Comments on an Australian Farm Institute Research Report ‘Australia’s Farm-Dependent Economy: Analysis of the Role of Agriculture in the Australian Economy’, published in March 2005
The purpose of this paper is to discuss a recent report by Econtech for the Australian Farm Institute and Horticulture Australia Limited that develops another way of measuring direct and indirect links between agriculture and the rest of the economy. The principal conclusion of the paper is that the measure put forward by Econtech and actively promoted by the Australian Farm Institute is misleading and unhelpful in the development of farm policies.
As usually measured, the share of agriculture in Australia’s gross domestic product is now a little over 3 per cent, measured as the farmgate value of production. The report published by the Australian Farm Institute suggests a much bigger number for agriculture’s share of GDP than that provided by conventional measures. Econtech included upstream and downstream economic activities in a revised way of looking at the agricultural sector. Econtech included industries producing farm inputs, and industries using food and fibre. This was described as the ‘farm dependent economy’. By definition, the FDE measure is larger than the conventional farmgate measure of agriculture’s share of GDP.
Many people are taking the FDE seriously. But should they? The observation that the agricultural sector is a substantial supplier and consumer is uncontroversial, but what are the implications of that observation? It is worth examining the report more carefully to understand its assumptions, data and underlying economics. The FDE is harmless enough at first glance but closer examination reveals unwitting traps that Econtech and the AFI have fallen into, some of which are potentially to farmers’ disadvantage. Most of the problems occur because of the way Econtech have treated the farm output sector. Measuring and making sense of the farm input sector is more straightforward than the farm output sector.
The value of the FDE is questionable. There is no logic in the proposition that a bigger number for agriculture’s share of GDP makes the agricultural sector inside the farmgate more important. Nothing in the economy has changed by the act of inventing the FDE. The policy issues confronting farmers, governments, input suppliers and customers of agricultural industries remain the same
The mining sector could easily be redefined and broken down to components such as ferrous and non-ferrous minerals, gold, coal, oil and gas. These components have distinct geology, regional distribution, ownership and separate markets. If individual components are less than 3 per cent, what alters with respect to the firms within the industries or the role of government? The mining sector produces many inputs for other parts of the economy. Are we to have a MDE?
A similar argument could be run about manufacturing with the constituent parts defined by capital intensity, labour market features, raw materials used, assistance levels or engineering criteria. Food and fibre processing are manufacturing activities sine qua non confusing comparisons of the FDE with other sectors of the economy. If food and fibre processing are part of the FDE, it should be left out of manufacturing, otherwise the sum of sectors adds up to more than 100 per cent. Econtech provide enough information for careful readers of their report to understand what is going on, but the point has been missed in newspaper commentary.
The idea of sectors of an economy is useful for some purposes but not others. Most often, firms within a sector are competing for the same resources and markets. In the Australian context, important unifying features for firms within a sector are the need to cooperate to sort out industrial relations issues and negotiate with governments over taxation and assistance. For agriculture, an important shared industry interest is the organisation of research and development, quarantine and so on. Farmers also share many common political interests with other rural residents in the delivery of communications and other government services. But fiddling with economic statistics to come up with a measure like the FDE does not advance these interests. On the contrary, most of the ostensible boost to the calculated share of GDP recorded in estimates of the FDE occurs in capital cities.
The FDE belongs in down-market parts of politics, public relations, journalism and lobbying where ‘mine is bigger than yours’ has an unhealthy and rather sad fascination. The FDE has nothing to do with flows of resources, capital and products between households and firms, including flows between countries, which are important to the working of the economy. The emphasis in the report on an artificial construct and a red-herring like the FDE detracts from useful parts of the analysis by Econtech. It is worth understanding linkages within the economy and effects on the rest of the economy of farm-related shocks. The computable general equilibrium (CGE) modelling results in section 5 of the report rise or fall on their own merits independent of the FDE. The four scenarios selected are interesting and well handled. The way the policy problem is formulated is arguable for the disease outbreak and interest rate increase scenarios.
