CONTENTS

Effects of Supply Response on Returns to Catfish Promotion

Effectiveness of Almond Export Promotion Programs in Pacific Rim Markets

Manager's Viewpoint

Editor's Notes

Director’s Corner

Selected Reading

Next Meeting

Effects of Supply Response on Returns to Catfish Promotion

by Henry W. Kinnucan

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.