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Analysis of dairy policy reform and trade liberalisation

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					                                               Unclassified                                                     COM/AGR/TD/WP(2004)20/FINAL
                                               Organisation de Coopération et de Développement Economiques
                                               Organisation for Economic Co-operation and Development
                                               ___________________________________________________________________________________________
                                                                                                                        English - Or. English
                                               DIRECTORATE FOR FOOD, AGRICULTURE AND FISHERIES
                                               TRADE DIRECTORATE
Unclassified
COM/AGR/TD/WP(2004)20/FINAL




                                               Joint Working Party on Agriculture and Trade




                                               AN ANALYSIS OF DAIRY POLICY REFORM AND TRADE LIBERALISATION

                                               AN ANALYSIS OF INTERNATIONAL DAIRY TRADE LIBERALISATION




                                               This is the final version of a study which was carried out under the 2003/2004 Programme of Work of the
                                               Committee for Agriculture.




                                               Contact: Pavel Vavra (pavel.vavra@oecd.org)
                       English - Or. English




                                               Document complet disponible sur OLIS dans son format d'origine
                                               Complete document available on OLIS in its original format
COM/AGR/TD/WP(2004)20/FINAL


                                                Foreword

     This report is one of several studies that have been carried out under the Assessing Future
Agricultural Markets, Trade and Policies activity of the 2003-2004 Programme of Work of the OECD’s
Committee for Agriculture. Within this overall activity, studies were scheduled to provide assessments of
the market, trade and welfare impacts of domestic and trade policy reform for selected commodities that
currently receive very high support and protection. The report investigates empirically the impacts of
international dairy trade liberalisation with the Secretariat’s Aglink and PEM models. In this analysis, the
individual policy measures related to quota systems and price support instruments are simultaneously
reduced or removed in order to assess the impact of international dairy trade liberalisation on production,
consumption, trade, prices, income and welfare. The main authors of this report are Pavel Vavra and
Roger Martini, economists in the OECD Directorate for Agriculture. Many colleagues in the OECD
Secretariat and delegates from Member countries furnished useful comments on earlier drafts of this report.




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                                                            TABLE OF CONTENTS




   I. Introduction ..............................................................................................................................................4
   II. The world dairy markets .........................................................................................................................5
   III. Agricultural policies supporting dairy production .................................................................................9
   IV. International dairy trade liberalisation.................................................................................................12
   V. Summary ...............................................................................................................................................35
   VI. Main conclusions.................................................................................................................................38
REFERENCES..............................................................................................................................................40
ANNEX 1 ......................................................................................................................................................43
ANNEX 2. .....................................................................................................................................................55
ANNEX 3 ......................................................................................................................................................61
ANNEX 4. .....................................................................................................................................................66



Tables

   Table 1. Unilateral liberalisation experiments ...........................................................................................30
   Table 2. Ranking of impacts of unilateral liberalisation experiments .......................................................31
   Table 3. Simultaneous liberalisation experiment.......................................................................................33
   Table 4. Partial price transmission in the EU ............................................................................................34



Figures

   Figure 1. Comparison of per capita consumption with per capita production of milk (in milk equivalents)6
   Figure 2. Production trends of major dairy products ...................................................................................7
   Figure 3. Consumption trends of dairy products in OECD and non-member economies ...........................7
   Figure 4. Trends in trade volumes and market shares for major dairy products and exporters ...................8
   Figure 5. Declining world dairy prices in real terms ...................................................................................9
   Figure 6. OECD average Producer Support Estimate for milk, 1986-2002...............................................10
   Figure 8. Impact of trade liberalisation on world dairy product output .....................................................25
   Figure 9. Comparison of milk price and quantity adjustments in individual scenarios: The case of Canada26
   Figure A3.1 PEM Land Allocation Structure . .........................................................................................65




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         AN ANALYSIS OF DAIRY POLICY REFORM AND TRADE LIBERALISATION

              ANALYSIS OF INTERNATIONAL DAIRY TRADE LIBERALISATION



I. Introduction

1.        Milk producers, in virtually every OECD country and in many non-member economies, benefit
from government interventions that boost the prices they receive for their raw milk production.
Government support and protection for milk producers is also more widespread than for any of the other
commodities for which the OECD calculates producer support estimates (PSE). As a result, milk is one of
the most heavily protected agricultural commodities, with an average OECD-wide percent PSE in 2000-02
of 46%. The support to milk producers as measured by the PSE amounts to 16% of the total PSE as
calculated for OECD countries (OECD 2003a).1 2

2.        The majority of support to milk producers is delivered through market price support. In general,
milk price support at the farm level is achieved either through trade measures (import tariffs, tariff rate
quotas and/or export subsidies) applied to dairy products or through a combination of trade measures and
discriminatory pricing arrangements. Even after the WTO Agreement on Agriculture, dairy trade continues
to be distorted by average bound tariffs that are among the highest of all agricultural commodities, by a
large number of tariff-rate quotas (TRQs), low minimum access requirements, a number of special
safeguard provisions, and use of export subsidies and other export support.

3.        Consequently, the evaluation of the consequences of international dairy trade liberalisation is of a
particular interest for OECD and non-member economies. Despite the high level of interest, the analysis of
trade liberalisation in the dairy sector is a complex exercise and there is only a limited number of studies
that have focused on this issue. The intricacies of the dairy sector, where from one input (raw milk, bulky
and largely non-traded) many outputs (which are often joint products: cheese/whey powder, butter/SMP)
can be produced and traded, complicates the analyses of dairy trade liberalisation.

4.        The analysis of international dairy trade liberalisation, undertaken by the Secretariat and
presented in this document, forms a part of broader work evaluating the consequences of dairy policy
reform. The individual policy measures applied in the dairy sector (trade measures, pricing arrangements
and quota systems), analysed separately in the previous parts of this project (Trade and economic effects of
dairy price support measures [COM/AGR/TD/WP(2003)1/REV2] and Trade and economic effects of milk
quota systems [COM/AGR/TD/WP(2004)19/REV2)]), are simultaneously reduced or removed in order to
assess the impact of international dairy trade liberalisation on production, consumption, trade, prices,
income and welfare. To use the complementarities of Secretariat’s models the empirical analysis is carried

1
         For example, in Canada and the United States milk producers receive 36 and 24% respectively of all
         producer support which compares to 17 and 10% in the European Union and Japan (2000-02 average,
         OECD 2003a)
2
         Note, that recent reform of the EU CAP will likely have an impact on PSE measures for the EU (see
         document OECD 2004b).


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out with the Aglink and PEM models. The Aglink analysis addresses potential commodity impacts. The
PEM analysis focuses on economic costs and benefits — the potential welfare impacts.

5.         The remainder of the document is organised as follows. The following section describes basic
characteristics of world dairy markets and trends in trade in dairy products. That description is followed by
a discussion of the composition of and trends in agricultural policies supporting dairy production. These
two preceding sections provide a background for the analysis of dairy trade liberalization. The empirical
analysis is described in the fourth section of the paper, where the Aglink and PEM results are presented and
discussed. The results are summarised, important caveats noted and main conclusions and lessons drawn in
the final sections.

II. The world dairy markets

6.        This section describes the basic characteristics of milk and dairy product markets and provides a
background for the analysis of dairy trade liberalization. Some specifics of milk production and markets
are briefly explained. The focus is on a description of the structure of dairy markets and on major trends in
milk and dairy product production, consumption, and trade.

Production and consumption of milk and dairy products

7.        Milk is a bulky, highly perishable commodity subject to bacterial contamination. A given unit of
milk contains a certain amount of milk fat, protein and other solids. The level of these components in milk
changes only slowly over time. The components are used in dairy products in various, mostly fixed,
proportions (for example, butter contains mostly milk fat, skimmed milk powder contains non-fat solids
while different cheeses are produced with varying proportions of these components). Milk is produced
continuously every day throughout the year. Milk production systems differ depending on the degree of
integration with crops and its relation to land. In general, livestock production systems are differentiated
into grazing, mixed farming and industrial systems (de Haan et al., 1997). Industrial systems where milk is
produced by feeding animals concentrates made from grains and oilseeds are expensive in terms of energy
used. Grazing is typically considered the low cost production system but it is subject to marked seasonal
variations.

8.        A review of milk production developments over the last three decades reveals that world milk
production trended upward from the 1970s until the mid-1980s, then declined mainly as a consequence of
quota level reductions in the European Union and increased only modestly in the 1990s. The highest
increases in milk production have occurred in non-member economies and in that part of the OECD area
not subject to production quotas (mainly Oceania). Although historically the larger share of global milk
production has been produced in the OECD area, world output is currently equally split between OECD
countries and non-member economies, although the latter are expected to rapidly increase their share
(OECD, 2003b). Geographically, the shift in milk production is directed mainly from North to South, and
more specifically from Europe and North America to Asia, Latin America and Oceania.

9.        Despite the operation of a milk production-limiting quota system, the European Union remains
the world largest dairy market and milk producer. In fact, following the 2004 enlargement the EU has
considerably strengthened its already dominant position, with a total output of about 144 mt.3 The second
largest milk producer is India with about 88 mt (of which 47 mt is buffalo milk), followed by the United
States with 77 mt. Cow milk remains the most important milk produced, accounting for 84% of the total.
Other types of milk (and their share of total world production) are buffalo milk (12%), goat milk (2%) and


3
         The milk quota allocated to the ten new EU members represents about 16% of the total EU quota.


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sheep milk (1%). It is worth noting that while in the last 10 years the production of cow milk has grown by
less than 10% the production of buffalo milk has grown by almost 40% (IDF, 2003).

10.       Figure 1 compares per capita production and consumption (in milk equivalents) of dairy
products. It is evident that, with the exception of Oceania and South America, the differences are small,
resulting in equally small net import or net export positions, compared to total milk production. Part of the
reason for the fact that local supply typically provides the majority of local dairy consumption stems from
the bulky and perishable nature of milk, which limits the tradability of the product.