Apart from the desire to look good in an imagined competition about the share of agriculture in GDP, another rationale for espousing the dubious concept of the FDE appears to be foreign imitation. Other rich countries like the United States, Canada and the United Kingdom have done it, why not Australia? Government agencies were involved in calculation of the FDE (or like concept) in the other countries. The tradition of public service in agriculture-related departments in Australia has sometimes been compromised by accommodation of bad ideas appealing to parts of the farming community, but nothing like the extent of rich countries of the northern hemisphere where rural fundamentalism and protectionism are influential in departments responsible for agriculture.
An important difference for Australian agriculture is dependence on exports. The need to consider foreign trade imposes discipline on agricultural policy. Domestic concerns dominate the farm policies of the US and UK. Canada is an interesting case. The grain-livestock economy of the Prairies is foreign-trade exposed but other industries are more regulated and assisted. This can be explained by tensions within the Canadian Federation. There is also an unresolved tension among Australian farmers between pursuing a market-oriented approach to agriculture and returning to the defensive protectionism of earlier years. The AFI is caught up in this dilemma. Espousing superficial ideas like the FDE undermines their emerging credentials as an independent analyst and commentator on important rural matters.
The remainder of these comments is organised as follows. A few brief comments follow on the standard approach to the role of agriculture in the economy. A more detailed account of how Econtech calculate the FDE is provided in the next section, together with further comments on its pitfalls. The CGE models and scenarios are discussed in the fourth section. A brief conclusion follows.
A declining share of agriculture in the economy is a commonplace of economic development. And it probably should be a cause for celebration rather than regret. According to a report by the Productivity Commission (2005) agricultural output has grown two and a half times in the last forty years. But the rest of the economy has grown faster. Better to suffer the adjustment problems brought about by productivity improvement in agriculture in rich countries than the food shortages and poverty of third world countries, where agriculture is a much larger share of the economy.
The theory of agricultural development that best explains agriculture’s declining share of the economy is most closely associated with the work of Nobel Laureate, Theodore Schultz. In briefest outline, Schultz emphasised the faster rate of growth of supply of agricultural products compared with the rate of growth of demand. The demand for food at the farmgate is largely unresponsive to income once basic nutritional requirements are satisfied. Obviously, the composition of diets change and more post-farm services are consumed with increasing incomes. The growth in agricultural supply is the result of the application of biological and mechanical innovations based on scientific research. The consequence is falling prices and incomes for farm products and farmers, unless migration out of farming restores the economic balance between the farm and non-farm sectors in the returns to farm labour.
A range of policies was proposed to enable this process to proceed with minimum disruption. Schultz looked beyond technological determinism as an explanation for the increase in agricultural output. The increased capacity of ‘the human agent’ through education was recognised as a powerful force for productivity improvement. This provides an economic argument for investment in both agriculture-specific education and general education for the emigrants from agriculture.
Australia was lucky enough to have economists like Keith Campbell and Ross Parish, taught directly by Schultz, and their many influential contemporaries to adapt this simple message to Australian conditions. Of particular interest, including to Schultz, was the question why the onset of a farm problem was delayed in Australia compared to other rich countries? A variety of explanations were canvassed. By the time Kym Anderson of the University of Adelaide provided a subtle theoretical explanation of why agriculture must decline even in a country like Australia with a comparative advantage in agriculture, the conditions delaying the onset of a farm problem in Australia had passed and Australia had a fully-fledged farm problem. The key to Anderson’s analysis was differences in income elasticities of demand for goods and services rather than differences for food and non-food goods in the usual exposition of the analysis. This extension of Schultz’s theory by Anderson explains why manufacturing’s share of GDP also falls with economic growth.
The following simple equation describes the calculation of the FDE:
FDE = agricultural sector + farm input sector + farm output sector
The agricultural sector accounts for around 3 per cent of GDP, the farm input sector slightly less than 1 per cent and the farm output sector 8-9 per cent. In thinking about domestic macroeconomic effects of agriculture on incomes and employment, it makes some sense to consider the agricultural sector and the farm input sector together, although the link is weakened to the extent that farm inputs are imported. The Australian Bureau of Statistics collects information on which part of an industry’s output is destined for agriculture. For example, official statistics for the chemical industry separate agricultural chemicals – fertilisers, pesticides and so on – from other chemicals. The economic fortunes of this part of the local chemical industry are tied to the agricultural sector. Agricultural machinery is also recorded separately by the ABS.
