5. CHAPTER 5: RESEARCH METHODS & MODELING
5.2. Discrete Optimization
Some authors stated that discrete optimization has a more realistic way to apply the revenue management concepts in terms of pricing and revenue optimizations than continuous
78 systems, because the most of the entities of interest (demand, supply, prices, agreements and so on), are discrete rather than continuous. Nevertheless, this represents a huge challenge in terms of knowledge to analyze and understand the concepts, discrete optimization is more computationally difficult and the interpretation of data requires a lot of expertise if the main target is the agricultural commodity markets.
Quoting Phillip, R. (2005, 326 pp.): “In continuous optimization we are navigating a smooth surface, looking for the highest point. If the continuous function is differentiable (as we have assumed), either we are at maximum or the local derivatives give us a clear direction to move. In contrast, discrete optimization is like hopping from island to island in an archipelago, looking for the island with the highest peak. When we are on a particular island there may be no indicator to tell us which island to jump to next.”o In this sense, the above state can explains the nature of global commerce, particularly in the whole mosaic of agricultural goods and related commodities.
The continuous approach is not exact, but is enough. In other words, most of the pricing and revenue optimization problems, and using the RM principles as a guide to correct policy decision, specifically in terms of agricultural subsidies can be a simple (but not ordinary) nearest feasible integer solution that usually can provide a good output to the strategy and actions to take. In the case of discrete approach, can be more accurate but requires complicated formulas and a lot of expertise, that usually and ironically can distorted the researcher mind to take crucial decisions clearly. In summary, depending on the expertise, time and available resources can represent a titanic task.
79
Chapter 6: RESULTS
6.1. Period of analysis (1993-2007)
The data available for the analysis and later on forecasting come from the FAOSTAT database (Agriculture Statistics) of Food and Agriculture Organization of the United Nations –FAO- and OECD Review of Agricultural policies for the Chapter of China. Yet though the importance of agriculture in China’s economy has declined, it is still an important sector, accounting for almost 15% of GDP and above 40% of employmentd. Is important here to remark that inside the cereal sector there was also an significant reorganization as land sown to rice and wheat tended to decline, while land sown to maize increased, maybe regarding the bio-fuels increasing offer.
Nevertheless, wheat is a primary agricultural commodity inside China & generally world’s economy. Is well known, that increased food production was accomplished by increasing agricultural land, but the area of cultivated land has been declining and output rising due to higher productivity regarding the greater use of fertilizer, pesticide and mechanical inputs and investment. The safeguard of the environment and the aptitude to develop agricultural productivity are integrally linked, and where markets are not able to take environmental externalities into account, there is a need for effective policies, from the economic perspective, at macro and micro level, a lot of this related issues can be mend through the implementation of well targeted subsidies.
The main agricultural policy measures employed by the government cover producer support measures, general services and consumer support measures. In turn, producer support measures cover both domestic and trade policy measures; these can be through input subsidies (water, fertilizer, seeds in a very low cost) or on the other hand, can be as the form of direct payments in terms of money related with quantities produced or total value of production. In line with its WTO accession commitments, China is not allowed to apply export subsidies. The
80 distortions on grain markets are still relatively high, mostly due to state trading, which continues to drive a wedge between domestic and world prices.
Figure 12: Composition of Producer Support Estimate for China, 1993-2003
Figure 13: China’s Producer Support Estimate by commodity, 2000-2003 average
81 Figure 14: Output indices for main crops, 1990-2003; 1990 = 100
Figure 15: Total cereal production and nominal farm gate prices, 1993 – 2003
82 Figure 16: Crop yields for grain production, 1990 - 2003
Important here to remark, China’s agro-food imports and exports have developed in line with the overall value of agricultural production but slower than the whole economy.
6.2. Increasing the wheat production: Subsidies?
There are two diverse elements to food self-sufficiency in China. One element is the market supply of food (grains especially), and the other is the non-market supply–farm produce which is consumed directly by the farm household. Given the fact that most farmers derive their grain supply from their own production, food security for the agricultural and general population has normally been considered in terms of macroeconomic level as a priority.
