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Newsletter--Volume 1, Number 4

A paradox of industry-sponsored advertising is that the very thing that causes it to be effective -- elevation of market price -- undermines its effectiveness in the long run. Producers in competitive industries respond to elevated prices by expanding output. Upon reaching the market, the expanded output places a downward pressure on price which, if sufficiently strong, may leave producers no better off with the advertising program than without it. The hypothesis that states profits from generic advertising may prove illusory without effective supply control is sometimes referred to as the “rent-dissipation hypothesis.” In a forthcoming article in Marine Resource Economics, we test the rent-dissipation hypothesis using the catfish industry as a case study. This article highlights our main findings.

Our model consists of five equations describing wholesale demand, farm supply, farm-wholesale price transmission, farm-level rent (profit), and an equilibrium condition. The equilibrium condition equates wholesale demand with farm-level supply multiplied by a conversion factor to give the number of units of wholesale product produced from one unit of the farm product, the so-called “dressing percentage.”

We solved our model for two alternative reduced forms. In our “fixed proportions” scenario, we derived the relationship between industry profit and advertising when the dressing percentage is unaffected by changes in relative prices. In our “variable-proportions” scenario, we derived the relationship between industry profit and advertising when the dressing percentage varies in response to changes in relative prices. By comparing simulations based on the two scenarios, we were able to analyze the impact of processing technology on advertising rents.

Rent-dissipation implies that industry profits decline as producers respond to advertising-induced price increases by expanding output. An implicit assumption here is that consumers respond relatively quickly to advertising (within a year or less). Producers respond much slower because of the biological lags associated with production, the time required to decide whether observed price changes are transitory or permanent, and the costs associated with adding to productive capacity. Taken together, these factors suggest that supply response proceeds slowly, with little if any output expansion occurring in the first year following an increase in advertising. Thus, the question becomes: how long does it take for supply response to dissipate the profits generated by the original increase in advertising? Or, put another way, is supply response “slow enough” so that returns to advertising are positive over a reasonable time horizon (say three years)?

To answer the foregoing questions, we calibrated our model using catfish industry data and previously estimated parameter values for the industry. The catfish industry has structural characteristics that are common to other commodities--a concentrated processing sector and highly specialized production inputs at the farm-level. Thus, our results should be of general interest.

SIMULATION STRATEGY
Rent-dissipation was measured by simulating the model for a sustained 10 percent increase in advertising, and observing the effects on farm-level profit under alternative values of the supply elasticity. We simulated short-run (one year) returns to advertising with the supply elasticity set to zero. Returns in the intermediate run (two years) and long run (three years) were simulated in a similar fashion by setting the supply elasticity to 0.54 and 0.73, respectively, based on previous industry supply function estimates.

A comparison of the simulation results provides a measure of the degree to which industry profits declined as the extra supply induced by advertising came on the market. Advertising is deemed profitable if the cumulative sum of the profits (exclusive of advertising costs) over the three-year time horizon is sufficient to cover the cost of the increased advertising.

In general, theory suggests that producers do not bear the full burden of any promotion “tax,” but instead pass a portion of it along to consumers in the form of higher prices. Thus, we incorporated a parameter into the model to accommodate this tax-shifting hypothesis. In particular, we entertained two alternative hypotheses: producers pay half of the promotion tax and producers pay all of the tax. The latter scenario is probably closer to the “truth,” in that catfish supply is inelastic, especially in the short run, and demand is slightly elastic. The degree of tax shifting depends on the relative magnitudes of the supply and demand elasticities; the least elastic side of the market bears the greater incidence.

RESULTS
Our results confirm the tendency of generic advertising profits to dissipate over time as supply responds to price. But, the extent of the decline is sensitive to processing technology and tax incidence. If producers share the promotion tax equally with others in the marketing channel, advertising is profitable from the producer perspective--incremental benefits to producers exceed incremental costs throughout the three-year time horizon. However, if producers bear the full incidence of the tax and processing technology is characterized by variable proportions, an increase in advertising is profitable only in the first two years. In the third year, advertising rents are insufficient to cover the incremental advertising cost. But, the third-year loss is modest, and is more than offset by the gains in the first two years. It appears that supply is sufficiently price inelastic to render cooperative advertising a profitable venture for catfish producers when three years is deemed a relevant time horizon.