The farm output sector creates even more difficulties. How do we classify industries that depend on agriculture and use other inputs? The ABS provides no guidance, probably for good reason. According to Econtech, the farm output sector is made up of industries that use a large proportion of agricultural inputs, with large proportion meaning 15 per cent or more. This is the rub. Econtech then include all the production from these sectors in the farm-output sector arguing that the non-agricultural inputs must be combined with agricultural inputs and that marketing, processing, retailing or whatever then qualify to be part of agriculture. This is an unfortunate rural conceit.
Implicit in this assumption, is that inputs beyond the farmgate are used in the same proportions with agricultural inputs, which is manifestly not the case. The FDE will increase over time for reasons that have nothing to do with agricultural production. The income elasticity of demand for services consumed with food is much higher than food per se. An increasing FDE corresponds with a declining share of the consumer’s dollar received by farmers; wrongly perceived by many farmers and commentators as a sensible measure of the efficiency of agricultural marketing. Roadside stalls, a limited approach to agricultural marketing to say the least, represent a 100 per cent share. The long marketing chains from remote Australian farms to distant world markets imply much lower shares of the consumer’s dollar finishing up with Australian farmers.
Competition in industries using agricultural products proceeds according to the industrial organisation of the industries concerned. Competition is vertical (between marketing channels) and horizontal (firms within channels). Supply and demand in the markets for marketing services determines the size of marketing margins and the FDE. This is independent of the supply and demand for agricultural products.
What happens after a product is sold is the business of the purchaser and his/her customers. Food preparation at home is not included in estimates of GDP. Does it make the slightest difference to our farmers whether Australian consumers choose to cook at home or eat out?
Farmers are interested in efficient marketing, implying a lower FDE. Restricted competition and natural monopoly may be issues in some markets for marketing services, as in other industries. But these are problems to be settled beyond the farmgate by trade practices legislation and regulatory authorities.
Locally produced agricultural inputs are not necessary to produce all output in the farm output sector. This is most obvious when imports are available. Production in the farm-output sector is then not connected to local agriculture. Australians would regard it strange if foreign calculations of the FDE included further processing of Australian products exported in unprocessed form. An Italian FDE that included the Italian early wool processing, textile and clothing industries would be bizarre.
The weakest part of the AFI report is its ambiguous attitude to further processing of agricultural products or value adding. This is most evident in uncritical evaluation of work by the United States Department of Agriculture and a couple of Australian state governments that espouse a naïve view of the economics of further processing. Comparison of the amount of value adding to agricultural products in different countries is wrong in theory and potentially damaging in practice. Mercantilist statements such as Canada exports value adding activities to the US at the expense of Canada are almost hostile to rational development of agricultural trade.
Worse still, Econtech claim at page 22 that “the Australian agricultural sector may be losing valuable export earnings by not processing more of its exports.” The claim is based on the simple observation that prices are higher for processed products than unprocessed products. The same claim could be made in all countries, telling us nothing about where post-farm activities should be conducted.
More ‘value adding’ and further processing of agricultural products were slogans of the 1980s. The record of Australian firms that acted on this advice was unimpressive. So were the consequences for agricultural research. Many government research agencies drifted into research programs on downstream activities that should have been the domain of the private sector. Promotion of the FDE concept could lead to some more sloppy thinking on agricultural policy beyond the farmgate.
The economics of marketing and processing on both the cost and demand sides determine whether it is advantageous to add value close to the point of production or close to the point of consumption. How much ‘value’ is added should be an empirical question. Some transport, product and demand characteristics favour local processing and others do not. Some initial processing is necessary for meat and dairy products because of their perishability. This is not usually thought of as value adding because it is necessary to bring agricultural products to the market. Differential trade restrictions on processed and unprocessed products are an important determinant of whether agricultural products can be successfully processed in Australia. Patterns of protection usually favour exports of unprocessed products.
