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Free-Rider Effects of Generic Advertising: The Case of Salmon

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NEC-63 Fall 2003 October 6-7, 2003 Embassy Suites Hotel South Lake Tahoe, CA Evaluation of Non-Advertising Promotion Strategies More information

Free-Rider Effects of Generic Advertising: The Case of Salmon

Henry W. Kinnucan and Øystein Myrland
Auburn University and University of Tromsø

Background

The Norwegian Seafood Export Council (NSEC) was established in 1991 as a marketing board with the purpose of promoting seafood from Norway both domestically and in the export markets. Norway is a net exporter of seafood, and the annual exports is about $4 billion. The export share is as high as 96%. The annual advertising budget of NSEC is about $41 million funded by an export levy. About 98% of the budget is allocated to export promotion. For salmon the initial levy was 0.75%, but on 1 July 1997 a trade agreement between Norway and the European Union went into effect. Under the Agreement, the promotion levy on Norwegian salmon entering the EU market was increased to 3.00%.

The levy’s proceeds are to be used by Norway to fund generic marketing of Atlantic salmon in Europe. In this respect the salmon program provides a useful case study in that free-rider benefits have direct policy relevance. Specifically, to the extent that the 3.00% levy increases profits for United Kingdom (UK) producers without reducing profits for Norwegian producers, the Agreement might be considered a success.

Free-rider effects of commodity promotion - a neglected issue

Generic advertising of a homogenous commodity is a type of public good. That is, the benefits of any price rise caused by the advertising are shared by all of the commodity’s producers, regardless of whether they paid into the program or not. This ability to “free ride” weakens the producer’s incentive to contribute to the program. Despite its obvious importance, the free-rider issue has received relatively little attention in the commodity promotion literature.

The objective of this research is to determine the size and distribution of the free-rider benefits generated by Norway’s salmon promotion program. In addition to identifying program impacts worldwide, we assess the effects on producer returns of Norway’s feed quota, a policy intervention that limits supply response.

If we look at global production and trade of Atlantic salmon we find three main producing countries, and three main import markets. Norway is the largest salmon producer globally. Its share of world exports is currently about 47%. Comparable numbers from Chile and the UK are 19% and 16%. Canada and the Faroe Islands contribute 9% and 5%.

Turning to the import side, the EU is the largest importer of salmon, accounting for 54% of world imports in 1999-2001. The comparable figure for the US is 21%, and Japan’s share is 7%. Altogether some 984 thousand tons of Atlantic salmon are traded globally.

Norway is the only producing country that uses substantial funds for generic advertising in export markets. Most funds (72%) are spent in EU markets, and 14% is allocated to Japan. No advertising is done in the United States due to a prohibitive tariff on salmon from Norway.

It is evident from the foregoing that salmon provides an excellent setting for addressing the free-rider issue. We have only one advertiser, Norway, facing four main competitors: Chile, UK, Canada and the Faroe Islands (FI). UK producers clearly gain from the advertising scheme, as both the advertising and the export levy raises the EU price. FI producers gain for the same reason: their exports to the EU are not subject to the tax, yet they are able to benefit from the higher price induced by the levy and advertising.

Less clear are the effects on Chilean and Canadian producers, as they sell primarily into non-EU markets, where price may rise or fall. The export tax places a wedge between the EU price and the price that Norwegian producers receive. This wedge causes Norway to redirect its exports (neglecting the advertising effect) to non-EU markets. Consequently, price in non-EU markets will decline unless the advertising increases demand sufficiently to absorb the extra quantity in those markets. At issue, then, is whether the benefits accruing to UK and FI producers outweigh potential losses to Norwegian, Canadian and Chilean producers due to the higher levy.

Model

To answer that question we developed a model of the world salmon market. The model consists of 22 equations describing prices, production, and trade flows. In addition, the model takes into account the funding mechanism, i.e., the export levy, and treats advertising budget and its allocation across customer markets as endogenous.

