The 'Domain' for Levy-Funded Research and Extension: General Notions with Particular Applications to the Australian Dairy Industry

Julian Alston [1]

Department of Agricultural and Resource Economics
University of California, Davis

General Musings on Efficiency and Equity Aspects

More-Specific Ideas on Levy-Funded Research in the Dairy Industry

References

In Australia, a variety of institutions are engaged in providing funds for agricultural research and extension, and making decisions about the allocation of those funds among alternative research and extension programs. These institutions are intertwined in complicated ways. In dairy research, for instance, the Dairy Research and Development Corporation (DRDC) combines levy-based funds with matching funds from the federal government to provide partial funding support for research and extension programs conducted by state-government agencies (such as Victoria's Department of Natural Resources and the Environment, DNRE), by federal agencies (such as CSIRO or ABARE), and by private firms in Australia as well as some overseas research bodies. The fact that most of the projects funded by the DRDC are in some sense joint ventures (involving a mixture of federal funding, levy funding, and other funding) adds complications to the problem of defining the appropriate division of labour between the DRDC and the other agencies engaged in dairy industry research ¾ the R&D "domain" for the DRDC.

General Musings on Efficiency and Equity Aspects

In beginning to broach this topic, let us abstract from the joint-funding aspect and consider the DRDC as though it were a stand-alone enterprise, funded entirely using levy funds, and ask a question in principle: What should be the scope of its research portfolio, and which lines of research ought to be left to other sources of funds? In addressing this question, a reasonable starting point is to acknowledge that there are both economic efficiency and equity dimensions to the issue. A simple economic efficiency rule is that the DRDC ought to allocate its funds so as to maximize the total benefits ¾ but whose benefits (and costs) ought to be counted, benefits to all Australians or just benefits to the Australian dairy industry? And within the industry, should we count benefits just to dairy farmers or benefits accruing to processors and manufacturers as well? Should they count equally, or should farmer benefits get more weight? It is not trivial to separate the equity and efficiency issues.

It is reasonable to define economic efficiency in terms of the benefits to Australia as a whole. Further, under a reasonable simplifying assumption ¾ that, under the recently deregulated market structure, DRDC research has a negligible impact, if any, on world prices, and thus on prices paid and received for dairy products in Australia ¾ it is a reasonable approximation to equate industry benefits with Australia's benefits (i.e., there are no consumer benefits and no optimal trade-tax arguments to bother about). The remaining equity issues concern the distribution of the benefits and costs of levy-funded research within the industry, between dairy farmers and other participants in the marketing chain ¾ including input suppliers as well as processors, manufacturers, and retailers ¾ and among farmers (and others) depending on the extent to which they can adopt new technology resulting from the levy-funded research. These can be thought of as vertical and horizontal dimensions of the distributions of costs and benefits of levy-funded research.

First, consider the vertical dimension. One result from the literature is that, under commonly made assumptions, the benefits from research at one stage of a multistage production system will be distributed up and down the production-marketing chain in the same proportions as the cost of a levy collected at the same stage of production (e.g., see Alston and Mullen 1992). This result leads to the conclusion that it would be both fair and efficient to finance commodity-specific industrial research entirely using commodity levies. Moreover, if the production technology across the stages of production is of a fixed-proportions nature, the research could apply at a different stage than the levy and yet the benefits would be distributed in proportion to the costs.

A breakdown of the congruence (or concordance) between the distribution of benefits from research and the distribution of the costs of a levy used to finance it could arise from several sources, individually or combined. These sources include:-

1. variable factor proportions in production, with research results applicable at a different stage of production than that where the levy is collected,

2. imperfect competition among processors or retailers, or

3. a non-parallel research-induced supply shift (the perfect matching of incidence of costs of a levy and benefits from research requires that the levy-funded research reduces average and marginal costs by the same amount per unit, such that the supply curve shifts down in parallel).

Since we cannot rule out these elements altogether, we cannot be sure that benefits from levy-funded research will be distributed vertically among participants along the supply chain in proportion to the costs of a levy borne by participants along the supply chain. This uncertainty means that an industry group (such as an RDC) is likely to opt for a rate of levy that is less than the social optimum. In an extreme scenario Arrow's 'impossibility' theorem would imply a levy rate of zero. An industry RDC is likely to opt for a mix of research programs that gives up some economic efficiency in exchange for more equity. This observation provides a theoretical basis for (i) multiple levies to fund different lines of research collected at different stages in the system (on both equity and efficiency grounds), and (ii) some matching grant support from the government (on efficiency grounds). In the case of dairy research in Australia, vertical distributional issues are muted to some extent by the important role of farmer-owned cooperatives in the processing and manufacturing sector.