It is always worth remembering that adding value is also adding costs. The size of the FDE is being treated like a success indicator when for many exports where Australia has an established comparative advantage such as grains, red meat and wool, a low contribution to the FDE is an indicator of successful marketing.
Econtech use three CGE models to simulate the impact on the impact of four shocks (‘scenarios’) on the agricultural sector and the Australian economy. For reasons that should become apparent, it is the effects on the economy that are of economic policy interest. Whether a formal analysis is undertaken of the size of the FDE is inconsequential to this part of the report of the AFI.
The models are:
These models allow economic effects to be traced through the economy, providing useful information on the important economic policy questions – ‘how much’, ‘when’, ‘where’? MM600+ is used to simulate the disease outbreak and no tariff scenarios. These can be thought of as structural changes to the economy. MMR is used to simulate the drought and drought assistance scenario (drought is a regional phenomenon). MM2 is used to simulate the interest rate scenario because higher interest rates are a temporary change to the economy related to the business cycle, not long-run changes. For each of the applications of the models, a baseline or base case scenario is calculated to compare with and without scenarios.
Fire blight is a damaging bacterial disease of apples and pears that affects many countries including neighbouring New Zealand. Australia is free of fire blight. Quarantine restrictions have protected Australia from fire blight so far. The issue is a source of tension between Australia and New Zealand. Fire blight reduces production of apples and pears. Based on technical data, Econtech assume losses of 20 per cent for apples and 50 per cent for pears in their simulations of a fire blight disease outbreak.
Production costs would also be higher if fire blight were introduced because of ongoing changes to management necessary to curtail its effects. These costs are not considered in the Econtech analysis. Econtech conclude that the outbreak does not have a significant impact on GDP. Agricultural output falls 0.4 per cent and the farm-output sector 1.2 per cent. Econtech have restricted their analysis to the six years following the disease outbreak. Econtech also undertook a regional analysis of GDP and employment. The effects are negligible, apart from the Goulburn Valley where apple and pear production is important.
Econtech claim that leaving out the additional costs of managing fire blight results in conservative estimates. This is so, but Econtech are perhaps being a little disingenuous in the way they have set the problem up. The Realpolitik of the fire blight controversy is the dispute with New Zealand over quarantine protocols. New Zealand has challenged the scientific basis of the protocols. There is an economic dimension to the dispute that runs alongside the technical argument. Despite extra production costs imposed by fire blight, New Zealand could still land apples and pears cheaply in Australia. The economics of packing and transport to Australian cities is a major reason for this. Several horticultural centres in New Zealand are located close to the coast. Sea transport is cheaper than land transport.
Australian consumers would be beneficiaries of lower prices. Many consumers might be prepared to take a punt on the chances of fire blight being introduced under the proposed protocols. A full CGE analysis should also take into account effects on consumers and ongoing production costs. Most likely, Australian incomes would be higher if imports of New Zealand apples were permitted.
Econtech have used their quarterly forecasting model MM2 to investigate the effects of an interest rate increase with cash rates rising from 5.25 per cent to 5.75 per cent. The increase is temporary lasting for two years. The results of the simulation indicate no significant effect on the agricultural sector but slight falls in the farm input and farm output sectors leading to a fall in GDP of 0.3 per cent. Most of the GDP effects are on the construction sector and capital-intensive industries,
The economic mechanism at work is that imports rise and exports fall with appreciation of the Australian exchange rate with a rise in cash rates. The interest rate policy of the Reserve Bank of Australia is intended to control inflation. The agricultural sector is vulnerable to inflation because costs increases cannot be passed on. Failure to keep inflation in check would have adverse effects on the agricultural sector. The RBA is thus generally acting in farmers’ interests when it raises interest rates, despite the conventional wisdom and bad press surrounding interest rate rises. It is almost implicit in this simulation that interest rate rises occur in a business cycle vacuum.
In this shock, remaining import tariffs are abolished using the MM600+ model. As would be expected, there is an increase of GDP and benefits to the trade exposed parts of the Australian economy like mining and most of agriculture. This is a sophisticated analysis where CGE modelling finds a fertile application.