Being the major supplier of salmon, Norway has been faced with several trade disputes over the last ten years. The 1997 Salmon Agreement discussed earlier is the result of one of these trade disputes. Faced with the spectre of import duties, Norwegian salmon producers agreed, with government backing, to a feed quota. The purpose of the feed quota is to adapt Norwegian production to market conditions. Since the feed quota limits Norway’s producers’ ability to respond to price signals, it is important that it be taken into account in the model.

This was done by reducing the magnitude of Norway’s supply elasticity. In addition, a shift variable is added to Norway’s supply equation to indicate how changes in the feed quota affect production levels.

Results

Based on model simulations, we would like to focus on five key findings:

1. Free-rider effects can be disproportionate.
2. Funding mechanism is important.
3. Supply response is important.
4. Advertising quality is important.
5. Free-rider effects can be larger than direct effects.

With respect to item 1, study results suggest that a doubling of the export tax used to fund Norway’s promotion program would have a positive effect on total (worldwide) producer surplus in the short run, but the gain’s distribution would be uneven.

In particular, we find that free-rider effects are four times larger than the positive effect to Norwegian producers funding the program. Specifically, Norway would receive 21% of the gain compared to 49% for the United Kingdom and 16% for Faroe Islands’ producers. The smallest gains accrue to Chile (8%) and Canada (4%). By way of comparison, Norway accounts for 47% of the world salmon market, followed by Chile, 19%; UK, 16%; and Canada, 9%.

The disproportionate gain accruing to UK producers is due to a double free ride: from the promotion, and from the export levy. If the promotion had been funded by a lump-sum tax instead of an export tax, the gain to UK producers would be much less, as a lump-sum tax has no effect on market prices. Hence, the funding mechanism has implications with respect to the free-rider issue (item 2).

An intuitive explanation of the disproportionate effects can be found by looking at the price mechanisms. Since the Law of One Price operates, we have a link between the salmon price in Norway, the EU, and the rest of the world. When advertising has a positive effect on demand for salmon in the EU, this has positive spill-over effects into the other markets. When price rises in the EU market it also affects the price in the other markets. However, these spill-over effects are smaller than the initial price effect in the EU.

Supply response (item 3) has a dramatic effect on producer returns, cutting worldwide producer benefits from $114 million to $33 million for the 1999-2001 evaluation period. Moreover, the short-run gain that Norway enjoys converts to a loss in the long run as the extra production depresses market price. This implies that increasing the tax to 6% tax rate may be unprofitable from the Norwegian producer perspective. (The current tax rate is 3%.) In fact, returns to all producers except UK and Faroe Islands are negative in the long run according to model simulations with baseline parameter values. This indicates the importance of incorporating supply response when evaluating program effectiveness.

Removal of the feed quota would diminish producer returns, but only about 5% in toto. But here again the distributional impacts are uneven, with Norway and Chile capturing a smaller share of total benefits, and UK and Faroe Islands producers a larger share as the extra supply from Norway enters the market.

The quality of the advertising (item 4) was measured indirectly through the advertising elasticities. We find that advertising elasticities play a pivotal role in determining total producer returns, as well as the distribution of those returns among geographic groups. For example, a 50% increase in advertising elasticities causes Norway’s share of short-run benefits to increase from 21% to 34%, and UK’s share to decrease from 49% to 33%. Thus, Norwegian producers cannot afford to be indifferent about program quality.

Our results overall suggest that in the case of salmon, free-rider benefits far exceed direct benefits (item 5). This underscores the potential importance of free-rider effects in comprehensive program evaluation. It may also help to explain why domestic producers of traded goods may be reluctant to fund generic advertising at the economic optimum.

Authors Acknowledgements

Henry Kinnucan is a professor in the Department of Agricultural Economics and Rural Sociology, Auburn University, USA. Øystein Myrland is an associate professor in the Department of Economics and Management, University of Tromsø, Norway.

Appreciation is expressed to Tom Sebulonsen and Jan Trollvik at the Norwegian Seafood Export Council for providing data and background information. The research was funded in part by the Norwegian Seafood Export Council.

For more information, see:

Kinnucan, H. W. and Ø. Myrland. “Free-Rider Effects of Generic Advertising: The Case of Salmon.” Agribusiness: An International Journal. 19 (2003): 315-324.

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