Next, consider the horizontal dimension of the distribution of benefits and costs of levies collected to fund research. A milk levy falls initially on all producers according to the amount of milk they sell but some of the levy cost is passed on, up and down the marketing chain, through induced changes in prices that depend on relative elasticities of supply and demand and so on, to be borne by individual middlemen and consumers according to the amounts of milk they buy. Every dairy farmer bears a cost in proportion to their individual production regardless of whether they adopt new dairy farming technology that is generated by the research funded by the levy. If prices were lowered as a result of productivity gains and supply increases deriving from adoption of new technology deriving from the research, non-adopting farmers would be made worse off by both the new technology and the levy used to fund it. (Non-adopters can be hurt by any new technology that causes prices to fall, but the injury is greater if they have had to help pay for the research that gave rise to the technology.) Even if price did not fall as a result, innovators would gain cost savings and in due course would expand while laggards would continue to move out of the industry.

In an inter-temporal variation on this theme, horizontal inequities can arise between generations of dairy farmers. The incidence of the levy is immediate, whereas the incidence of the benefits from research may take 20 years or more to affect beneficiaries. Only in the best of all worlds is it likely that the current levy payer will be entirely convinced that the future benefits ¾ to be collected by his successors ¾ will be capitalized fully into his current asset values. In such a case the temporal aspects of agricultural R&D would be irrelevant to the issue of who benefits when relative to who pays when. If doubt exists about the extent to which future benefits from research will be capitalized, in practice, into farm assets, then levy-funded research may be less oriented towards longer-term research (i.e., that will take a relatively long time to yield a payoff) than efficiency alone would dictate.

Horizontal inequity occurs when levy-funded research and extension is only narrowly applicable within the industry. That is, applicable in a certain geographical region only; or applicable for only certain types of farmers (e.g., irrigated versus non-irrigated or very large versus small; or applicable only for farmers eligible to participate in a particular extension program versus non-participants). An extreme form of horizontal inequity would be if levy funds were used to finance research that did not have any benefits within the industry but benefited other members of the society. For instance, this might occur if levy funds were used to finance research into environmental issues with a view to generating environmental benefits not confined to the industry or its participants.

Further, in a similar manner to the effects of vertical market mismatches between the distributions of costs and benefits, perceived horizontal inequities too are likely to give rise to under-funding of research overall (i.e. some potential efficiency benefits foregone in exchange for some hoped for equity gains). This observation provides a theoretical basis for: (i) multiple levies to fund different lines of research collected from different (horizontal) subsets of the industry (on both equity and efficiency grounds), defined spatially or in terms of the nature of their technology, and, (ii) perhaps some matching grant support from the government (on efficiency grounds).

More generally, on equity and efficiency grounds, levy funds ought not to be used to fund private goods such as those provided by narrowly focused extension (or research) programs and for which there is no prima facie evidence of a market failure. Such activities ought to be funded privately. Conversely, on equity grounds commodity levy funds should not be used to finance programs for which the group of beneficiaries extends far beyond the group bearing the major incidence of the levy. These activities ought to be funded publicly, using more broadly based taxes.

Because of (real or imaginary) horizontal and vertical equity problems, given the role of 'democratic' processes in setting the levy rate and research priorities, levy-funded programs left to their own devices are likely to under-fund commodity-specific research overall, and to under-fund certain types of research in particular. Curiously it is likely that both research for which the benefits may be narrowly confined within the industry and research for which the benefits are only partially confined to the industry, will be funded at less than optimum levels.

One correction for a problem of under-funding of research may be to provide supplementary (perhaps matching) funding from general government revenue, but the provision of supplementary funding might not correct the distortion in the mixture of types of research preferred because of the 'democratic' processes involved in setting levy rates and research priorities. (On the other hand, we ought to give some consideration to the possibility that commodity levies might provide a relatively cheap source of research funds, and what that implies. For instance, see Alston and Mullen 1992.)

More-Specific Ideas on Levy-Funded Research in the Dairy Industry

Why does it make sense for the Australian government to delegate its taxing powers to an organization, such as the DRDC, that represents the interests of a small, narrow group in society? Presumably it is because this is seen as a reasonably fair way of achieving the economic efficiency objective of reducing the under-investment in dairy research that would otherwise take place. It would appear to have been successful from that point of view (see Alston, Harris, Mullen, and Pardey 1999). This is an example of the use of hypothecated (or earmarked) taxes (rather than general revenues), which can be a fairer and more-efficient way of financing certain types of collective goods. A general problem with this type of approach is that, because of heterogeneity in the industry and the Research and Development (R & D) outputs (and their applicability and economic impacts inside and outside the industry), the 'ideal' tax base will vary across research projects and programs. The 'efficient jurisdiction' varies among projects and programs, as will the optimal rate of matching support from the federal (or state) government.