   Figure 1. Comparison of per capita consumption with per capita production of milk (in milk equivalents)



                   Oceania

            Western Europe                                                               810 kg/pc

                 CEEC+CIS

                    NAFTA

                 South Asia

              South America

                Other Africa
                                                                    per capita consumption (kg)
           N.Africa&MidEast
                                                                    per capita production (kg)
            Central America

                  S.E. Asia

                               0              100             200               300                  400
          Source: data from IDF-CFCE (2003)

11.       Global production trends over the last three decades for major dairy products, indicate that the
production of skim milk powder (SMP) has somewhat declined, that of butter has remained relatively
stable, while WMP and especially cheese production have substantially increased (Figure 2). Cheese is by
far the most important dairy product and increasingly more milk is being channelled towards its
production. These production trends have been to a large extent determined by changes in consumption.
These changes in turn have been driven, in OECD countries, by per capita income growth but also by
evolving nutrition and health concerns. Elsewhere, growth in demand for dairy products has been driven
mainly by growing per capita income, changes in lifestyle, urbanisation and population growth.




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                                               Figure 2. Production trends of major dairy products

                                               20
                                                              Butter
                                                              Cheese
                                               15
                                                              SMP
                              million tonnes                  WMP
                                               10



                                                5



                                                0
                                                    1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003


Source: OECD Secretariat


12.       Over the last two decades cheese (a relatively income-sensitive product) has recorded a dramatic
increase in consumption in OECD countries, but that in non-member economies has remained relatively
flat (Figure 3). The share of world cheese consumption attributable to the OECD area has increased from
63% in 1982 to 78% in 2002 and is expected to grow further. Butter consumption on the other hand, has
been slowly increasing in non-member economies, but has been on the decline in the OECD area where
demand from restaurants and hotels is not enough to compensate for the fall off in consumption in private
households.

             Figure 3. Consumption trends of dairy products in OECD and non-member economies

                                               20

                                                                                                                           NME
                                               16
                                                                                                                           OECD
                           million tonnes




                                               12


                                                8


                                                4


                                                0
                                                     1982

                                                            1992

                                                                     2002



                                                                            1982

                                                                                   1992

                                                                                          2002



                                                                                                 1982

                                                                                                        1992

                                                                                                               2002



                                                                                                                        1982

                                                                                                                               1992

                                                                                                                                      2002




                                                            Butter                 Cheese               SMP                    WMP



Source: OECD Secretariat


13.       World SMP consumption has been declining in OECD as well as non-member economies partly
due to the reduction in feed use and partly due to the fact that other “non traditional” dairy products (whey
protein concentrates, milk protein concentrates) are increasingly used as a source of milk solids. In
addition, WMP powder has been continuously replacing SMP in the milk reconstitution market of non-
member economies. The consumption of WMP in non-member economies has been increasing swiftly
over the last decades and currently more than three quarters of all WMP is consumed there.




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Trade in dairy products

14.       As has been the case in the past, the considerable cost of transporting bulk raw milk suggests that
the majority of milk to be consumed in fluid form will continue to be produced and processed near the
point of consumption. The differentiation of milk into largely non-tradable fluid (drinking) milk and
manufacturing milk that is tradable in the form of milk products is a typical characteristic for the dairy
sector and complicates the analysis of dairy markets and dairy policy reform.

15.       Despite technological developments in refrigeration and transportation, international trade in
milk and milk products represents only about 5-7% of world production of cow milk (intra-EU trade
excluded). In contrast, international trade in dairy products accounts for about 48% of the production of
WMP, 27% of SMP, 10% of butter and 7% of cheese. It follows, then, that a relatively small change in the
supply/demand balance of milk may have a substantial impact on traded dairy products. The relative
thinness and volatility of dairy markets is further enhanced by restrictions on market access through border
measures and by export support.

16.       Trade in dairy products has increased in the last decade mainly for cheese, which saw trade soar
by more than 50%, and WMP for which trade increased by 30% (Figure 4). On the other hand, trade in
butter and SMP has been stagnating. This reflects an ongoing trend in world markets for dairy products
from supply-led trade in bulk commodities (SMP, butter) to demand-driven trade in high value-added
products, such as cheeses.

          Figure 4. Trends in trade volumes and market shares for major dairy products and exporters


                                             1600
                                                        Rest of World
                                                        New Zealand
                                             1200       EU
                                                        Australia
                           thousand tonnes




                                             800


                                             400


                                               0
                                                    1992     2002        1992   2002    1999   2002   1992   2002
                                                    Butter   Butter     Cheese Cheese   SMP    SMP    WMP    WMP



Source: OECD Secretariat


17.       As dairy products are typically consumed in the country of origin, world export markets have few
big players – mainly the EU, New Zealand, and Australia (the United States is important on the SMP
export market). Figure 4 illustrates that the dominance of these three countries on world dairy markets in
the last decade has not weakened despite the increase in the volume of international trade. Nevertheless,
reflecting quota constraints on milk production and limitations on the volume of subsidised exports under
the Uruguay Round Agreement on Agriculture, the EU has lost a considerable share of world dairy markets
to Australia and in particular to New Zealand. Dairy production in New Zealand is based on grazing with
very low production costs. Around 97% of all milk produced is exported and the dairy industry accounts
for almost a quarter of New Zealand’s total export earnings. While New Zealand’s share of world milk
output is less than 3%, its share of world trade is more than 30% - and expanding. Similarly, Australia,
with less than 2% of world milk production, supplies almost 20% of global dairy trade.


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18.       On the import side the situation is much more fragmented. South America imports mostly whole
milk powder, Mexico imports SMP, Africa imports SMP and WMP and the EU imports mainly butter and
cheese from New Zealand. Whole milk powder, processed cheeses and feta are imported by Middle East
countries. Although the USA is exporting some of its cheddar production it is an importer of speciality
cheeses. Asia is an increasingly important importer of WMP, butterfat and cheeses. Generally speaking,
low value products are exported to developing countries while high value products are largely exchanged
among high income countries.

19.       Trends in world dairy prices indicate that in real terms they have declined substantially since the
early 1980’s (Figure 5). At that time world prices were to a large extent driven by subsidised exports from
the European Union and there was a sharp decline in prices as the surplus problem in the EU mounted.
Following the EU quota level cuts in the second half of the 1980s world prices temporary increased, later
resuming the general declining trend. It is also striking that in the 1980s prices of fat (butter) were
considerably higher than those for non-fat solids (SMP). The situation has been reversed in the 1990s and
butter prices are currently substantially lower than the SMP counterparts.

                                      Figure 5. Declining world dairy prices in real terms


                                    400
                                                                                           Butter
                                                                                           Cheese
                                    300                                                    SMP
                                                                                           WMP
                           USD/Kt




                                    200



                                    100


                                     0
                                          1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003


Source: OECD Secretariat


III. Agricultural policies supporting dairy production

20.       In general, support levels for milk are higher than for most other commodities within countries
and, with just a few exceptions, are high in most countries. Market price support (tariffs and export
subsidies, administered prices) is the main form of support provided to milk producers. Many countries
impose production-limiting quotas to control surpluses resulting from high support prices; in particular to
manage public stocks and expenditures on export subsidies.

21.       The OECD gathers information regarding the level of support provided to producers through all
types agricultural policy measures. The %PSE expresses the monetary value of this support as a share of
gross farm receipts (market returns plus support). A notable feature of the %PSE for milk, calculated at the
total OECD level, is the downward trend in support since the early 1990s, falling from a high of 59% in
1986-88 to 46% in 2000-02 (Figure 6).




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                       Figure 6. OECD average Producer Support Estimate for milk, 1986-2002

                                          Per cent of value of gross farm receipts

                            %
                      70

                      60
                                                                                      Payments based on income
                                                                                     and miscellaneous
                      50
                                                                                      Payments based on input
                                                                                     constraints
                      40
                                                                                     Payments based on input use

                      30
                                                                                      Payments based on historical
                                          Market price support                       entitlements
                      20
                                                                                      Payments based on area
                                                                                     planted/animal numbers
                      10
                                                                                     Payments based on output

                        0
                                                                                     Market Price Support




                           p
                         86
                         87
                         88
                         89
                         90
                         91
                         92
                         93
                         94
                         95
                         96
                         97
                         98
                         99
                         00
                         01

                      20 2
                        03
                         0
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       19
                       20
                       20
                       20
Source: OECD PSE/CSE database.


22.        Along with rice and sugar, milk is one of the most highly supported commodities. Support for
milk is significantly higher than that provided to other livestock products such as beef and sheepmeat.
Between 1986-88 and 2000-02 there has been a reduction in the level of support provided to dairy
producers in all countries except Norway where it has stayed the same, and in Hungary and Poland where
it has increased.4 The reduction in support to dairy producers has been most significant in absolute terms in
Australia, the Czech Republic, the European Union, Switzerland and the United States, with a
reduction in the %PSE of more than ten percentage points, with the greatest proportional decrease having
occurred in New Zealand (with currently the lowest %PSE in all OECD countries).

23.      Within the total OECD PSE there are significant variations between countries in the level of
support provided to dairy producers (Figure 7). Support levels in 2000-02 were highest in Japan and
Korea and the non-EU European countries of Iceland, Norway and Switzerland where over 70% of gross
farm receipts for dairy producers are generated by support policies. In the European Union, Hungary,
Canada, Mexico and the United States, it ranges between 45-55%. In the Czech Republic, Slovak
Republic and Turkey, support averages just over 30%, while it has been very low throughout the whole
period in New Zealand and Poland. The greatest reduction in support over the period took place in
Australia, whose support to dairy producers was more than halved.




4
    Note that in Poland, despite the increase, the PSE level is relatively low.


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                                       Figure 7. Producer Support Estimate for milk by country, 1986-88 and 2000-02


                          Japan

                        I c e la n d

                       N o rw a y

                 S w itz e r la n d

                          K o rea

                        C anada

               U n ite d S ta te s

                         OECD

                H u n g a ry (2 )

          E u ro p e a n U n io n

                  M e x ic o ( 2 )

                        T u rk ey                                                                 1 9 8 6 -8 8   2 0 0 0 -0 2

     S lo v a k R e p u b lic ( 2 )

      C z e c h R e p u b lic ( 2 )

                     A u s tr a lia

                   P o la n d ( 2 )

               N e w Z e a la n d

                                   -2 0 %    -1 0 %   0%     10%     20%     30%    40%     50%           60%        70%        80%   90%




Notes:
1. Countries are ranked according to 2000-02 levels.
2. For the Czech Republic, Hungary, Mexico, Poland and the Slovak Republic, 1991-93 replaces 1986-88.
Source: OECD PSE/CSE database, 2003.