The marginal benefit-cost ratios, under the conservative assumption that producers bear the full burden of the promotion assessment, range from 0.57 to 1.30 in the short run and 0.17 to 0.57 in the long run. This implies that alternative uses of advertising funds would need to generate rates of return of up to 130 percent for it to be profitable to divert funds from the advertising program to other uses (e.g., production research or new product development).

CONCLUSIONS
The major theme of this analysis is that the profitability of promotion is undermined by supply response. Our model indicates that two critical mediating factors are the incidence of the promotion tax and the nature of processing technology. Fixed proportions processing technology attenuates the supply-response problem. Similarly, the tax-shifting phenomenon can work in favor of promotion by permitting producers to share the cost of promotion with other participants in the marketing channel.

With few production alternatives existing for catfish ponds and equipment, asset fixity operates as a natural deterrent to entry or expansion, causing a relatively inelastic supply response at the farm level. Furthermore, demand for catfish at the wholesale-level is only slightly elastic and is probably inelastic at the farm level. This combination of elasticities, coupled with the magnitude of the demand shift as represented by the advertising elasticity, results in sufficient rents from increased advertising to more than offset incremental costs over any reasonable time horizon. Thus, the notion that producers are no better off with the promotion program than without it is not supported by our analysis.

Our findings are generalizable only to the extent that other industries have characteristics similar to those of the catfish industry. Asset fixity, which accounts for the sluggish supply response for catfish, may exist in other industries, especially those involving perennials such as almonds, raisins, walnuts, oranges, etc. This may not be the case for vegetables and some row crops, where inputs are less specialized and production lags are shorter. Then, too, farm-raised catfish is a relatively new product; this increases the likelihood that consumers will respond to catfish advertising. Clearly, the rent-dissipation hypothesis needs to be tested over a wider range of commodities before we can be confident that cooperative advertising ventures can indeed generate sustainable benefits for producers in the face of uncontrolled supply response in competitive markets.

Editor's Notes
John E. Lenz

With this issue, we close the first volume of the NICPRE Quarterly. In a slight departure from the theme-oriented approach we’ve taken with the first three issues, in this issue we offer a bit more diversity.

In our lead article, Henry Kinnucan summarizes a forthcoming journal article that he and his colleagues Robert Nelson and Hui Xiao collaborated on. Their focus is on catfish promotion, and the question of whether or not producers’ responses to higher prices diminish the profits attributable to increased advertising to the point where the increase is unwarranted. In the article here, they highlight several interesting aspects of their research.

In the other commodity-specific article in this issue, Shida Rastegari Henneberry summarizes a recent journal article on which she collaborated with Karen Halliburton. Their focus is on the effectiveness of almond promotion in selected Pacific Rim markets and differences in effectiveness attributable to promotion intensity.

The Manager’s Viewpoint in this issue comes from Jeff Manning, Executive Director of the California Milk Processor Board. Jeff draws on his experience in the advertising and promotion arenas to highlight some issues he believes are crucial in defining the role of a commodity board CEO.

Olan Forker, in his Director’s Corner, discusses the role of economic analysis in program evaluation. Olan makes the case that even in the absence of legal challenges, economic evaluation is an important aspect of program management.

We’ve also included a brief reader survey with this issue. Please take a couple minutes to complete the postcard and drop it in the mail. If you have additional comments about the newsletter, we’d like to hear them.

