When to Get In and Out of Dairy Farming: A Real Option Analysis

Agricultural and Resource Economics Review,  Oct 2006  by Tauer, Loren W

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The Dixit entry/exit real option model was applied to the entry/exit decisions of New York dairy farmers. For the cost structure of a 500-cow farm, the entry milk price is $17.52 per hundredweight (cwt) and the exit milk price is $10.84. For the 50-cow farm cost structure, the entry price is higher at $23.71 per cwt, and the exit price is also higher at $13.48. If infinite numbers of representative farms enter and exit at these prices, the price of milk should range between $13.48 and $17.52 per cwt.

Key Words: dairy farming, entry-exit, investment, real options

(ProQuest Information and Learning: ... denotes formulae omitted.)

Over forty years ago Glenn Johnson (1960) discussed how supply response in agriculture was nonsyrnmetrical, such that supply elasticity empirically often appeared to be lower for a price decrease than for a price increase. He postulated that this was due to fixed investment in land and labor, such that the opportunity costs were too great for exit except at very low prices. At that time the economic theory and mathematics to model this asymmetric response had not been developed, except for ad hoc approaches estimating separate output responses to price increases and decreases (Tweeten and Quance 1969). McDonald and Siegel (1985, 1986) were among the first to model the entry and exit into an industry using real option concepts, while Dixit and Pindyck (1994) developed and popularized the model. Essentially, this approach uses financial option theory applied to physical assets rather than financial assets, with the realization that the entry decision can be modeled as a call option and the exit decision can be modeled as a put option.

This article uses the model developed by Dixit (1989) to model the entry and exit decision of the dairy farmer. This model can result in a spread between the milk price that would encourage a dairy farm to exit the industry and that would encourage a new entrant. This is the case even while losses are incurred or profits are foregone. These losses or profits occur without exit or entry because the farmer holds unexercised options to exit or enter the industry. These exit and entry options have value and will not be exercised until the discounted losses or discounted profits exceed the value of the exit and entry option values, encouraging their exercise.

We determine what milk prices should encourage farmers to exit and enter the industry given the investment and cost structure of different types of New York dairy farms. What we find is that there are lower and upper prices such that exit does not occur until milk price moves below the lower price bound, and entry does not occur until milk price moves above the upper price bound, producing hysteresis between the price bounds. Since dairy producers have different costs of production, these price bounds vary by type of farm, although all may have the same milk price movement expectation.

There have been applications of real option concepts to agricultural investment decisions, including Richards and Patterson (1998) and Carey and Zilberman (2002), among many others. For dairy investment decisions, Purvis et al. (1995) modeled the freestall housing investment as a real option problem, and found that the present value of the investment would have to be much greater than the investment cost before the investment would be made. Engel and Hyde (2003) found the same for the adoption of robotic milking systems.

The Farming Entry and Exit Decisions as Options

Why a fanner may not get out of farming, even when he is currently experiencing losses, is easily expressed by any farmer. Next year might be better, and he is keeping his options open. Why someone may also hesitate to get into farming can also be expressed in option terminology. There may be profit today, but it might be wise to see if profitability continues before making the investment. The exit decision is viewed as a put option and the entry as a call option, with the farmer as a holder (buyer) of these options. These options have value.

The standard economic operating decision, given perfect information and no adjustment costs, is to invest when the product price is above the sum of fixed and variable cost. In a multi-period setting, that would be when net present value (NPV) is positive. The decision to shut down is when the product price is below variable cost. Given positive fixed and variable costs, this would generate both a lower and upper milk price band such that new investment would not occur until the upper milk price is reached, and exit would not happen until the lower milk price is reached. These options further increase the upper price and decrease the lower price. That is because if the upper price band is reached and you make the investment, you kill your option value to wait. Thus, it requires a milk price even higher than the sum of fixed and variable costs before you make the investment. In contrast, when you exit you kill the option to continue operating, and this takes a lower milk price than the variable cost alone.