There are a few tariffs protecting minor agricultural products and the farm output sector. Abolishing tariffs will have most effect on textiles, clothing and footwear (TCF) industries and motor vehicles. The agricultural sector benefits because of direct effects on costs and a favourable fall in the value of the Australian dollar. A slight offset is reduced domestic demand for cotton and wool from the TCF industry. Parts of the dairy industry also decline due to removal of tariffs on cheese and curd. Similarly, brandy production is protected by tariffs and suffers from their abolition.
A paradoxical result is that there is a slight fall in consumer living standards because of a fall in Australia’s terms of trade. Full details are not presented of the elasticity assumptions – that is, the price responsiveness of supply and demand. Statements about lower export prices following from increased supplies of wheat, iron ore, coal, gold and alumina suggest these assumptions may be on the low side.
The analysis demonstrates the regional benefits of existing tariffs for Victoria and South Australia at the expense of states with large agricultural and mining industries.
This is a transparent and thorough study of the effects on the agricultural sector and the economy of the removal of tariffs. It has nothing to do with the idea of the FDE.
The final scenario is a study of the effects of drought and drought assistance using the MMR model with data for 2002-03. Drought has direct effects on the regions affected and flow-on effects on the industries that use agricultural products. Drought was simulated by reducing agricultural production according to the falls that occurred in 2002-03. The second stage examined the extent to which the effects of drought were mitigated by assistance. Both stages are then compared with the baseline non-drought situation. One interesting sidelight on the results presented is that some regional areas receive disproportionate amounts of assistance. Presumably, the outcome is due to the arbitrary nature of ‘exceptional circumstances’ drought declarations.
Econtech estimate that the assistance package provided each regional resident with an average of $56 worth of additional consumption. Econtech emphasise that city residents are financing the drought assistance package. Yet, they conclude that there is no real change in total consumption per Australian. This is counter-intuitive because funds for drought assistance must have come from increased taxation or cuts to other programs, reducing the consumption of city dwellers.
This report is setting back the clock of agricultural policy discussion in Australia. The promotion of the FDE concept and especially its measurement should not be taken seriously. The FDE threatens to become one of those shibboleths that are trotted out whenever the agriculture sector is making a claim for assistance.
Much of Australia’s farm output sector is independent of the size of the agricultural production sector. In principle, with a bounteous season and a higher proportion of agricultural output exported, the FDE could fall because there are less costs of transformation of agricultural products for export than for the domestic market. This is plainly an absurd consequence. The FDE as measured has no significance for economic policy.
As demonstrated in CGE modelling of various scenarios presented in the report, linkages between agriculture and the economy are important. But this has nought to do with such an aggregate concept as the FDE.
 Tony Gleeson of Synapse Research and Consulting suggested and assisted this critique with comments on earlier drafts. Other helpful comments were received from colleagues in Commonwealth and state agencies.
 Rural journalists have suggested in comments on the FDE that the manufacturing sector is smaller, not noticing that some manufacturing output has been reclassified. The agricultural sector is supposed to have outstripped mining, manufacturing, construction, property and business services when if these sectors were represented in expanded form along their supply chains, Australia’s GDP would total way over 100 per cent! The reaction of rural journalists to the AFI report has been uncritical. Mainstream journalists show almost no interest.
 Productivity Commission 2005, Trends in Australian Agriculture, Research Paper, Canberra.
 For more detail on the theory of agricultural development proposed by Schultz, see any standard textbook on agricultural economics. The argument that Australian farmers are now seriously divided whether to go down a protectionist track is further developed in my paper ‘Australian Agriculture: Persistent Myths and Current Realities and/or Current Myths and Persistent Realities’ in Gleeson, T., Turner, C., and Drinan, J. (eds) 2005, Australian Values – Rural Policies: Symposium 2000, Rural industries Research and Development Corporation Publication No: 05/009.
 See K. Anderson (1987), ‘On why agriculture declines with economic growth’, Agricultural Economics, 1 (3), 195-208.