As a practical matter, it makes sense to have a single institution that aggregates across all of these possibilities (in terms of parts of the marketing chain and parts of the country), partly because it would be too costly administratively to have multiple programs. Realistically speaking, we are not looking for an 'ideal', perfectly fair and efficient structure and cannot precisely optimize every element. Instead, we seek reasonably to draw generally sound distinctions and rules of thumb that are not grossly at odds with the notions of fairness and efficiency. From that standpoint, we can try to delineate those lines of dairy industry R&D that are more- or less-appropriately financed and conducted using levy-based funding, and rules of thumb for determining how much to do and perhaps on what basis.

As a starting point, consider the following four broad criteria:

1. The dairy industry share of total benefits. If this is not high, then the research ought to be funded using broader-based funding;

2. The odds that the benefits are privately appropriable either because of property rights protection or trade secrecy, or because the benefits accrue to a small group. If these odds are high, then the research ought to be funded privately by the beneficiaries;

3. The odds that the private sector in Australia or overseas will invest in the area, which is related to the idea that the benefits are appropriable. If these odds are high, then there is no case for under-investment;

4. The odds that overseas governments will invest in the area. If these odds are high, then Australia can free ride on this activity and concentrate on other research areas.

The examples below illustrate how these criteria can be applied to draw inferences about who should do what in relation to different elements of related types of work, such as different types of extension, as well as between unrelated types of work, such as farm management extension versus food processing R&D.

Extension. It is generally accepted nowadays, although it was not always so, that individual farm management advice ought to be left to the private sector. On the other hand, broader-based farmer education-cum-extension programs might be funded in part by a combination of, say, DRDC funds, state-government funds, and private funds, depending on the details of the programs.

The extent to which education activities should be the subject of collective action or government action is a critical question. Theory suggests that much of such activity is the domain of a well-functioning private sector. For example, there is a substantial private-sector role in educating farmers about technologies and management practices that will assist them to meet private sector objectives. Some may argue that there is a potential market failure from lack of knowledge or failures of the capital market to lend for human capital creation. This would not justify the provision of programs funded by the DRDC, although it might justify government action to address such market failures directly. The possibility of a net payoff to collective action by the industry or by government will be greater for components of education-cum-extension programs that have more important public-good elements. For instance, there might be a public-good component in the development of materials or the training of staff to provide education services, where the cost would not be recovered by fees for participation that cover only incremental costs. Alternatively, in a setting in which private incentives are distorted, an education program might have consequences for other public goods, such as the rate of land degradation or environmental pollution arising from dairy waste. Or, we might be able to justify the public or collective provision of services to facilitate the organisation of private activities that might otherwise not be developed because of high individual transaction costs. Management clubs may be one example. This justification would require, of course, that the transactions costs are lower for the collective action than for individuals.

Farming Technology . The case for supporting research into pasture production using DRDC funds is strong, more particularly as the research relates to Australia-specific issues, and more particularly as it relates to pasture production issues specific to dairy rather than, say, beef or sheep production systems. More general research into pasture production might be financed by a combination of dairy industry and other industry funds and general revenue funds, for instance. Similarly, there is a case for the DRDC supporting research into Australia-specific dairy genetic issues (such as fertility of cows). There is less of a case for using the same funds for supporting more-general dairy genetic research that might be applicable anywhere in the world. There is no support for any case for using dairy levy funds to support general biotechnology research that might be applicable anywhere in agriculture, anywhere in the world.

Processing Technology . Given the multinational nature of dairy processing and manufacturing companies and the worldwide applicability of much of the technology, the case is weak for using levy funds for supporting research into milk processing and dairy products manufacturing. The case for using general revenue funds for such research is even weaker. One funding option might be to use a combination of levy funds and matching support from dairy processors or manufacturers, with appropriate treatment of the intellectual property issues.

Environmental Issues . The case for obliging the DRDC to finance research into general environmental issues such as global warming even if they are associated with dairy production is weak, given the relatively small share of any benefits or costs attributable to Australia, let alone the dairy industry (see Edwards (1989) for instance). On the other hand, a reasonable case can be made for using DRDC funds to address actual or potential pollution problems associated specifically with dairy production, such as livestock waste management or irrigation-based salinity problems.

Economics and Policy . Although the dairy industry might be a major beneficiary from economic research that leads to reductions in agricultural trade barriers, it is hard to separate the dairy industry from other industries in the context of WTO negotiations and analysis of their impacts. The beneficiaries from such 'transparency analysis' are widespread within Australia and among countries, and the dairy industry ought not to be asked to pay more than its fair share for such work.