The negotiations for WTO accession get inside the system external pressures to accomplish policies and institutional reforms regarding the Agreement on Agriculture. In order to be well ready for the bigger competition after the opening of its domestic markets, the government placed a strong importance on developing the efficiency rate of agricultural production.
Alongside with education programmes intending to approach at improving farmers’
take-up of technology, actions to assist raise the competitiveness of Chinese products in both
83 the domestic and international markets were put into practice. These measures were implemented in response to the impact of cheaper imports on domestic prices.
Table 1: China’s wheat trade data generated, 1993 – 2007.
Year Production 2007 15,348,160 109,298,296 105,633,866 1,940,001 1,934,469 3,669,962 2006 15,400,880 108,466,271 104,254,259 1,926,238 1,912,133 4,226,117 2005 13,889,270 97,445,196 105,143,982 5,407,000 1,106,000 (3,397,786) 2004 13,204,060 91,952,238 105,224,849 8,913,000 1,559,000 (5,918,611) 2003 11,930,640 86,488,264 108,087,305 2,220,000 2,911,000 (22,290,041) 2002 12,461,280 90,290,262 109,844,131 2,312,000 1,328,000 (18,569,869) 2001 13,035,750 93,873,234 112,035,916 2,281,000 1,032,000 (16,913,682) 2000 14,137,420 99,636,127 112,957,909 2,615,000 488,000 (11,194,782) 1999 16,655,560 113,880,088 113,679,686 2,062,000 393,000 1,869,402 1998 16,140,200 109,726,066 113,896,196 3,094,000 547,000 (1,623,130) 1997 18,263,710 123,290,085 113,960,844 3,474,000 957,000 11,846,241 1996 16,326,300 110,569,193 113,433,186 9,798,000 1,045,000 5,889,007 1995 15,035,140 102,211,429 113,818,329 13,211,000 621,000 983,100 1994 14,646,730 99,301,440 112,354,733 8,825,000 601,000 (4,829,293) 1993 15,737,580 106,394,921 112,345,914 7,781,000 605,000 (1,225,007)
AGGREGATE 222,212,680 1,542,823,110 1,656,671,105 75,859,239 17,039,602 (57,478,372)
AVERAGE 14,814,179 102,854,874 110,444,740 5,057,283 1,135,973 (3,831,891)
Source: FAO
6.3. The optimal approach for subsidization
The major Chinese policy actions employed by the national government, discussed in before, cover producer support measures, general services and consumer support measures. In turn, producer support measures cover both domestic and trade policy measures.
Regarding the food price subsidies, since 1992, China has paid subsidies to urban consumers to offset the price increases of food products.c Although some of the subsidies are still paid, there has been a significant decline in the level of budgetary expenditure on them.
84 Figure 17: Comparison of different type of prices for Wheat, 1990 - 2003
Protective prices were prices set by the government, at which the state guaranteed to purchase all output of specific commodities offered for sale to the state. The protective prices were generally above the market price (except for soybean). There were two major problems with the implementation of this measure. First, the SGEs were expected to undertake state procurement at protective prices and to operate as a commercial enterprise marketing grains at a profit. It is reported that many SGEs sought to depress prices paid to producers or even rejected purchases of grains they believed could not be easily on-sold–profit-seeking behavior not in accordance with the income supporting aims of state procurement at guaranteed prices.
Second, budgetary constraints for many sub-national governments in major grain producing regions resulted in the policy being under-funded; payment for state purchased grains could not always be made in cash or in a timely manner.
Conversely, for wheat, domestic prices were lower than the international indicator price, suggesting that domestic and trade policies prevented farmers from receiving as good a return on their wheat crop as was possible on world markets. Benefits from this subsidy may accrue indirectly to the majority of farmers through reduced costs faced by farm service providers, such as harvesting companies.
85 In the beginning of this period, government applied a subsidy that was designed to ameliorate the impact of the food price increases, rather than calculated to fully offset the additional food costs faced by individual urban consumers. Following the initiation of the subsidy, each subsequent food price rise entailed an associated subsidy level increase. The subsidized food prices could be expected to increase the quantity of food demanded, thus increasing prices further, and potentially contributing to an inflationary spiral.