24.       Although the market price differential has decreased, trade barriers continue to offer significant
protection to dairy producers in most OECD countries. Market price support policies are designed to
protect producers from lower and variable world market prices, insulating them from world market
developments; and they have been effective in doing so. For example, in 1997, the average price received
by OECD dairy farmers was 90% above the border reference price but in 1998 the difference increased to
130% when the reduction in border prices was not matched by a similar reduction in producer prices.5

25.      The importance of market price support reflects the historical use of trade measures e.g. tariffs,
import quotas and export subsidies in many OECD countries to protect dairy producers from lower priced
traded products and to enable domestic pricing arrangements. In almost all instances, tariffs on dairy
products are above the country average for all agri-food products and are among the highest on agricultural
products. Average tariffs vary considerably between OECD countries: they are comparatively low in
Australia and New Zealand, and comparatively high in Canada, the European Union, Japan, Norway,
Poland and Switzerland. The most significant user of export subsidies on dairy is the European Union,
accounting for 81% of the total during the period 1995-2000, with Switzerland accounting for a further
10% of total export subsidies. Nevertheless, export subsidies from the EU have been declining over the
period 2000-2003.


5.                 As measured by the Producer Nominal Protection Coefficient (NPCp), an indicator of the nominal rate of
                   assistance to producers measuring the ratio between the average price received by producers (at the farm
                   gate), including payments per tonne of output, and the border price (measured at the farm-gate level).


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26.       While there is some variation between countries in terms of the composition of support provided
to dairy producers, the most distorting categories of support dominate. Market price support has
traditionally been the most dominant support category in all OECD countries except in New Zealand and
has remained so with only a few exceptions. However, market price support in Canada, the European
Union, Norway and Switzerland has been accompanied by restrictions on the level of production, i.e.
milk quotas. Payments based on input use constitutes the next most important category of support, with
every OECD country implementing support measures to dairy farmers that are classified in this category
(e.g. subsidies to improve manure storage facilities, fuel tax rebates). Payments based on output are
relatively important in Iceland, Norway and the Slovak Republic; payments based on animal numbers in
the Czech Republic, Norway and Switzerland; and payments based on historical entitlements in
Australia and Switzerland.

27.       There have been some attempts to introduce or increase support provided through less production
distorting measures and through those more directly targeted at environmental or farm income objectives.
For example, support measures classified under payments based on historical entitlements have been
introduced to the benefit of dairy producers in Australia, Canada, the Czech Republic, the European
Union and Switzerland. Measures classified under payments based on input constraints or payments
based on overall farm income have been either introduced or increased in many countries, but their overall
significance remains very low in all cases.

28.       There have also been increases in the most distorting forms of support in some OECD countries
between 1986-88 and 2000-2002. The importance of market price support measures in gross farm receipts
has increased for dairy producers in Canada, Hungary, Norway, Poland and Turkey, although producers
in Canada and Norway have been constrained by production quotas. Payments based on output have been
introduced in the Czech Republic, Hungary and the United States but these are all relatively small. They
have also been expanded in Iceland, the Slovak Republic and Switzerland although in all three countries
quantitative limits are placed on production. Canada completed a gradual phase-out of such payments in
the 2001/2002 dairy year. While both the level and percentage change has been small in some instances,
the importance of payments based on inputs in gross farm receipts has increased in Australia, the
European Union, Hungary, Japan, Korea, Norway and the Slovak Republic.

IV. International dairy trade liberalisation

29.       As noted at the outset, despite the interest in the area of dairy policy reform, there are few studies
that have undertaken a complex analysis of trade liberalisation in the dairy sector. A list of such studies
may be found in Meilke and Lariviére (1999). The following paragraphs review the results of international
dairy trade liberalisation according to some recent studies.

30.        FAPRI (2002), using a partial equilibrium dynamic model, estimated that under a full
liberalization scenario the net trade of all dairy products (butter, cheese, SMP, and WMP) would increase
relative to baseline levels. Argentina, Australia, and New Zealand all gain while the European Union
would lose market share in all dairy products compared to the baseline. EU butter and SMP exports would
decrease significantly as the elimination of milk production quotas and intervention buying results in lower
milk production, lower domestic prices, less butter and SMP production, and more domestic consumption
of all dairy products. World butter prices were estimated to increase by 40%, cheese prices by 22%, SMP
prices by 30% and WMP prices by 26% on average over the baseline period.

31.        Zhu et al. (1998) used a hedonic spatial equilibrium model and showed that full trade
liberalization would reduce milk prices in Canada by 32%, in the EU by 26%, and in Japan by 36%. Milk
prices would increase in Australia and New Zealand by 22% and 51% respectively. The impact on U.S.
milk prices was estimated to be relatively small – a reduction of 0.4%. Butter prices in New Zealand were


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estimated to increase by 76%, cheese prices by 45%, and SMP and WMP prices by 32% and 45%
respectively. The study shows that milk production in the EU and Canada would increase by 2% and 3%
respectively. These increases in milk production following the large cut in prices reflect the assumed high
quota rents in this study.

32.       Larivière and Meilke (1998) used a non-spatial, multi-region model of the world dairy sector and
noted that world dairy product prices would increase substantially under free trade. Their simulation results
showed that world butter prices would increase by 32%, cheese prices by 44% and SMP prices by 15%.
World milk production would increase by 0.8% while world production and consumption of butter and
SMP was estimated to increase by 0.3% and 2.3% respectively, and cheese production and consumption
would decline by 0.6%. Simulation results for Canada showed domestic milk price reduction of 36% and
milk supply increase of 6.9%.

33.       Using a derivative of the OECD’s Aglink model, Shaw and Love (2001) estimated impacts of
increasing market access and reducing export subsidies for dairy products. The study found that the value
of world dairy trade would increase by USD 1.8 billion relative to a 1999 baseline under an increased
market access scenario, with the value of milk production rising in Australia, New Zealand, and Argentina
(with increases from 7 to 9% relative to the base), and declining in the EU and the United States (1.2% to
1.4% decline). With export subsidies reduced by half, domestic prices would fall and the value of milk
production would decline in the EU and remain unchanged in the United States. The volume of EU milk
production was assumed to be bound at the quota level.

34.      Langley et al. (2003) used a partial equilibrium dynamic model in which a full liberalisation
scenario of the dairy sector showed milk prices increasing in Australia, New Zealand and Argentina
by26%, 24% and 22% respectively, while they decreased in Canada, the EU-15, the USA and Japan by
35% in the first and 8% in the three other countries. The world price of butter was estimated to increase by
58%, the cheese price by 30% and those for SMP and WMP by 9% and 18% respectively. The volume of
trade would decrease for butter, SMP and WMP and increase for cheeses and other dairy products.
However, products would be traded at higher prices and the value of dairy trade was estimated to increase
by USD 2 billion. The medium-term effects of the experiment resulted in 3-4% lower production of raw
milk and dairy products in heavily subsidized countries such as the EU. On the other hand production in
Canada would increase by 12%.

35.       The above studies all used different models in structure, data and parameters (i.e. country and
product coverage, length of run, different assumptions on product supply and demand etc.).6 Thus, it is no
surprise that the results differ across studies. The results are also subject to the caveats and limitations of
modelling of such a significant change in the world dairy sector. A general discussion regarding the
problems of modelling dairy trade liberalisation can be, for example, found in Meilke and Lariviére (1999).
Nevertheless, all studies show significant increases in world dairy prices, important redistribution of milk
production and trade among regions and sizeable impacts on consumers and producers in reformed and
other regions. The studies differed in the size of the estimated impacts and, importantly, also in the size and
direction of milk supply adjustment in countries where policies were reformed in the presence of
production quotas.

36.       An analysis of international dairy trade liberalisation has been also undertaken by the Secretariat
as part of a broader project evaluating the consequences of dairy policy reform. In the analysis, individual
market price support policy measures are simultaneously reduced or removed in order to assess the impact
of dairy trade liberalisation on production, consumption, trade, prices, income and welfare. The empirical

6
         There are other studies that have estimated partial trade liberalization scenarios such as Bouamra-
         Mechemache et al (2002) or Donnellan and Westhoff (2001).


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simulations are carried out using the Secretariat’s Aglink and PEM models (see Annex 3 for a description
of the Aglink and PEM models). The results of the simulations are presented and discussed in turn.
However, it should be noted that Aglink and PEM do not produce identical results. These models were
developed for different purposes, and accordingly have different structures, country, product and time
coverage. The simulation experiments are designed with the specific strengths and weaknesses of each
model in mind, and their objectives are different. While Aglink and PEM results are not directly
comparable, the two models have been used jointly in this analysis to complement the market and trade
insights gained with Aglink with those from PEM results which focus more on income and welfare.

37.        Thus, it is important in reading the following results to keep in mind that the simulation
experiments are not strictly comparable. For example, the welfare analysis conducted with PEM refers to
market and trade results of PEM only and do not correspond to Aglink results. It is also important to be
aware of the general limitations of analysing dairy trade liberalisation, such as those discussed in Meilke
and Lariviére (1999). More specifically, the dairy products produced, consumed and traded in the Aglink
and PEM models are assumed to be homogeneous. No account has been taken of different product
attributes or different production practices, which can influence costs of production, product prices and
consumer choice. Another limitation concerns the absence of risk in the analysis as risk and producers’
attitude toward risk influence production decisions. Another caveat is the fact that the rest of the world
(ROW) is treated as a single block in the models. Many countries that are implicitly represented in the
ROW module also use market price support and other policy measures. Given the size of the ROW, in
terms of milk and dairy product production and consumption, the response of this region to trade
liberalisation is crucial for the results of such a scenario.7

38.        Further, given the high level of protection in the dairy sector the scenario of full trade
liberalisation creates a shock to the model beyond what many would consider “marginal” or small. In
addition, the models do not allow for structural change that can be expected to take place following such a
shock. Moreover, the impact of trade liberalisation depends heavily on the production response subsequent
to the removal of milk production restrictions in countries that employ a milk quota. Thus, the results are
influenced by the milk supply response assumptions in quota operating countries. Finally, the results also
depend on the price transmission through the supply chain. The usual assumption of perfect price
transmission might be contested on the ground of increasingly high concentration at the processing and
retail level.