Director's Corner
Olan D. Forker

An important issue facing any commodity promotion program is the adequacy of its evaluation efforts. At the recent NEC-63 conference in Sacramento, California, co-sponsored by the California Agricultural Issues Forum, the focus was on program evaluation and legal issues facing mandatory commodity promotion programs. We had several papers about the legal issues. There were also several papers about evaluation, that is, the measurement of the degree of success of a program’s efforts. Measuring the degree of success of a strategic objective is a necessary part of good management and need not be justified on the basis of protection against legal action. It should be obvious that having good solid management and evaluation practices in place will help everyone involved (producers who fund the programs, advisory boards, government agencies, and the courts) make more informed decisions as to the continuation of mandatory programs or parts thereof.

One of the difficulties in measuring the degree of success of any commodity promotion program’s efforts is that true “test” and “control” markets do not generally exist. In most instances it is possible to track changes in awareness, consumer attitudes, and sales. Most promotion organizations maintain tracking studies to monitor the marketplace before, during, and after specific program efforts. However, tracking studies do not provide an indication of what the marketplace would have been like without the program effort. Such an assessment requires some form of statistical or econometric analysis to assess what the price and sales volume would have been without the program effort, or with the effort at a different level of intensity. Although no true test and control comparisons exist, it is possible to simulate what the market would have been like had the program effort been at a different intensity level.

Simulations involve several steps. The first is collecting data about the various conditions that have existed in the marketplace over time. The necessary data include the sales volume and price of the commodity being studied, the price or sales volume of competing products, the amount of brand advertising, consumer purchasing power, market demographics, and a measure of the level of program activity (e.g. advertising expenditures). Second is the development of an economic (econometric) model that describes, as nearly as possible, the nature of the marketplace before, during, and after various promotion programs have been conducted. The model is developed using the data that describe market conditions during the time period under study. When developed, the model can be used to answer “what if” questions: "What would the market outcomes have been with changes in prices, available supplies, consumer purchasing power, or promotion activity?" Using the model to estimate changes in the marketplace assuming changes in any one of the explanatory variables is called “simulation.” It is through simulation that one can estimate or predict the market impacts of alternative levels of promotion activities, including no activities.

Like any other evaluation method, the econometric tool is not perfect. All econometric and statistical techniques carry with them some probability of being right or wrong in describing true conditions. However, since the analyst, unless omniscient, never knows the true conditions, we must rely on statistical measures to assess our results. A standard, though often overlooked, statistical measure for assessing econometric estimates is the “confidence interval.” Based on the data used for estimation, a confidence interval is simply a range, that we can state with a particular degree of confidence, contains the true value we are trying to estimate. Although not perfect, econometric models can provide reliable estimates of the economic returns to a commodity promotion effort. “What degree of confidence do you have that the estimate approximates the true marketplace response?” is always a reasonable question to pose.

Individuals associated with NEC-63 and NICPRE have been involved in the development of economic techniques to simulate market conditions with and without various advertising efforts for about 20 years. Thus, there is a great deal of experience available in doing this kind of evaluation and in understanding the usefulness of the estimates.

EFFECTIVENESS OF ALMOND EXPORT PROMOTION PROGRAMS IN PACIFIC RIM MARKETS
Shida Rastegari Henneberry

The U.S. government spent nearly 20 million dollars promoting almonds in the Pacific Rim during the seven year period 1986-92. These expenditures were mainly funded by the Market Promotion Program (MPP), which replaced the Targeted Export Assistance Program (TEA) in 1991. The nonprice export promotion programs (MPP and the Foreign Market Development Program [FMDP]) are currently administered by the United States Department of Agriculture’s Foreign Agricultural Service (FAS).

Although agricultural products receive the majority of federal export assistance, FAS has not established a consistent method for evaluating the effectiveness of promotion expenditures. The larger magnitudes of MPP funding have brought increased public and Congressional scrutiny to government promotion programs in general. The MPP, in particular, has recently been criticized for assisting large U.S. food companies, such as Blue Diamond, with branded promotion. Although calls to repeal the MPP have been suppressed, legislation has been proposed to tighten both FAS and participant management practices of the program. Without analysis of their effectiveness, it has become increasingly difficult for their supporters to justify the continuation of these programs.

