare without political schemesEconomic Efficiency (R) =

Welfare = Consumer Surplus + Producer Surplus + State Budget

• the concept of consumer and producer surplus is applied (cf. e.g. PINDYCK AND RUBINFELD, 2005):

(welfare is calculated as present value of the welfare of all T production periods)


ResultsEffects of Lower Price Limits on Trigger Prices (P*), Option Values (F0) and Economic Efficiency (R)

14


• GBM with drift rate α = 0% and volatility σ = 20%, r = 6%, T = 100, Δt = 1, N = 50, k = 1, ς = -1

• PMIN in relation to the total investment cost per output unit and year k = 1

P MIN P* F 0 R0% 1,5819 -0,0042 100,00%

80% 1,3202 -0,0025 81,07%90% 1,1929 -0,0011 72,82%95% 1,0841 0,0004 65,35%


ResultsComparison Lower Price Limits vs. Investment Subsidies

15


• GBM with drift rate α = 0% and volatility σ = 20%, r = 6%, T = 100, Δt = 1, N = 50, k = 1, ς = -1

• PMIN and s in relation to the total investment cost per output unit and year k = 1

• investment subsidy is fixed by iterative searching at the same trigger price level

P MIN P* R s P* R80% 1,3202 81,07% 16% 1,3210 93,48%90% 1,1929 72,82% 24,5% 1,1915 89,35%95% 1,0841 65,35% 31,5% 1,0865 84,90%

Lower Price Limit Investment Subsidy


• conceptual basis for a detailed policy impact analysis for competitive markets that underlie real options in general, and dairy sector in specific

• vast modelling flexibility

• political schemes generally increase willingness to invest

• however, they do not offer any sustainable financial benefits to producers and reduce the welfare

• investment subsidies are more advantageous than lower price limits under given assumptions

Conclusions

16


• investigate effects of the abolishment of EU milk quota system

• besides investments integrate disinvestments into the model

Future Research

17

18.02.2011

Thank you for your attention.


1. Generate of first population g = 1 of N genomes by drawing random values for the firms‘ trigger prices

2. Determination of option values via stochastic simulation

3. Application of the GA Operators (Fitness Evaluation Selection & Replication Crossover Mutation)

4. Next generation g = 2

5. Repeat steps 2 and 3 iteratively, until no better investment strategies can be found

Appendix: Genetic Algorithms

19

1

2

3

4

5


Appendix: Determination of the Economic Efficiency

20


Limitations

21

• GBM might not be plausible for application to dairy sector

• in reality, dairy farmers just have limited possibilities to expand production capacities

• assumption of homogenous agents

assumptions need to be relaxed in future research


ABEL, A.B. AND EBERLY, J.C. (1994): A Unified Model of Investment under Uncertainty. American Economic Review 84: 1369-1384.

BALMANN, A., HAPPE, K. (2001): Applying parallel genetic algorithms to economic problems: the case of agricultural land markets. IIFET Conference “Microbehavior and Macroresults”. Proceedings. Corvallis, Oregon.

CAREY, J.M., ZILBERMAN, D. (2002): A model of investment under uncertainty: modern irrigation technology and emerging markets in water. American Journal of Agricultural Economics 84 (1): 171-183

DIXIT, A. (1991): Irreversible imvestments with price ceilings. Journal of Political Economy 99 (3): 541-557.

DIXIT, A. AND PINDYCK, R.S. (1994): Investment under Uncertainty. Princeton, US: Princeton University Press.

ENGEL, P.D., HYDE, J. (2003): An Real Options Analysis of Automatic Milking Systems. Agricultural and Resource Economics Review 32(2): 282-294.

EUROPEAN MILK BOARD (2009): http://www.europeanmilkboard.org/en/special-content/news/news-details/browse/48/article/declaration-of-the-international-congress-of-non-governmental-agricultural-organizations-of-new-eu.html?tx_ttnews%5BbackPid%5D=78&cHash=0bbc4614a7

FORREST, S. (1993): Genetic algorithms: principles of natural selection applied to computation. Science 261: 872-878.

GOLDBERG, D.E. (1989): Genetic Algorithms in Search, Optimization and Machine Learning. Reading, MA: Addison-Wesley.

HOLLAND, J.H. (1975): Adaption in Natural and Artifical Systems. Ann Arbor. MI: University of Michigan Press.

Appendix: Literature (I)

22


Appendix: Literature (II)

23

LEAHY, J.V. (1993): Investment in Competitive Equilibrium: The Optimality of Myopic Behavior. Quarterly Journal of Economics 108: 1105-1133.

MCDONALD, R., SIEGEL, D. (1986): The value of waiting to invest. Quarterly Journal of Economics 101: 707-728.

MITCHELL, M. (1996): An Introduction to Genetic Algorithms. Cambridge, MIT Press.

NATIONAL MILK PRODUCERS FEDERATION (2009): http://www.nmpf.org/files/press-releases/Price_Support_Expansion_062609.pdf

ODENING, M., MUẞHOFF, O., BALMANN, A. (2005): Investment Decisions in Hog Finishing: An Application of the Real Options Approach. Agricultural Economics 32: 47-60

PIETOLA, K.S., WANG, H.H. (2000): The Value of Price and Quantity Fixing Contracts. European Review of Agricultural Economics 27: 431-447.

PINDYCK, R.S., RUBINFELD, D.L. (2005): Microeconomics. Upper Saddle River, NJ: Pearson Prentice Hall.

PURVIS, A., BOGGESS, W.G., MOSS, C.B., HOLT, J. (1995): Technology Adoption Decisions Under Irreversibility and Uncertainty: An Ex Ante Approach. American Journal of Agricultural Economics 77: 541-551.

RICHARDS, T.J., PATTERSON, P.M. (1998): Hysteresis and the Shortage of Agricultural Labor. American Journal of Agricultural Economics 80(4): 683-695.

TAUER, L.W. (2006): When to get in and out of dairy farming: A real option analysis. Agricultural and Resource Economics Review 35(2):339-47

TRIGEORGIS, L. (1996): Real Options. Cambridge, MIT Press.

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