39.        Many of these caveats are common to large world agricultural commodity models, reminding us
that models are only an imperfect approximation of the reality. Some of the caveats will be addressed via
sensitivity analysis and additional scenarios. The sensitivity analysis is useful in helping to understand
results, and use of this tool is made here in both the Aglink and PEM analyses. The primary benefit of such
analysis is not to put a range on the results such that we are convinced that truth lies somewhere within, but
rather to see if the basis upon which conclusions are drawn are sound. In any case, the conclusions drawn
from the analysis in this paper take care to use the results indicatively rather than definitively. That is, the
results are used to say something about the nature, possible direction and potential changes in markets,
income and welfare due to liberalisation in the dairy sector, rather than to provide definitive forecasts.

Aglink results of dairy trade liberalisation scenarios- Evaluating the market and trade impacts

40.      Aglink is a partial equilibrium dynamic supply-demand model of world agriculture, developed by
the OECD Secretariat in close co-operation with Member countries. It represents annual supply, demand
and prices for the principal agricultural commodities produced, consumed and traded in Member countries.

7
          The rest of the World module represents about 33% of world milk production in the Aglink specification
          and about 60% of world milk production in the PEM specification.


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The dairy component of this model covers production and consumption of milk and main dairy products in
major OECD and several non-member economies markets, covering both importers and exporters. Thus,
the Aglink representation of the dairy sector allows the analysis of impacts on world markets for tradable
dairy products where those markets are explicitly modelled. (see Annex 3 for a description of the Aglink
model). The simulation experiments are conducted using the baseline data of the Agricultural Outlook
2003-2008 published in OECD (2003b) (See Annex 4 for the description of the policy assumptions for
dairy markets for the baseline period 2003-2008).

41.       In general, agricultural markets are modelled in Aglink specifically to best capture individual
policies and particular market settings relevant for each country. It follows that certain modifications to the
model are required for a scenario such as a major dairy policy reform where support policies are eliminated
or much reduced.

42.        For example, in quota operating countries represented in Aglink, a milk supply function had to be
introduced, based on assumptions for quota rent and long term supply elasticity.8 All border measures were
removed and all equations for subsidised exports of dairy products were eliminated. All domestic market
clearing price identities were replaced by price transmission equations and trade becomes the market
clearing identity. Since world prices in Aglink are based on the Northern European price, adjustments to
reflect transport costs were implemented in modules other than the EU module. In the EU module an
adjustment was needed in the price transmission equation of cheese, to reflect the different types of cheese
used to denominate EU and world prices.9 Where it was appropriate, consumer subsidies were eliminated.
Where domestic price discrimination existed, the fluid milk price was determined by the industrial milk
price plus 50% of the baseline fluid milk premium.10 11 (Annex 3 explains in more detail the functioning of
the dairy market in Aglink). For further details on various modifications to the Aglink model see technical
report OECD (2004).

43.       Any border protection, tariffs, production quotas, support prices and consumer subsidies were
eliminated and any fluid milk premium reduced by half. Only market price support policies were
eliminated, direct payments were kept to their baseline value if they are exogenous or were calculated by
the model where they are endogenous. Scenarios of a complete elimination of all market price support
policies have been produced initially per country/region. These scenarios have been merged one by one in
the next step. This process has allowed for the isolation of the contribution of each country’s reform to the
overall impact on world markets.

8
         In order to use the complementarities of the Aglink and PEM models, the PEM assumptions on quota rents
         and supply elasticities were implemented in Aglink. The modelling of milk supply functions with Aglink
         and PEM has been discussed in the document [COM/AGR/TD/WP(2004)19/REV2].
9
         The cheese price in the European Union Aglink component is for Emmental while the world price indicator
         is for cheddar. The difference in the price of these two cheeses has been consistently 30% and this factor
         was used in the price transmission equation.
10
         EU butter intervention stocks are declining very rapidly in the baseline and were left at the baseline level.
         SMP intervention stocks go to zero already in the baseline. In the USA, the baseline butter and SMP stocks
         were assumed to decline faster in the trade liberalisation scenarios (see technical report OECD (2004) for
         more detailed description of Aglink modifications).
11
         The retention of 50% of the fluid milk premium is arbitrary and was chosen in the absence of tangible
         estimates of the natural fluid milk premium. The presence of natural (market driven) premium arises due to
         market driven factors such as consumer preferences, transportation costs and seasonality (for more detailed
         discussion see [COM/AGR/TD/WP(2003)1/REV2]. The 50 % of the baseline fluid milk premium was
         added on top of the manufacturing milk price (in this scenario linked to the world prices of dairy products)
         to approximate the level of the fluid milk price. This procedure was carried out whenever the baseline data
         indicated a difference between fluid and manufacturing milk.


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44.       The results of the trade liberalisation scenarios simulated with Aglink are presented in Annex 1.
The tables in the Annex show results in percent changes from baseline levels for prices, production and
consumption of milk and dairy products. The trade figures are shown in thousand tons. The baseline levels
refer to the last year values (2008) of the Agricultural Outlook baseline 2003-2008 published in OECD
(2003b). The columns following the baseline levels illustrate the reform scenario results for a particular
country or group of countries. The name of the reformed country or region appears always in the columns’
headings. Thus the results show the market impacts of removal of market price support in a particular
country while all other countries would keep their policies at baseline levels.12

45.       The regions (group of countries) in the tables are defined as follows: Europe − a scenario of dairy
policy reform in all the European components of Aglink13, NAFTA − a scenario of dairy policy reform in
all NAFTA countries (United States, Canada, and Mexico), Atlantic − a scenario which combines reform
in Europe and NAFTA countries. Finally, a scenario involving reforms in all Aglink countries was
produced. The results are presented under the heading ALL and are highlighted in bold. For convenience,
the ALL scenario is in the text referred as Aglink multilateral scenario (reform in countries represented in
Aglink). It is important to keep in mind that the word “multilateral” is strictly connected to Aglink
countries and cannot be considered in a broader sense as for many developing countries (represented in
Aglink in a single block Rest of the World) dairy policies are not modelled and hence not reformed. Each
column in the tables presents a “contribution” of a particular country/region to the process of dairy policy
reform under which milk market price support is completely eliminated. The description of individual
scenarios is summarised in Annex 1.

46.       As discussed above, such type of analysis is subject to certain caveats and limitations. Some of
the limitations were also identified at the dairy experts meeting held in Paris in September 2003 (OECD
2003c). Most notably there is uncertainty about the price transmission to consumers of reduced farm and
wholesale prices resulting from reform. Box 1 highlights some of the main issues related to the subject of
imperfect price transmission. While this subject deserves further investigation, a detailed analysis of price
transmission was outside the scope of the present study. Instead, a simplified sensitivity analysis was
constructed to test the impacts of presumed imperfect price transmission for dairy products specifically
modelled in Aglink.

47.      More specifically, the Aglink demand functions for dairy products and fluid milk uses wholesale
or farm prices instead of consumer prices. The elasticities used in these demand functions are therefore a
composite of the demand elasticities relative to retail prices and of the elasticities of transmission from
wholesale (or farm) to retail prices. The demand elasticities used are affected by the relationship between
wholesale and retail prices that existed over the period of estimation. By construction, it is implicitly
assumed that this relationship will neither change over time nor following a policy reform. This
assumption may be contested on the basis of the very high level of concentration of the retail food industry
in most OECD countries. In the imperfect transmission scenario (labelled in the tables as Retail) it was
assumed that consumers in countries affected by the reform would only benefit from half the decline in
producer prices recorded in the scenario of simultaneous dairy policy reforms.




12
         For the dairy markets baseline policy assumptions see Annex 4.
13
         Complete elimination of all market price support measures in the EU-15, Poland, Hungary and Russia
         (Note, that since the analysis was completed Poland and Hungary joined the European Union).


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                      Box 1. Price transmission along the supply chain - issues and findings

      The vertical adjustment to price shocks along the chain from producer to wholesale and to retail, and vice versa,
is an important characteristic of the functioning of markets. As such, the process of price transmission through the
supply chain has long attracted the attention of agricultural economists as well as policy makers. In this respect, a
common concern of policy makers relates to the assertion that price reduction at the farm level is not fully transmitted
down the supply chain, so that final consumers might not be able to benefit fully from this drop in prices. The
implication of the incomplete pass-through of prices would be smaller effects on consumer welfare and an increase in
rents for the firms in the downstream sector.

       A number of reasons are put forward in the literature that attempt to explain the asymmetries and imperfect pass-
through of prices. For example, prices at the retail level may not adjust due to so called menu costs, which are costs
associated with making frequent changes in retail prices and the uncertainty of whether the price shock is permanent
or transitory (Ball and Mankiw, 1994). Response might also be asymmetric due to inventory management strategies,
so that retailers may reduce their prices more slowly compared to reduction in farm prices to prevent running out of
stock (Reagan and Weitzman, 1982). Wohlgenant (1985) also demonstrated that lags between retail and wholesale
food prices can be explained by inventory behaviour of retailers. Alternatively, retailers selling perishable goods might
be reluctant to raise prices in line with an increase at farm level given the risk that they are left with spoiled product
(Ward, 1982). Azzam (1999), using a two-period model of spatially competitive retailers, has shown that asymmetry
can occur even in a competitive environment due to intertemporal optimizing behaviour so that retail prices may rise
relatively more than decline. Gardner (1975) pointed out that in addition to other causes, farm-retail price asymmetries
might be the result of government intervention to support producer prices. Serra and Goodwin (2003) studied price
transmission in the Spanish dairy sector and argued that scarcity of milk to some extent created by quota system may
lead to a situation in which industries compete to increase both their access to milk quota and their retail market share,
and thus may not pass the farm level price increase fully to the retail level.