Table 2: China’s crop variables and prices for wheat, 1993-2007
Year Harvested
2007 23,721,075 46,076 4,100,004 258.40 340.02 2006 23,613,067 45,934 4,130,004 220.02 204.34 2005 22,792,462 42,753 4,600,004 165.10 168.21 2004 21,626,074 42,519 4,800,003 165.55 151.22 2003 21,997,075 39,318 4,500,004 186.63 149.36 2002 23,908,072 37,765 4,400,004 127.58 138.37 2001 24,664,068 38,060 4,800,004 126.86 119.54 2000 26,653,326 37,382 5,000,004 118.26 105.39 1999 28,855,019 39,466 5,100,002 144.48 113.08 1998 29,775,167 36,851 5,050,001 162.58 136.19 1997 30,057,020 41,018 5,200,001 169.49 179.15 1996 29,611,057 37,340 5,100,001 189.80 201.81 1995 28,861,315 35,414 5,120,003 173.03 145.97 1994 28,981,966 34,263 4,900,078 126.00 132.27 1993 30,236,410 35,187 5,100,081 123.92 134.75
AGGREGATE 395,353,173 589,346 71,900,198 2457.7 2419.67
AVERAGE 26,356,878 39,290 4,793,347 163.85 161.31
Source: FAO
As for other transition or developing economies, the results have to be interpreted carefully bearing in mind recognized limitations with respect to policy and commodity coverage, and data availability. In addition, the macroeconomic and institutional framework within which agricultural policy measures have been applied may have an impact on the
86 results. Thus, the market price support(MPS) element may capture the effects not only of agricultural policies as such, but also macroeconomic policies (in particular through the exchange rate) and of imperfect price transmission from the border to the farm gate level.
Nonetheless, other aspects such as a long-lasting inefficient downstream sector, a large share of agricultural production consumed on farms, not strong price transmission compared to grown-up market economies, and data collection systems covering behind the changes in the economy, may distort the measured level of support.
Figure 18: Chinese % PSE by commodity, average 2000-2003
Figure 19: Distribution of producer support by commodity, 2000 – 2003 average
87 6.4. Data Analysis
Before enter in the analysis itself, is important to remark that in this sense, the whole thesis proposal is a conceptual model, which involve political, economical and econometric measures. In this sense there are some basic assumptions that make the model feasible and logic to work. These are as follow:
9 The market prices are set under the supply and demand economic model of price determination in a market. Logically, China’s wheat market is a competitive market, and price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium (partial or general) of price and quantity.
9 Eventually, there are no trade barriers for commerce. Despite the fact that is something relatively uncompleted now, the tendency in following years and according to WTO regulations for the future will be minimized to 0.
9 The conceptual model itself, work under classic economic principles, but it’s relevance relies in how a pure business concept itself (in this case revenue management) can be applied in governmental policies decision in order to increase its economic welfare and promote low costumer prices and guarantee food security in benefit of general population.
From all data presented, and in order to find the optimal price under the basic pricing approach, the data output was to find the price response curve in term of the willingness to pay (w.t.p.) and under the assumption that all potential demand (D) will be targeted between the maximum price (world price or producer price) and the minimum possible (world price or producer price) depending on the year’s tendency analyzed to apply a subsidize, but theoretically between the maximum price in the market (world or domestic) and 0.
88 Table 3: Price Gap, consumption, sensitivity and elasticity, 1993-2007
Year Price Gap 2002 10.79 (2,191,785) (203,131,140) 0.01845 138.37 2001 (7.32) (921,993) 125,955,328 0.00610 126.86
In this sense, it’s important to remark the tendency of wheat which compared with other crops tends to be very volatile, but never the less, in terms of the relative production amount, demand and change regarding the change in prices, relatively inelastic.
How can this be interpreted? Well, demand is so big and usually cannot be fulfilled with domestic production, but on the other hand, each farmer’s production (no matter how big is) cannot influence in the prices established by the market, that means, wheat as a commodity is offered according the market price, cause it’s demand is almost equal to the entire market.
Buyers are totally indifferent among the offerings of different sellers, and among them there is a perfect knowledge about all prices being offered, and they will buy the product only from the lowest price seller.