This article summarizes the results of a recent study completed by Karen Halliburton and Shida Henneberry at Oklahoma State University. Our study examined the effectiveness of the U.S. government’s nonprice export promotion programs for almonds in the Pacific Rim markets of Japan, South Korea, Taiwan, Hong Kong, and Singapore. More specifically, part of this research was intended to answer the following questions: 1. Have the promotion expenditures had a positive impact on almond imports of selected Pacific Rim countries? and 2. Has there been a difference in the effectiveness of promotion programs based on the level of promotions? That is, how does the effectiveness of promotion vary in markets with large-scale promotions compared to markets with medium- or small-scale promotions?

The Pacific Rim is the second-largest regional market (the largest being the European Community) for U.S. almond exports. Japan has been the largest recipient of U.S. promotion expenditures in the Pacific Rim. Although Japan has historically been a strong and growing import market for almonds, in recent years growth has begun to slow in this market. This has coincided with acceleration of imports by other East Asian and Southeast Asian countries where medium-scale promotions (South Korea, Taiwan, and Hong Kong) and small-scale promotions (Singapore) have been conducted.

METHODOLOGY
To measure the effectiveness of Almond export promotion programs, an econometric import demand model was developed and estimated using data for the seven year period 1986-92 across five countries (Japan, South Korea, Taiwan, Hong Kong, and Singapore). The model specified total volume of almond imports of each country to depend on the import price of almonds, import price of almond substitutes such as cashews and other nuts, import price of almond complements such as sugar and cocoa butter, income, and almond promotion expenditures in the studied countries. In theory, the promotion expenditures, income, and price of substitutes are expected to be positively correlated with imports (direct relationship), while price of almonds and price of complements are expected to be negatively correlated with almond imports.

Data for promotion expenditures were provided by USDA/FAS, data on other variables were collected from publications by the United Nations and the International Monetary Fund. Three specifications of the model were used to compare the results for consistencies.

RESULTS
Our results consistently indicated a strong relationship between the price of almonds and the demand for almond imports in the Pacific Rim. Nevertheless, the empirical evidence suggests that promotion expenditures in South Korea and Singapore were ineffective during the 1986-92 period. However, results concerning Japan, Taiwan, and Hong Kong were less conclusive. Under some specifications of the model, promotions were effective in increasing almond imports in Japan, Taiwan, and Hong Kong. Using the results from these specifications, further analysis showed that the government received returns ranging from $4 to $9 for every dollar of TEA/MPP expenditures spent in these three Pacific Rim countries.

Ineffectiveness of promotion in some of the Pacific Rim countries may be due to various reasons. While ineffectiveness in countries where promotion has been medium- or small-scale may have been because the government did not spend enough money on promotions in these markets (particularly in Singapore where promotion expenditures were less that one percent of Japan), ineffectiveness in more developed markets may have been caused by the mature level of U.S. almond exports to these markets. Also, ineffectiveness may have been a result of inefficient allocation of funds to activities within each of the countries. For example, too much emphasis on processors compared to the retail level.

Shida Rastegari Henneberry is an Associate Professor in the Department of Agricultural Economics at Oklahoma State University.

Manager's Viewpoint
Jeff Manning, Executive Director
California Milk Processor Board

What Is The Role of A Commodity Board CEO?

"I am certainly not one of those who needs to be prodded. If anything, I am the prod."--Sir Winston Churchill

This is at once an important and interesting question. Its importance stems from the fact that commodity boards--whether they be national or local, large or small, food or fiber--are the only way that American agriculture can effectively and efficiently impact demand for its crops. Therefore, the people who run them have enormous fiscal (as in billions of dollars) and social (as in millions of families) responsibilities.

It’s an interesting question; unlike the private sector, where sales, profits, and stock price are clearly visible measures of performance, a commodity board’s success (or failure) is frequently abstract, shifting, and difficult to quantify. It is also of interest because the CEO operates within a paradox--enormous autonomy offset by committee decision making.