      Many of these arguments relate to an adjustment problem at the retail level and prices which may be “sticky” in
the short run, can be expected to adjust in the long run. However, imperfect price transmission in the long run is often
seen as being an outcome of market power and oligopolistic behaviour. Many empirical studies have supported this
hypothesis. Wann and Sexton (1992) modelled the California pear industry and showed retail price enhancement
above the competitive norm in canned pear and fruit cocktail markets, although the hypothesis of competition in the
raw pear input market was also rejected. The asymmetry in price adjustment due to market power, albeit at a local
level, was also noted by Benson and Faminow (1985) who argued that that consumers' choice between food stores is
based on locational convenience and presence of search cost might thus create locally imperfect markets. Gohin and
Guyomard (2000) strongly rejected the hypothesis that French food retail firms behave competitively and illustrated
that more then 20% and 17% of the wholesale-to retail price margins for dairy and meat products, respectively, can be
attributed to oligopoly-oligopsony distortions. Abdulai (2002) illustrated that increases in producer prices of pork in
Switzerland that result in the reduction of the marketing margin are passed on to retail prices faster than reductions in
producer prices that lead to increases in the marketing margin. Similar results were found by Kinnucan and Forker
(1987) who estimated price transmission for dairy products in the United States and showed that transmission
elasticities for rising farm prices were larger that corresponding elasticities associated with falling farm prices,
depending on the dairy product.

      London Economics (2003) investigated the links between retail and farm gate milk prices in the UK, Denmark,
France and Germany. The study has found that in the UK a unit increase in the retail price of liquid milk is fully
transmitted to the farm gate price whereas a unit increase in farm gate prices results in only a 0.56 increase in the
price at retail and a unit decrease in farm gate price reduces the retail price by 0.71. In Germany, the study also found
two-way price transmission, though rather imperfect. In Denmark, the study found no evidence of price transmission in
any direction. In France, farm gate price changes were mainly but imperfectly transmitted to retail prices. The study
associated some of the resulting differences among countries to differences in market structures, differences in the
transmission of information or government interventions. A study on the impact of peanut policy changes in the United
States concluded that data on farm-to-retail price margins for peanut butter indicate that farmers are capturing a
smaller share of the retail price of peanut butter (about 20%) following the reform as compared with an average of
about 25% between 1988-1998 (Dohlman et, al., 2004). However, here, it is important to note that a change in the
farmer’s share of the retail margin does not necessarily point to imperfect price transmission and has to be evaluated
against the development of other input costs. That is, costs related to processing, packaging, moving, advertising,
storing and numerous other activities must be acknowledged. Thus, along with the potential that price transmission
may be delayed, it may also be obscured by a variety of other costs that must be paid by consumers when they buy a


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COM/AGR/TD/WP(2004)20/FINAL


retail product that is in some way derived from farm-produced goods.

       Although, market power was often identified as the main cause of imperfect price transmission, recent research
shows that this does not always have to be the case. McCorriston et al (2001) demonstrated that price changes can be
greater or smaller than the competitive benchmark case depending on the interaction between market power and
returns to scale. That is, if the cost function is characterised by increasing returns to scale, the influence of market
power might be offset and the level of price transmission may increase relative to the competitive case. Weldegebriel
(2004) also argued that the presence of oligopoly and oligopsony power does not necessarily mean imperfect price
transmission. The author has illustrated that the functional forms of retail demand and farm input supply are key factors
in determining the level of price transmission. Bettendorf and Verboven (2000), using a model of oligopolistic
interaction, showed that the week transmission of coffee bean prices to consumer prices in Netherlands was due to a
relatively large share of costs other than the costs of beans. The authors concluded that the market was relatively
competitive. Empirical results of Holloway (1991) suggest that, during the period 1955-83, departures from competition
in the retail markets of the major food groups have been relatively insignificant, that is results are not statistically
different from the outcomes under perfect competition. Serra and Goodwin demonstrated that asymmetries were not
present in the price transmission of highly perishable dairy products in Spain supporting the theory that market power
could be consistent with symmetric price relationships. The issue of market power in a rapidly restructuring food
supply chain and its impact on margins and price transmission remains an issue of further research.

      As noted above, price transmission is a particularly vital issue in the context of a major agricultural policy change
as it affects the welfare impacts of reform on market participants. For example, McCorriston and Sheldon (1996) have
estimated the price transmission and welfare impacts of tariff reduction following changes in the EU banana regime.
The authors have noted that the higher the number of stages in the vertical market structure characterised by market
power of the market actors, the likelier is a lower pass-through of price changes (the theoretical framework for
measuring impacts of successive monopolies in a vertical market chain can be found in Cotterill, 2002). The simulation
results showed that, compared to a competitive case, the consumer surplus increased by as much as 49% for the
single-stage monopoly case, compared with only 24% in case of a the two-stage monopoly. As expected, the single-
and two-stage Cournot oligopoly cases showed relatively higher increases in consumer welfare, with 71% and 39% per
cent, respectively, when compared to the consumer surplus gain of the competitive case. These results, however, are
based on various hypothetical scenarios rather than testing to determine which case is most likely. Sexton et al. (2003)
have analysed specifically the implications of vertical market structure for trade liberalisation and market access with
particular attention to impacts on developing countries. The authors reiterated that given that the food sector is most
appropriately characterized by a successive oligopoly/oligopsony situation, the implication of reducing tariffs is different
in magnitude than that implied by models that assume perfect competition. The authors also pointed out the rapidly
increasing trend of consolidation and concentration in the food industry which might reduce the share of benefits from
liberalization within the food marketing chain that would accrue to developing countries.

      Although the results of price transmission between the farm and retail level differ among studies depending on
the method used and the country and commodity covered, many of these studies point to some degree of imperfect
pass-through of price changes along the supply chain. This suggest that an analysis of trade liberalisation that does
not account for vertical market structure may likely over-estimate the benefits to consumers in reformed countries as
the reduction in farm prices might be less then perfectly transmitted to final consumers. The pass-through of benefits
depends very much on the character of the primary and processed commodities, demand and supply specificities, and
the market structure, in particular the market power of actors at individual levels of the vertical supply chain. The
subject of imperfect price transmission remains an important topic for further research that may become increasingly
important in the context of further market concentration and trade liberalisation.




48.       Another important analytical issue concerns the assumptions used in constructing specific supply
functions in countries which currently operate a quota system, as the supply response in these countries is
not directly observable for the period that the quota is binding. More detailed discussion on modelling of
milk supply in the presence of quotas is available in the document [COM/AGR/TD/WP(2004)19/REV2].
The importance of assumptions made concerning quota rent and supply elasticities for modelling supply
response under quota were discussed there in detail. However, an array of plausible assumptions can be
made concerning quota rent calculation, and there will always be uncertainty about the chosen value.
Thus, it was deemed necessary to undertake a sensitivity analysis with respect to the possible range of



                                                            18
                                                                         COM/AGR/TD/WP(2004)20/FINAL


quota rent and supply elasticity assumptions regarding the underlying supply function.14 The results of this
sensitivity analysis are presented in Annex 2 and described after the discussion of the main results of the
trade liberalisation scenarios.

Results for the European Union15

49.       Table A1.1 illustrates the dairy trade liberalisation scenario results for the EU. The results
indicate that the unilateral reform by the EU alone reduces the internal price of milk by as much as 16.5%.
It should be noted that this is a considerable reduction as it has to be compared to the 2008 level which is
already subject to a price decrease from the 2003 levels reflecting the CAP policy measures assumed in the
baseline.16 Reform in other European countries does not have a substantial impact on the EU market.
However, combining the reform process of Europe and NAFTA reduces the domestic milk price in the EU
by 12.3% which is by 4 percentage points less than under the unilateral reform. Under the multilateral
(ALL) reform scenario, the milk producer price would be reduced by 9.8%, which is almost by
7 percentage points less when compared to the unilateral reform case.17 The difference stems from the fact
that EU prices are directly linked to world dairy prices in the scenarios and world prices increase
substantially more under the Aglink multilateral reform as compared to the unilateral reform case. The
impact of these scenarios on milk production reveals a similar pattern and shows a fall in production
following the price decrease. At the end of the base period, milk production in the EU would decrease by
10.7% (unilateral reform) and 7.3% (Aglink multilateral reform) respectively. These results are sensitive to
assumptions concerning quota rent as will be discussed later.

50.       The impact on dairy prices is consistent with the current butter/SMP price policy tilt in the EU
which is in direct contrast with the world market price ratio for butter and SMP. 18 While the world market
price of butter has recently been well below the SMP price (and is so also in the baseline), the opposite is
the case for EU support prices. Consequently as a result of MPS elimination the butter price in the EU falls
by 34% (unilateral reform) and 25% (multilateral reform) respectively while the SMP price increases
following the substantial rise in the world price for SMP.

51.       As expected, consumption of dairy products would increase following the price reduction, except
for SMP. SMP consumers not only face an increase in domestic market prices but also an elimination of
the SMP consumer subsidy. Most of the milk is channelled to cheese production away from SMP and
butter production. Following the reform process, the EU would change its status of a net exporter of dairy
products to that of a net importer, with the exception of WMP. Consumption of WMP in the EU is


14
         Another limitation concerns the absence of risk as an explanatory variable in the Aglink milk supply
         functions. Several scenarios were undertaken under the assumption that farmers are risk averse and that a
         downward shift in reformed countries supply could be expected. However, the assumption of the shift was
         arbitrary and the results are not reported in the document. Nevertheless, as expected, the results showed
         that world prices would increase more under these scenarios.
15
         It should be noted that EU in the 2003-2008 baseline used in the simulations refers to EU-15. The policy
         assumptions for the EU are those of Agenda 2000 (see Annex 4)
16
         The 2003-2008 baseline (OECD 2003b) assumes a 15% cut in EU support prices for butter and SMP.
17
         Again, it should be noted that the word “multilateral” is used in the text to reflect a scenario where
         countries represented in Aglink reform their dairy policies rather than all countries in general (see the
         definition of the Aglink scenarios in Annex 1).
18
         As butter consists mainly of fat and SMP mainly of non-fat solids components of milk, butter/SMP tilts do
         not alter the target or support price for milk because the sum of the two products' values remains
         unchanged.


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COM/AGR/TD/WP(2004)20/FINAL


relatively little with very low demand elasticities. It should also be noted that the net imports figure for
SMP reported in table A1.1 includes imports of non-fat solids.19

52.       The results of the alternative scenario indicate that under the assumption of imperfect price
transmission to consumers following dairy policy reform, the increase in consumption in the EU is
necessarily smaller (by about half).20 It follows that this smaller increase in consumption reduces import
demand for dairy products and world dairy prices increase by less when compared to the “full
transmission” Aglink multilateral scenario case. Correspondingly, domestic producer prices (directly
linked to world prices) are also lower, and as a result milk and dairy products production declines.