New Product Development . The private sector has reasonably strong commercial incentives to develop new products, where intellectual property can be protected by both trade secrecy and patents. Moreover, when product innovations are applicable in other countries, not just Australia, multinational firms involved in dairy processing and manufacturing are in a comparatively good position to appropriate the returns to investing in product development R&D. It is difficult to make a case for collective action by Australian dairy farmers, or for intervention by the Australian government, on the grounds of a private under-investment this type of research.

Other Collective Actions . Levy funds also might be used in future, as they have in the past, to finance other activities such as generic commodity promotion and industry public relations. In either of these cases, the justification for the use of any matching support is weaker than for most types of R&D, even though the problems of heterogeneity of interests and mismatching of the incidence of benefits and costs within the industry are likely to be significant. The real issue is that in such activities there might no longer be a strong link between the national interest and the collective industry interest. This raises doubts about whether it is appropriate even to allow the use of levy funds for promotion or public relations. The issue is whether in such activities 'self help' translates into 'help yourself', such that any industry benefits from this type of collective action are being achieved only at the expense of the nation as a whole. In any event, generic promotion is expensive folly in the current dairy market setting. Given the deregulation of the milk markets that was implemented in recent years, the only remaining price premia are constrained by actual or potential arbitrage within Australia, or between Australia and international markets. Hence, generic promotion mainly acts to shift sales from export to domestic markets, with no gains to producers (e.g., see Alston, Carman, and Chalfant 1994 or Hill, Piggott, and Griffith 2000). The same deregulation has also had implications for the benefits from different types of research, especially the distribution of the benefits (e.g. see Freebairn 1992).

These examples illustrate the ideas that all of the options involve mixed signals and different potential mixtures of funding approaches. A single policy approach such as funding based on an all-milk levy with 1:1 matching support is not likely to be the right recipe for most cases. Some approaches call for this recipe in combination with additional support from the federal or state government, or from the private sector. In other cases levy funding alone without the matching support, or some other different rate of matching support, might be apt. Some problems might call for broader-based industry funding (e.g., a levy on all the grazing industries). This funding could be raised by either a supplementary levy, or by using existing levy funds in a joint venture among RDCs. In some situations it might be (or at least perceived to be) more efficient and equitable to have a separate pool of funds based on levies on manufactured dairy products, as opposed to levies on milk. Furthermore, and importantly, some actions ought to be ruled out as not being in the national interest and thus not being a justifiable application of the government's taxing powers.

Questions about the optimal levy rate, or the optimal matching arrangement, and thus 'how much funding', are empirical questions that cannot be answered with in-principle arguments. If we believe that the 'democracy' problem continues to be an impediment to achieving an efficient total amount of funding, then a higher marginal rate of matching support from the federal government may be warranted on economic efficiency grounds. This could be achieved in a budget-neutral way by setting a lower rate of matching support for inframarginal spending, which is the converse of the approach of reducing the matching support at the margin that was recommended by the Industries Commission. As a practical matter, it is useful to look at the portfolio of recent past, current, and proposed (but unfunded) projects and ask of each: was it (or would it have been) a profitable investment from the national point of view, and who in the nation would have received the benefits? The answers to those questions ought to give guidance about the total funding base and priorities for support using DRDC funds.

References

Alston, J.M., H.F. Carman, and J.A. Chalfant. "Evaluating Primary Product Promotion: The Returns to Generic Advertising by a Producer Cooperative in a Small, Open Economy," in E.W. Goddard and D.S. Taylor (eds) Promotion in the Marketing Mix: What Works and Why? Proceedings from the NEC-63 Spring '94 Conference on Toronto, Ontario, April 28-29, 1994.

Alston, J.M., M.S. Harris, J.D. Mullen, and P.G. Pardey. "Agricultural R&D Policy in Australia" Ch. 5 in J.M. Alston, P.G. Pardey, and V.H. Smith, eds. Paying for Agricultural Productivity , Baltimore MD: Johns Hopkins University Press, 1999.

Alston, J.M. and J.D. Mullen. "Economic Effects of Research into Traded Goods: The Case of Australian Wool" Journal of Agricultural Economics 43(1992): 268-278.

Edwards, G.W. "Big Problems Facing Small Societies" Australian Journal of Agricultural Economics 33,2(1989): 71-87.

Freebairn, J.W. "Evaluating the Level and Distribution of Benefits from Dairy Industry Research" Australian Journal of Agricultural Economics 36,2(1992): 141-166.

Hill, D.J., R.R. Piggott and G.R. Griffith. "Profitability of Incremental Generic Promotion of Australian Dairy Products," Agricultural Economics , 1502 (2000): 1-14.

[1] I am grateful for helpful comments on drafts, provided by Paul Donnelly, John Freebairn, Rick Lacey, John O'Connor, Phil Pardey, Roley Piggott, and Alistair Watson, as well as some workshop participants.