89 The seller as mentioned before is relative small to the total size of the market. In this scenario, has no pricing decision –his price is set by the operation of the larger market.
Quoting a popular text inside pricing and revenue optimization (Phillips, R., 2005, 39 pp.) “In a competitive market, each firm only has to worry about how much output it wants to produce.
Whatever it produces can only be sold at one price: the going market price.”o
Under this assumptions is possible to elaborate the so called curves and find the optimal price with an incremental cost (marginal cost) set by the cost of produce one unit (in this case tone) in that year:
Table 4: China’s price response curves, incremental cost & margin for wheat, 1993-2007
Year D (tonnes) Slope Price Response Curve d(P)
Incremental Cost (USD/tonne)
Margin (USD/tonne)
2007 105,633,866,000 310,669,566 105633866000 - 310669566P 140.42 199.60
2006 104,254,259,000 473,839,919 104254259000 - 473839919P 141.99 78.03
2005 105,143,982,000 625,075,691 105143982000 - 625075691P 142.53 25.68
2004 105,224,849,000 635,607,665 105224849000 - 635607665P 143.60 21.95
2003 108,087,305,000 579,152,896 108087305000 - 579152896P 137.95 48.68
2002 109,844,131,000 793,843,543 109844131000 - 793843543P 138.01 0.36
2001 112,035,916,000 883,146,114 112035916000 - 883146114P 138.87 -12.01
2000 112,957,909,000 955,165,813 112957909000 - 955165813P 141.89 -23.63
1999 113,679,686,000 786,819,532 113679686000 - 786819532P 146.26 -1.78
1998 113,896,196,000 700,554,779 113896196000 - 700554779P 147.10 15.48
1997 113,960,844,000 636,119,699 113960844000 - 636119699P 148.14 31.01
1996 113,433,186,000 562,079,114 113433186000 - 562079114P 147.66 54.15
1995 113,818,329,000 657,795,348 113818329000 - 657795348P 147.10 25.93
1994 112,354,733,000 849,434,740 112354733000 - 849434740P 147.50 -15.23
1993 112,345,914,000 833,735,911 112345914000 - 833735911P 147.92 -13.17
Source: FAO
Finally, all the data processed and after make the mathematical procedures to find the intended variable, is possible to find the optimal price sustained in the price response curve and willingness to pay for each year, which in the case is less then both prices (world and
90 producer price) the subsidy is not necessary to apply cause high market prices “pull” the enough the world or producer price to exceed the optimal. In this sense, the amount of subsidy encountered (which theoretically is negative) can be applied from producer as investment in their own infrastructure or research to boost production in their crop’s techniques.
Table 5: Optimal price, price gap with the market price and subsidy to apply
Year P*
(USD/tonne)
Price gap (USD/tonne)
Producer
price World price Subsidy (USD)
Change in Trade Balance 2007 240.22 (18.18) 258.40 340.02 (1,986,796,383.44) -0.15 2006 181.00 (23.34) 220.02 204.34 (2,531,183,343.43) 1.80 2005 155.37 (9.73) 165.10 168.21 (947,938,650.02) -0.74 2004 154.57 3.35 165.55 151.22 308,359,070.09 -2.77 1997 163.64 (5.85) 169.49 179.15 (720,872,142.78) 0.50 1996 174.73 (15.07) 189.80 201.81 (1,665,898,411.74) 0.83 1995 160.06 14.09 173.03 145.97 1,440,589,488.81 5.91 1994 139.88 13.88 126.00 132.27 1,378,684,294.40 0.75 1993 141.33 17.41 123.92 134.75 1,852,689,192.06 -45.92
Source: FAO
So according to the results presented, inside the conceptual model, the continuing process of global integration carries with it implications for farmers and the related supplying and processing industries in many parts of the world, and impacts the world economy. An assessment of agricultural and trade policy impacts is bound to be complex and is often supported by quantitative policy analyses. The development of global models is now well established and has become an integrated part of world economies and world economic reviews.
91 Partial models consider the agricultural system to be a closed system without linkages to the rest of the economy. Exogenous variables are used to capture the effects of the rest of the domestic and world economy. Supply and demand relationships are represented by means of behavioral equations, which are used to estimate the parameters of the independent variables.