Results for Canada

53.        Table A1.2 in the Annex presents the results for Canada. The direction of the results is similar to
those presented in Table A1.1 for the EU. In comparing the results it shows that milk and dairy producer
prices would see much larger cuts in Canada than in the EU. However, again it must be noted that the cuts
are relative to the baseline levels of 2008. These had already shown a 17% reduction in the implicit milk
support price in the EU, while in Canada’s baseline the industrial milk target price was projected to
continue to increase. So the price cuts following reform are from a relatively much lower level in the EU
than in Canada at the end of the baseline.

54.      While price cuts are much more severe in Canada, milk production under the ALL multilateral
scenario decreases only slightly. This reflects a lower supply elasticity and a higher quota rent assumption
in Canada when compared to the EU. The sensitivity to the supply response assumptions is discussed later.
The results for Canada also indicate that, similar to the EU, the largest drop occurs in butter prices.
Consumption of milk and dairy products increases in response to substantially lower prices, with the
exception of SMP. Consumption of SMP falls because the amount of SMP used for feed under the supply
management structure is eliminated in all scenarios.

55.       A substantial quantity of milk is expected to be channelled to the production of other dairy
products (mainly ice-cream). Given the fact that the price of sugar is much lower in Canada than in the
United States (due to the US sugar support policy), Canada should enjoy a significant competitive
advantage in the ice-cream market and most of the exports of other dairy products would be destined to the
United States. Nevertheless, it should be noted that in order to properly balance Canadian milk production
with that of dairy products, an increase in raw milk imports from the United States occurs in most of the
scenarios (see net imports of milk in Table A1.2). The results for the imperfect price transmission scenario
(Retail) follow the same direction as discussed in the case of the European Union. That is, consumption in
Canada increases only by about half of the increase observed under the All scenario. Producer prices fall
for milk as well as for all dairy products relative to the perfect price transmission (All) scenario case. Milk
production falls by 2.6% as compared to a 0.8% decline in the All scenario.




19
         The SMP production in the EU module is calculated as a residual of the not-fat solids market. In the
         scenarios, in order to prevent a model output that would yield negative SMP production (due to a fall in
         milk production and a large increase in production of fresh dairy products), imports of non-fat solids
         (i.e. whey powder concentrates or milk protein concentrates) were introduced to ensure a minimum level of
         SMP production. The non-fat solids import variable was introduced on a SMP equivalent basis in the SMP
         world market clearing price identity.
20
         In the case of SMP the larger proportion of consumption decrease comes from the elimination of
         consumption subsidies.


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                                                                          COM/AGR/TD/WP(2004)20/FINAL


Results for the United States

56.       Table A1.3 in the Annex presents scenario results for the United States. The results are very
similar to those for the EU. The reductions in milk and dairy product prices (slight increase in the case of
SMP) are almost comparable in both countries. Nevertheless, the decline in milk production in the United
States is smaller when compared to the European Union. In the unilateral scenario, production is reduced
by 11.6% while in the Aglink multilateral scenario the reduction amounts to 4.6% as compared to the
baseline level.

57.        Butter prices in the unilateral scenario are estimated to fall by 39% which compares to a 27% fall
under the Aglink multilateral scenario. On the other hand while SMP prices fall by 12% in the unilateral
scenario, the price in fact increases by 4% in the Aglink multilateral scenario. These results show that there
is a large difference in internal price changes for butter and SMP. As in the case of the EU, this stems from
the butter/SMP price policy tilt which is much in favour of butter.

58.       Thus, as the butter price falls, production of butter is substantially cut which has a significant
negative impact on the production of SMP. As the production of dairy products falls and consumption rises
the United States becomes and net importer of dairy products with the exception of whey powder. Whey
powder is produced jointly with cheese. As US cheese production falls in response to a large decline in
prices, the supply of whey powder drops as well. This triggers an increase in whey powder prices with
some reduction in consumption. It should also be noted that the baseline fluid milk premium in this
scenario was reduced by 50% (see footnote 10).

Results for Japan

59.      Although Japan reformed its dairy policy in 2001, its milk sector remains the most protected of
all OECD countries, with the highest border measures (see Figure 7). The majority of support to milk
producers is classified as market price support so it could be expected that the elimination of market price
support measures would have a substantial impact on the dairy sector in Japan.

60.       Table A1.4 illustrates that the elimination of market price support in Japan has generated a very
large decline in milk and dairy product prices. Milk prices in the Aglink multilateral scenario fall by about
55% while butter and SMP prices fall by 74 and 59% respectively. Note that the decline in cheese prices is
relatively small as cheese has not been a so-called designated supported product which is the case for
butter and SMP. Nevertheless, the production of dairy products in Japan would not be sustainable at such
low prices, although a minimum level of manufacturing milk processing was assumed even after the
elimination of trade barriers. As a result of the large drop in production, net imports of dairy products and
in particular butter and SMP would increase significantly.

61.       During the model simulations, milk production declined rapidly, as milk price fell, while fresh
dairy product consumption was increasing strongly. This eventually created a situation where fresh dairy
product consumption became larger than milk production.21 Two options were available to solve this
problem. First, it could be assumed that reconstituted fluid milk would be produced from imports of WMP
and as a result fluid milk prices in Japan would continue to be strongly determined by world prices of dairy
products, and in particular WMP. The second option was to assume that Japanese consumers would,
because of their strong purchasing power, refuse to consume reconstituted fluid milk. Under such
conditions, the fluid milk price would be calculated through an internal market clearing price mechanism,
as transport costs would act as a natural trade barrier. The latter option was used and the fluid milk

21
         It should be noted that already in the baseline more than 60% of milk production is used for fluid milk and
         fresh dairy product use.


                                                       21
COM/AGR/TD/WP(2004)20/FINAL


premium charged on top of the manufacturing milk price has increased in the scenarios.22 Thus, although
milk production in Japan would decline by about 20% it would survive and milk producers would continue
to supply the Japanese fluid milk market.

Results for Mexico

62.      Support to milk producers in Mexico consists almost entirely of market price support. Table A1.5
shows that, as expected, the elimination of market price support measures generated large decreases in
milk and dairy product prices. The milk producer price would decline by about 50%.23

63.        In response to a significant drop in prices, milk production declined by about 24% and production
of all dairy products was radically reduced. The large drop in prices on the other hand stimulated
consumption of milk and dairy products. The consumption of milk powders has increased but the increase
is relatively small when compared to that for other dairy products. This can be explained by the fact that
Mexico currently operates a program (LICONSA) which distributes reconstituted milk from milk powders
to the poor. Even though this program acts as a consumer subsidy it is in fact detrimental to milk producers
as imports of milk powder under the program and consequently reconstituted milk to some extent competes
with domestic milk production. LICONSA was not eliminated in the scenario since the objective of the
program is to support poor people and not dairy farmers.

64.        The budget of the LICONSA program is assumed to remain at baseline levels. This, coupled with
the increase in the weighted average world price of milk powders under these scenarios automatically
reduces imports of milk powders and subsequent milk powder consumption through the LICONSA
program. Thus, although the drop in domestic prices stimulates domestic consumption, substantially less is
distributed and consumed under the LICONSA program as compared to the baseline. Nevertheless, despite
the fact that imports under LICONSA are reduced, total imports of powder - and of other dairy products –
increase following the elimination of border measures. .

Impact on countries that operate without MPS policy.

65.       In general the results of the scenarios for countries that currently operate without MPS policies
indicate that policy reform in a single reformed country brings them only a modest increase in producer
prices and production and a decrease in consumption. As other countries join the dairy policy reform
process, these impacts become substantially bigger. The results for Australia, New Zealand, Argentina and
Brazil are presented in Annex 1 in tables A1.6 – A1.9.

66.       As these countries already operate at world price levels, the results for each of them are to some
extent similar. In the multilateral (ALL) policy reform scenario the milk producer prices would increase on
average by about 25% in Australia, New Zealand and Argentina. Differences in price changes stem from
differences in domestic markets and in the price trends projected in the baseline. The impact on production
is, to some extent comparable, but varies according to differences in supply response in individual
countries.

67.      The results in the tables confirm that Aglink multilateral (ALL) reform brings the highest increase
in producer prices and production in countries that operate without MPS policy. In these countries, the

22
         Note that initially the fluid milk premium was reduced by 50% in line with other countries using the
         domestic pricing arrangements
23
         It should be noted that in estimating domestic milk prices, the large absolute processing margin had to be
         reduced in this scenario as it is at a relatively high level (compared to producer price) in the baseline (for
         details see a technical report OECD (2004).


                                                         22
                                                                       COM/AGR/TD/WP(2004)20/FINAL


estimated benefits to producers brought about by the reform process in Europe and NAFTA illustrates that
the reform process in Europe (most notably in the European Union alone) brings substantially higher
increases to milk producer prices in these countries than reform in NAFTA countries alone. This result
reflects the dominant position of the European Union as the world’s largest dairy producer and exporter.

68.        While producers benefit, consumers in these countries are affected negatively by the reform
process. The results illustrate the reductions in consumption in the various countries in response to the rise
in prices. The figures also show much higher impacts of the reform on consumers in Argentina and Brazil
when compared to those of New Zealand and Australia. As a result of a significant increase in world dairy
prices, the consumption of these products decreases in Argentina and Brazil by nearly 20%. This is due to
the fact that consumers in these countries are much more sensitive (have higher demand elasticities) to
price changes than those in Oceania and hence would tend to loose more from global dairy trade
liberalisation .

69.       In general, as milk and dairy prices increase in these countries, production increases and
consumption decreases. As a result, exports increase significantly for all dairy products and most notably
for cheese. Part of the reason for such an increase in cheese exports (particularly in Argentina and Brazil)
is the fact that cheese consumption is relatively sensitive to price and represents the largest share of all
dairy products consumed. Thus, as prices rise, there is a relatively large drop in cheese consumption (in
absolute terms) which releases a substantial amount of cheese for exports.

70.       Table A1.10 presents the results for all other countries not specifically accounted for in the
analysis; in the Aglink model called ‘rest of world’ (ROW). The dairy sector there reacts directly to world
prices and no policies are assumed in place. This is indeed a limitation as many countries implicitly
represented in ROW do apply some type of policies, including market price support policies in some of
them, although typically at lower levels of support when compared to majority of OECD countries.

