Agricultural and Food Policy, Livestock Production/Industries,

Balmann, Alfons

Feil, Jan-Henning

Musshoff, Oliver

English

Research Papers in Economics

Policy Impact Analysis in the Dairy Sector 
˗ An Agent Based Real Options Approach ˗ 
 
 
 
Jan Henning Feil
a, Oliver Musshoff
a, Alfons Balmann
b 
aGeorg August Universität Göttingen, Department of Agricultural Economics and 
Rural Development, Farm Management Group, Goettingen 
bLeibniz Institute of Agricultural Development in Central and Eastern Europe (IAMO), 
Department of Structural Development of Farms and Rural Areas, Halle (Saale), 
Germany 
 
 
 
 
 
 
 
Poster prepared for presentation at the                                                         
Agricultural & Applied Economics Association’s 2011 
AAEA & NAREA Joint Annual Meeting,                                     
Pittsburgh, Pennsylvania, July 24-26, 2011 
 
 
 
 
 
Copyright 2011 by Jan-Henning Feil, Oliver Musshoff and Alfons Balmann. All rights 
reserved. Readers may make verbatim copies of this document for non-commercial purposes 
by any means, provided that this copyright notice appears on all such copies. Policy Impact Analysis in the Dairy Sector
– An Agent-Based Real Options Approach –
Jan-Henning Feil, Oliver Musshoff and Alfons Balmann 
Objectives
D lt f tl t bd lt i k td l
Motivation/Research Gap
 Abolishment of EU milk quota system by 2015
Higher levels of (dis)investments in the dairy sector can be expected
 Extreme milk price fluctuations in 2007-2009
Dairy farmers and lobbyists started to ask for additional political support
 Studies have proven that the real options approach (ROA) is more advantageous 
for analyzing dairy investments than traditional investment models
 However, no real options model yet allows the analysis of investments under 
consideration of competition and political schemes 
 Development of a conceptual agent-based real options market model 
allowing the impact assessment of different political schemes
 Application of the model to the German dairy sector by comparing 
exemplarily the effects of 
− lower price limits maintained by governmental purchases of excess supply
− investment subsidies 
on investment trigger prices, firm profitabilities and economic efficiencies
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Real Options Approach
 Analyses investment decisions in a stochastic and 
dynamic context
 Exploits analogy between a financial option and an 
investment project to evaluate entrepreneurial 
flexibility
 In contrast to financial options, real investment 
projects are also open to other market 
participants, which affects the price dynamics
Price Dynamics with and without Competition (geometric Brownian Motion)
investment trigger  
= reflecting barrier 
sample path of prices 
without competition 
(unregulated price 
process) 
price 
sample path of prices
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Prices need to be determined endogenously
Competition has to be taken into account
Numerical model allows endogenous derivation of price dynamics and investment triggers in competitive markets
Basic Model Assumptions
 N homogenous competing risk-neutral firms
 Firms can make investments up to a given maximum
Investment Behavior of the Firms and Optimization of the Model
 Rational expectations and complete information of the firms 
Each firm maximizes its expected net present value by finding the optimal investment trigger price
time
sample path of prices 
with competition 
(regulated price 
process) 
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t  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 in a period
 Irreversible investment
 In every period, production declines corresponding 
to a geometric depreciation rate
Each firm maximizes its expected net present value by finding the optimal investment trigger price
 Firms with lower trigger prices have a stronger tendency to invest
− Firms are sorted according to their trigger price level, starting with the lowest
− Firm n+1 does not invest, if firm n is not already completely invested
 In every period a “last” firm invests such that its trigger price equals the expected product price of the 
next period
 Optimal trigger prices are derived by a combination of genetic algorithms and stochastic simulation 
 Economic efficiency of political schemes is calculated as quotient of welfare with political schemes and 
welfare without political schemes
Effects of Lower Price Limits on Trigger Prices, Expected Net Present Values and Economic Efficiencies under General Conditions
 Model parameters:
− Demand process: geometric Brownian Motion with drift = 0.0% or 2.5% and volatility = 20% or 40%
− Price elasticity = -1, depreciation = 0%, risk-free interest rate = 6%, T = 100 years, N = 50 firms, total costs of investment per output unit = 1 €
 Lower price limits given in percentage of the total costs of investment
Volatility
Drift
Trigger 
Price
Expected 
NPV
Econ. 
Efficiency
Trigger 
Price
Expected 
NPV
Econ. 
Efficiency
40% Lower 
Price 
Limit
20%  Results summary:
− Increase of lower price limit induces decline in trigger prices
− Firms do not make any profits despite of lower price limit
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Empirical Application to the German Dairy Sector: Comparison of the Effects of Lower Price Limits and Investment Subsidies
 Model parameters:
− Demand process: geometric Brownian Motion assumed with estimated drift = 1.40% and volatility = 19.23% based on time series of inflation-adjusted milk prices
0% 1.5819 -0.0042 100.00% 2.3934 -0.0413 100.00%
80% 1.3202 -0.0025 81.07% 1.5359 -0.0020 71.77%
95% 1.0841 0.0004 65.35% 1.0560 0.0018 55.34%
0% 1.3809 0.0076 100.00% 2.1724 -0.0060 100.00%
80% 1.2244 -0.0036 86.96% 1.4460 0.0350 79.41%
95% 1.0398 0.0027 73.28% 1.0203 0.0538 67.22%
2.5%
0%
− Economic efficiency decreases with implementation and increase of lower 
price limit
− Increasing drift rates induce decreasing trigger prices
− The higher the volatility, the stronger the reduction in trigger prices and 
economic efficiencies by increasing lower price limits 
Lower 
Price Limit
Trigger 
Price
Econ. 
Efficiency
Lower 
Price Limit
Trigger 
Price
Econ. 
Efficiency
0% 0.5060 100.00% 0% 0.5060 100.00%
80% 0.4538 88.89% 81% 0.4526 97.53%
Lower Price Limit Investment Subsidy
− Price elasticity = -1.0, depreciation = 4.5%, inflation-adjusted interest rate = 3.69% based on time series, T = 100 years, N = 50 firms, total costs of investment per kg 
milk = 0.37 € (incl. variable costs for fodder, labor etc.)
 Lower price limits given in percentage of total costs of investment, investment subsidies given in percentage of the initial investment outlay
 Investment subsidies are fixed by iterative searching at the trigger price level of lower price limits
 Results summary:
− Both the increase of lower price limit and the investment subsidy induce 
decline in trigger prices and economic efficiency, as shown under general 
conditions
− Investment subsidies cause less stronger welfare reductions than lower 
price limits for achieving the same trigger price level (this can also be
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Further information: Jan-Henning Feil
Platz der Goettinger Sieben 5, 37073 Goettingen
E-mail: Jan-Henning.Feil@agr.uni-goettingen.de
 Model provides a conceptual basis for policy impact analysis for competitive 
markets underlying real options effects
 Vast modeling flexibility by use of genetic algorithms and stochastic simulation
 Investment subsidies are preferable to lower price limits
95% 0.3870 75.85% 180% 0.3895 93.19%
Main Conclusions Future Research
 Besides investments integration of disinvestments in the model
 Investigation of effects of the EU milk quota abolishment
price limits for achieving the same trigger price level (this can also be 
confirmed under general conditions)

Policy Impact Analysis in the Dairy Sector ˗ An Agent-Based Real Options Approach ˗

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