Given this brief backdrop, here is one man’s admittedly biased point-of-view regarding what a commodity board CEO’s job is (or should be) all about.

LEADERSHIP, LEADERSHIP & MORE LEADERSHIP

I know this seems incredibly self-evident. But, over the past 20 years of working with commodity boards, there has been a huge void in the type of leadership we expect from private sector CEOs. By this I mean the leadership characterized by vision, courage, accountability, creativity, and a relentless dedication to hard business results.

Why? Simple. Commodity board CEOs are often so concerned with keeping their constituencies happy that they veer away from the healthy, productive confrontation that drives a private sector leader. As Churchill implied, being a “prod” is not always the easiest, most popular route to success. Further, because boards often lack tough, concrete annual goals (and because the programs often lack “horizons”), there is a strong tendency to consider the position as a lifetime job. Bad idea. This breeds complacency and risk avoidance--two routes that run directly counter to potent leadership.

OBJECTIVES, OBJECTIVES & MORE OBJECTIVES

In the absence of sales and profit goals, it is absolutely crucial for the CEO to set objectives. They can take any form so long as they are relevant, legal, and measurable. Increasing consumption is always a good starting point. But, objectives may be expressed in terms of crop values, share of shelf, exports, etc. My least favorites are advertising awareness and consumer attitudes. The reason is that, while these may indicate that something is happening in the marketplace, they aren’t legitimate ends unto themselves. Ultimately, producers and processors can’t take awareness or attitude scores to the bank.

RESULTS, RESULTS & MORE RESULTS

Another area where a CEO must lead a commodity board is on the research and evaluation front. Clearly, this subject strikes closest to the hearts of the folks reading the NICPRE Quarterly. It is crucial that all research and evaluation relate directly to the objectives set by the board. It’s amazing just how much time, effort, and money is spent measuring “stuff” that has little or nothing to do with achievement of a board’s stated mission and goals. For example, a board’s primary objective may be to increase per capita consumption of beef, milk, or potatoes. However, the board may spend hundreds of thousands (even millions) of dollars researching new products or processes that may have 10- or even 20-year horizons and whose chance of impacting consumption are, at best, marginal.

It is the CEO’s job to avoid these tangents and drive tough, objective, and annual measurement of a program. There is substantial risk in taking this approach, (i.e., it has a way of spotlighting failures as well as successes). So be it. Just as a private sector CEO must deal with upturns and downturns in distribution, sales, and profits, so must a commodity board CEO be willing to ride the measurement roller coaster.

EXCELLENCE, EXCELLENCE, & MORE EXCELLENCE

This is one of the most difficult areas of performance to evaluate. What exactly is “excellence ?” As a long-time friend once said, “It is like trying to wrap your arms around 100 pounds of JELL-O.” However, despite its evasive nature, excellence remains crucial to a CEO and his or her board. The reason is that most boards compete head-to-head with the largest, most heavily-funded companies in the marketing world--Beef vs. Purdue; Potatoes vs. Quaker/Rice-A-Roni; Butter vs. Mazola and Wesson; Milk vs. Coke, Pepsi, Snapple, et al. Unless a commodity board CEO drives his/her organization to higher and higher heights of excellence, the chances of ever achieving his or her lofty objectives are slim indeed.

So, that’s my take on what commodity board CEOs should be doing with their time. Certainly research, and very possibly economic modeling, is pivotal to the job. The challenge is using research with the precision of a surgeon and tying every research project --no matter how small--back to a fundamental business objective. Since we opened with a presidential quote, let’s close with yet another.

"Wisdom consists not so much in knowing what to do in the ultimate as knowing what to do next."--Herbert Hoover

Selected Readings

Halliburton, K. and S.R. Henneberry. “The Effectiveness of U.S. Nonprice Promotion of Almonds in the Pacific Rim.” Journal of Agricultural and Resource Economics 20(1):108-121.

Kinnucan, H.W., R.G. Nelson, and H. Xiao. “Cooperative Advertising Rent Dissipation.” Marine Resource Economics 10(1995): forthcoming.