71.       The table illustrates that milk production following the Aglink multilateral (ALL) scenario would
increase, albeit not excessively (about 3%). Dairy product production, in particular SMP, increases more
significantly. It should be noted that in the baseline a relatively small volume of SMP is produced
(compared to the level of SMP production relative to butter production in table A1.10) as the majority of
skim milk is used in its fluid form. In the scenarios, following the increase in production of butter and
(fluid) skim milk, and the reduction of (fluid) skim milk consumption, large quantities of skim milk
become available for production of skim milk powder.

72.      It is also worth noting that dairy product production in the ROW represents a relatively small
proportion of milk production. Thus, the increase in milk production, coupled with a substantial reduction
in consumption is enough to change the ROW position from a net importer to a net exporter for all dairy
products with the exception of WMP, which remains crucial in many countries for milk reconstitution.

Impacts on world markets

73.       Turning attention to the impacts of the reform on world dairy markets and on other agricultural
commodities, Table A1.11 in the Annex shows the results for world commodity prices, world milk and
dairy product production, and world dairy trade. As expected, world prices for all dairy products increase
significantly in all scenarios. In the multilateral (ALL) scenario the world butter price would increase by
57%, that for cheese by 35%, that for WMP by 17% and the SMP price by 21.5%. It should be noted,
however, that these results are to a large extent influenced by model assumptions and limitations (as
discussed in paragraphs 38-39) particularly the fact that the rest of the world module (accounting for one-
third of world milk production) does not adequately represent the various policies in countries not
specifically modelled in Aglink.


                                                     23
COM/AGR/TD/WP(2004)20/FINAL


74.       The figures for other commodities indicate that as a result of dairy policy reform, world wheat
and coarse grain prices would be slightly lower than under the baseline. This reflects the fact that the
countries implementing dairy reform are often characterized by milk production systems which use more
grain in feed ratios as compared to other countries in Aglink. The reduction of milk production in the
reformed countries thus leads to lower demand for feed grains. World prices for oils would increase as a
result of the demand substitution effect generated by higher butter prices. Higher oil prices lead to
increased crush and larger meal production. But as meal demand weakens with a decline in meal used for
feed, world oilseed meal prices fall.

75.       The US beef price initially falls relative to baseline levels as milk production in the United States
declines and more cows are culled. However, at the end of the baseline period the US beef price increases
slightly as there is less milk production, a smaller dairy cow herd and thus proportionally less culled cows.
By contrast, in the EU, the beef price declines at the end of the baseline period as more beef is produced.
Given the fact that in the EU beef and dairy cattle compete for the same land, the decline in EU milk
production leads to an increase in the amount of suckler cows, which produce beef more efficiently than
dairy cows. As a result, beef supply increases despite the decline in the number of milk cows.

76.       An interesting question is whether or not world milk production would increase under the dairy
policy reform scenario. The answer is not obvious because both producers and consumers are affected by
the reforms. Milk production in countries subject to the reform would fall but at the same time
consumption would increase. On the other hand, production in countries without market price support
would increase while consumption would fall. The impact on world prices and overall production results
from a complex balancing of the dairy market.

77.      The results presented in table A1.11 indicate that under the Aglink multilateral (ALL) scenario
world milk production would be only slightly lower than in the baseline. Similarly, overall world
production of dairy products would not see much change. Nevertheless, WMP production would decrease
by about 2.7% while cheese production would increase by 2.1% (Figure 8). The different results for these
two products are largely driven by changes in consumption following the reforms.

78.       WMP has been imported primarily by the non-member economies where it is used for milk
reconstitution. In fact, 89% of global WMP consumption is realised in non-member economies. It follows
that substantially higher world market prices for WMP, resulting from the reform, reduces demand and
correspondingly imports into these areas. The table indicates that world WMP trade would decrease by
about 3%. On the other hand, in the case of cheese, almost 80% of world cheese consumption comes from
OECD countries. Thus, as a result of the dairy reform, the considerable reduction of internal prices for
cheese in the reformed OECD countries would increase cheese consumption and trade in cheeses. The
table indicates that trade in cheeses would increase by 25%.




                                                      24
                                                                          COM/AGR/TD/WP(2004)20/FINAL


                       Figure 8. Impact of trade liberalisation on world dairy product output



                            3

                            2

                            1

                       % 0

                           -1

                           -2

                           -3
                                Milk       FDP Butter Cheese SMP                  WMP


Source: OECD Secretariat


79.       The results in the Annex indicate that all world dairy product prices were estimated to increase
following the reform, with the most striking increase occurring for butter. This raises an interesting point:
market price support artificially depresses world market prices but also creates considerable relative
distortions within the dairy market. That is, the policy decision in heavily protected countries to tilt
butter/SMP support prices in favour of butter, favours the production of fat for which demand is
declining.24 The excess fat not consumed domestically is then “pushed” onto the world market through the
use of export subsidies, with the consequence of greatly depressing world butter prices. After the removal
of market price support policies the relative fat/non-fat solids balance on dairy markets is corrected.

80.       In summary, the results of the Aglink dairy trade liberalisation scenarios presented in Annex 1
indicate two broad directions of adjustment. For countries currently applying market price support, the
unilateral policy reform has a strong negative impact on domestic prices and production, positive for
consumption. But as other countries join the dairy policy reform process the impact of the MPS elimination
diminishes substantially. Figure 9 illustrates graphically the reduction in adjustment following the reforms
in the case of Canada. The smaller the country (in the milk production sense), the larger the benefits it
draws from other (larger) countries joining the dairy reform process. On the other hand, for countries that
currently operate without MPS policy the opposite is typically true. That is, a policy reform in a single
reformed country brings only a modest increase in producer prices and production (decrease in
consumption) in countries with little or no market price support. But as other countries join the dairy policy
reform process these impacts become substantially more profound.




24
          In all fairness it should be noted that the EU has acknowledged its butter/SMP policy tilt and in its CAP
          reform reduced support price of butter considerably more that SMP price, somewhat reducing the disparity.


                                                        25
COM/AGR/TD/WP(2004)20/FINAL



   Figure 9. Comparison of milk price and quantity adjustments in individual scenarios: The case of Canada



                           0

                       -10

                       -20
                   %
                       -30

                       -40

                       -50
                               Canada NAFTA Atlantic           All                   Retail

                                            Milk Price      Milk Quantity
Source: OECD Secretariat


Sensitivity analysis of the quota rent and supply elasticity assumptions in Aglink

81.        As was noted above, the specification of milk supply functions is of crucial importance for
modelling dairy policy reform. In this respect the assumptions made concerning quota rent and supply
elasticities are of crucial importance when quota elimination is part of policy reform. The initial
assumptions used in the Aglink scenarios are based on quota rent and supply elasticity values in the PEM
model, and a sensitivity analysis was conducted on these assumptions. More specifically, the supply
elasticities were initially increased by 10% and then decreased by 10% for the milk supply schedules of the
EU and Canada respectively. In the case of quota rent assumptions, the quota rent was increased and
decreased by 3 percentage points. Thus, for example for the EU (base quota rent of 20%), the sensitivity
analysis was carried out with 17% and 23% quota rent (higher quota rent implies lower marginal cost of
production at the quota level and thus more efficient milk production). The results of these sensitivity tests
are presented in Annex 2 in Tables A2.1 to A2.3 for the elasticity assumptions and in Tables A2.4 to A2.6
for the quota rent assumptions. The tables show results in percent changes from baseline levels for prices,
production and consumption of milk and dairy products. The trade figures are shown in thousand tons. The
column following the baseline levels illustrates the results of the Aglink multilateral dairy policy reform
(labelled as base scenario) and results in bold repeat the ones presented in Annex 1 under the heading ALL.
The rest of the columns illustrate the impact of different assumptions for the EU and Canadian milk supply
schedules respectively.

82.        The results in Table A2.1 show that the assumption of a 10% higher EU supply elasticity reduces
milk production in the EU by an additional 0.8 percentage points. On the other hand milk production
increases under the assumption of a lower elasticity when compared to the base scenario. Changing the
supply elasticity in Canada has virtually no impact on the markets of the European Union, whereas the
impact on the domestic market (presented in Table A2.2) is, as expected, more profound. Again, a higher
elasticity induces lower production and vice-versa when compared to the base scenario. These results for
the European Union and Canada stem from the fact that domestic prices following the reform fall below


                                                     26
                                                                         COM/AGR/TD/WP(2004)20/FINAL


the shadow price of quota in both countries.25 In the case where prices would stay above the shadow price
of quota, the scenario with a higher elasticity would indeed cause higher production response compared to
the status quo.

83.      Table A2.3 illustrates the impact of different supply elasticity assumptions on world dairy prices.
A higher EU supply elasticity, which, as noted above, reduces EU domestic milk and dairy product
production, causes a marginal increase in world dairy prices when compared to the base scenario. The
opposite is true for a lower EU elasticity assumption. The impacts on world dairy prices of different
assumptions concerning the milk supply elasticity for Canada are negligible.

84.       The sensitivity analysis for the EU quota rent assumptions presented in Table 2.4 indicates that
with a higher quota rent (quota rent of 23%), production in the EU would decrease by 5.9% following the
multilateral dairy policy reform. This compares to a 7.3% reduction in the base scenario and a 8.6% drop in
the scenario with a lower quota rent assumption (quota rent of 17%). It is also evident from Table A2.4
that the higher quota rent assumption in the European Union would result in deeper cuts in milk producer
prices (−11.1%), more profound cuts in dairy product prices and correspondingly larger increases in dairy
product consumption. The different assumptions on the quota rent for Canada have only a small impact on
EU markets.

85.       Similarly, a change in the quota rent assumptions for Canada has a considerable impact on
Canadian milk production. Table A2.5 illustrates that in the case of a higher quota rent assumption in
Canada (quota rent of 26%) milk production there would increase by 1% following the multilateral dairy
policy reform. In the case of the lower quota rent assumption (quota rent of 20%), milk production would
decrease by 2.6% as compared to the baseline. The impact of different assumptions concerning the
Canadian supply schedule has only a limited impact on internal Canadian prices as Canada plays a
relatively minor role on world dairy markets. An interesting result comes with respect to cross-border trade
of milk with the United States. While under the original supply function assumptions some milk would be
imported from the United States to Canada, the scenario with a higher quota rent assumption (lower
marginal cost of production) suggests that Canada would in fact export some milk to the United States.