This single conceptual model implies that demand and supply interrelationships among agricultural products are captured. These partial equilibrium models are commonly applied to detailed trade policy analysis for a specific product. According to neo-classic theory, the producer is assumed to be a maximizer of profit or net returns, which are subject to some technical and institutional constraints. In this regard, economic theory suggests that the supply of products to the next highest level of the market channel depends on the expected profits accruing to the decision maker.
The government’s production plan as the producer’s technical constraints define the physical relationship between factor inputs and the maximum output level for the given technology, per unit of time. This can be closely related to government agricultural policies, international agreements, and so on. The constraints can be the food security, which is the major concern inside the productions policy, government’s budget for subsidization (in the case is applied), social welfare which is related to the capacity to integrate the final price for consumer and the incremental cost of production in farm, etcetera. To illustrate this physical relationship between output and factor inputs, consider a farm that uses land, labor, and other inputs (fertilizer and capital), in the production of the concerned commodity (for this study, wheat).
The profit maximization or cost minimization approach can now be used to derive the output supply response from the profit function by means of the first order conditions or in other words in terms of the willingness to pay. The subsidization function that includes the optimal price perceived by the farmers multiplied by the production amount for that specific
92 year must satisfy the following conditions, firstly, the supply and demand functions have to be linearly homogenous, secondly, it must be increasing in fixed quantities and output prices and decreasing in input prices, and thirdly, it has to be twice differentiable and must satisfy the condition of convexity in prices, both in domestic and world markets.
When the marginal product of a factor input is multiplied by the price, the value of the marginal product is calculated, which is the rate of increase of the producer’s revenue from additional employment of an input. In this sense, the objective function of profit maximization implies that the expected value of marginal product is equal to input costs, i.e. a farmer who maximizes profit will produce where the expected value of marginal product is equal to input cost or in this case the incremental cost. However, the first order condition is not sufficient for profit maximization and the second order condition needs to be integrated.
The basic Price and Revenue Optimization approach allows us to obtain the subsidization amount originated in the commodity supply and factor demand equations with partial differentiation scenario of the indirect profit function. The indirect profit function is defined as the maximum profit associated with the given product and factor prices. On the other hand, the “law of demand” states that the higher the prices, the less of a given good will be purchased.
This implies that the demand curve is downward sloping. For the ultimate buyer of food, demand could relate retail prices to amounts that will actually be consumed within a given time frame, not the same for the farmer’s price related to the input cost. However, the final consumer is not the only actor on the demand side. It’s possible to distinguish between two main categories of domestic demand, namely, demand for direct use and inventory demand.
The demand for direct use consists of primary as well as derived demand. Primary demand can be signified as the demand at a retail level where the individual consumer can make decisions based on price and preference, and this is the case for the wheat commodity because it’s a product that can be included in a perfect competitive market.
93 Expectations are determined by the expected utilization of the commodity (in our case wheat), product availability, and future changes in other market factors such as market prices and agricultural policies, there is where the revenue management concept can be implemented.
Although demand for direct use and inventory demand could be regarded as isolated from international markets, this is not the case since nations participate in an international market and also face export or import demand, as well other factors that can be constraint the model.
Nevertheless, there are some assumptions that had been already mentioned in previous chapter and under that one the model can be applied and be feasible.
94
Chapter 7: CONCLUSIONS & FUTURE RESEARCH
7.1. Main Conclusions
The mix of measures used to support farmers is dominated by market price support, a category known to be amongst the least efficient and most trade distorting means of providing agricultural assistance, but nevertheless, according with this thesis proposal, can be one of the most important tools to use in the future to regulate the WTO agricultural policies if applied in a correct manner. Optimizing farm support would therefore improve the efficiency of
The mix of measures used to support farmers is dominated by market price support, a category known to be amongst the least efficient and most trade distorting means of providing agricultural assistance, but nevertheless, according with this thesis proposal, can be one of the most important tools to use in the future to regulate the WTO agricultural policies if applied in a correct manner. Optimizing farm support would therefore improve the efficiency of