86.        Table A2.6 illustrates the impact of sensitivity analysis of quota rent assumptions on world dairy
prices. Given the size of the EU market, changes in the quota rent assumptions, as expected, impacts on
world prices. Under the quota rent assumption of 23%, milk production in the EU is reduced less, which
causes imports to decline and world prices for dairy products to decrease by about 1 to 2 percentage points
relative to the base scenario. In the case of the quota rent assumption of 17%, the large drop in EU milk
production results in an increase in EU imports, which strengthen world prices for dairy products by about
1 to 2 percentage points relative to the outcome of the scenario with the original assumptions. The impacts
on world dairy prices of different assumptions concerning the supply schedule for Canada are relatively
minor.

87.       The sensitivity analysis has shown that the supply schedule assumptions can have a considerable
impact on estimated milk production. The quota rent which determines the vertical position of the supply
curve is, in particular, critical: whether domestic prices following reform are above or below the shadow
price of quota determines whether the country or region produces more or less milk when compared to the
quota level observed prior to the reform. It should be noted that the range of quota rent in the sensitivity
analysis exercise is to, by no means, imply a plausible range of quota rents for each country. The


25
         This fact also partly explains the larger decline in EU milk production when compared to that Canada in
         the base scenario, and which reflects the model assumption of an EU milk supply elasticity of 1.23, which
         is higher than the 0.81 milk supply elasticity assumed for Canada.


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COM/AGR/TD/WP(2004)20/FINAL


simulations with different quota rents are merely to test the sensitivity and robustness of results to a
different set of assumptions.

88.        As discussed in the analysis of milk quota systems, a wide range of assumptions regarding quota
exists in the literature. As expected studies that have used higher quota rent assumptions arrived at lower
reduction or an increase in milk production in quota countries following the trade liberalisation and a quota
system elimination. For example Larivière and Meilke (1998) used an assumption of 35% quota rent in
Canada and estimated milk supply in Canada to increase by 6.9% under a trade liberalisation scenario. For
a comparison, the estimated results of an alternative scenario with Aglink, using 10 percentage points
higher quota rent in Canada (33% quota rent), indicates that milk production in Canada would increase by
5.6% under the ALL scenario. Similarly, in the case of increasing the EU quota rent by 10 percentage
points (30% quota rent) milk production would decline in the EU by only 2.5% as compared to 7.3%
reduction with 20% quota rent.

PEM results of dairy trade liberalisation scenarios- Evaluating the welfare impacts

89.       The Policy Evaluation Model (PEM) is a partial equilibrium static model including 5 major
commodity categories and covering six countries (EU, USA, Mexico, Canada, Switzerland and Japan) plus
a rest-of world component (see Annex 3 for the description of the PEM model). It is calibrated to a 2002
base year using primarily data from the OECD PSE database.26 Elasticity parameters are selected to give
the model a medium-term (5-7 years) adjustment horizon. The dairy sector is represented in terms of raw
milk equivalents. A single supply of raw milk is demanded by separate domestic markets for milk for fluid
and industrial uses. Industrial milk (dairy products are expressed in raw-milk equivalent terms) is a
tradable commodity in the model. The model is intended to represent price effects within a competitive
market framework. As such, the welfare results presented below reflect the impact of changes in markets
occurring through the price mechanism, and do not make any claims regarding welfare changes in their
most general sense (including for example, externalities and other non-market effects, general equilibrium
effects, effects of market failure, effects of structural change in production technology, and other social
costs of adjustment). Some of the other mechanisms through which policy reforms may affect production
and trade are considered in the document “Decoupling: a conceptual overview” (OECD 2001).

90.       Results of the PEM model reflect the 2002 base year; thus are not represented as net of program
changes after that date. Thus, reported changes in production, prices, and welfare do not reflect program
changes made after the base year but within the adjustment period of the model, such as the recent 2003
CAP reform nor the full implementation of Agenda 2000 in the EU, for example. Annex 3 contains a fuller
description of the PEM model.

91.        As is the case with all equilibrium models, scenarios leading to large percentage changes in
prices are subject to the caveat that the elasticity parameters in the model are assumed accurate only for
prices “close” to the baseline equilibrium. In order to address this, all scenarios are combined with a
sensitivity analysis that varies all parameters within their plausible ranges as identified in the reports by
Abler (2001) and Salhofer (2001). In addition, unit marginal cost is also varied in a range between one-half
and double its base value. A Monte-Carlo approach is used where all parameter values (plus unit marginal
cost) are drawn from uniform distributions, and the scenario run using this new parameter set. This is
repeated for 500 draws and the extreme high and low values for all results are identified. These maximum
and minimum results define the range of results that alternative but plausible parameter choices would
yield.



26
         The EU is treated as a single region in the model.


                                                        28
                                                                          COM/AGR/TD/WP(2004)20/FINAL


92.       In many cases, this sensitivity analysis produces no variation in the results in each scenario. This
is the case where the scenario dictates the result; in all of these scenarios, support is eliminated, so there is
no variation in the change in taxpayer welfare or quota rent. Taxpayer costs and quota rent will always
change from the base value to zero. Only when sensitivity analysis identifies some variation are the results
shown. This is to enhance readability of the tables.

93.       Support to milk production in the six regions represented in the PEM as measured by the %PSE
ranges from 45% in Mexico to 74% in Japan. The monetary value of this support ranges from
USD 1.1 billion in Mexico to USD 18.4 billion in the European Union and totals some USD 36 billion for
the entire PEM region. As is typical of support provided to the dairy sector, most of this is in the form of
market price support. They represent some of the most protected agricultural markets in the OECD and the
potential gains from reform of their dairy sectors are correspondingly large. In this section the results of
simulation experiments using the PEM to investigate the potential of dairy reform to improve welfare will
be presented.

94.       In the first set of experiments, dairy policies were eliminated unilaterally in each PEM region.
That is, support was reduced to zero in one region only, leaving all others’ policies unchanged (Table 1). In
all scenarios the elimination of price support is sufficient to make quota no longer a binding constraint in
the model, thereby “eliminating” the quota restriction. Since quotas are endogenous in the model, no
special modifications are required in moving from a situation where the quota is binding to one where this
is not the case. In addition to market price support, support in the form of consumption subsidies and
output support were also eliminated. Policies are represented in the PEM according to the categorisation in
the PSE and are reflected as price wedges in the market where they have their initial incidence. Since each
region represents a separate experiment, the results shown in Table 1 are not additive and do not in any
way indicate global net results. In each experiment, production is reduced, and the country becomes a net
importer of dairy products. Table 1 presents the commodity market impacts as the outcome of the
experiment in level terms, and below that in terms of percentage change.

95.        The presence of a binding quota makes the supply function more inelastic on average. This is
because the supply function contains a vertical component where the quota is binding and supply does not
change in response to price changes. The larger this vertical component is (larger quota rent), the more
inelastic the total supply response will be. For example, the percentage price decline in Canada is nearly
double that of the United States, but the supply response is the same in percentage terms.

96.        As might be expected, the most dramatic market results are seen in countries with the highest
initial rates of support. Switzerland, Canada, and Mexico see the highest reduction in domestic milk
prices, while production is most strongly impacted in Switzerland, Mexico, and the United States. Scale
of production is much more important in determining the effects of reform on world prices, with the
United States and the European Union having a more significant impact on world prices, followed by
Japan (Table 2).

97.       In these results, the country with the highest initial percentage PSE, Japan, sees a relatively
moderate impact in production and prices, especially when compared with countries such as Mexico, with
a relatively low %PSE for milk. The relatively moderate production change seen in Japan is explained by
the assumption in the model that fluid milk is non-tradable and so fluid demand must be supplied by
domestic producers. For this reason, domestic production must always at least equal domestic fluid
demand. Japan is the only country for which this becomes a binding constraint in the model27, with all
27
          While all countries in the model become net importers as a result of liberalisation, domestic production
          level still exceeds the portion of domestic demand that is for fluid products. Note, that the net import
          position of specifically modelled countries in PEM is balanced by increase in net exports from rest of the
          world (ROW in PEM includes countries such as New Zealand, Australia, Argentina).


                                                        29
COM/AGR/TD/WP(2004)20/FINAL


domestic production dedicated to fluid use, and all manufacturing milk demand supplied by imports. This
requirement for domestic fluid supply-demand balance drives the results for that country. It is also the
reason that the ranges of possible results indicated by sensitivity analysis are quite narrow; the fluid
demand function is the major determinant of supply, making the results insensitive to changes in other
parameters. In an autarkic market for fluid milk, world price does not play a role in price formation (the
domestic fluid market is essentially isolated from the rest of the world).

98.      Because of the assumed natural barrier to fluid trade, domestic fluid milk is still able to command
a premium of 170% over the world price. This premium moderates the effect of liberalisation of dairy
policy on producer price, production, and welfare.28

                                           Table 1. Unilateral liberalisation experiments


                                              Canada          European Union           Japan            Mexico          Switzerland        United States
Commodity Market Impacts:                                                         ~ result of experiment in levels ~
  Domestic Production (m tonnes)                 6.5                96.2                5.6            4.8                   1.6                55.0
                                              5.83/7.32         86.61/106.47          5.58/5.63         4.59/4.89          1.4/1.91          54.71/55.42
     Net Exports (m tonnes)                     -5.7               -29.2               -15.1              -8.8              -2.7               -25.0
                                             -6.41/-4.95        -37.84/-19.84       -15.1/-15.09       -8.94/-8.64        -2.9/-2.39        -25.31/-24.68
     World (border) Price (USD/tonne)          156.3               188.2               160.0             159.6             161.6               193.5
                                            155.9/156.55       182.48/195.23       162.09/162.22     158.99/159.22      161.58/161.99      185.46/186.19
                                                                                           ~ % change ~
     Producer Price                              -41                -36                 -32          -41                     -72                -27
                                             -42.6/-39.76       -38.18/-33.86       -32.48/-30.81     -41.57/-41.48     -71.99/-71.92       -23.39/-23.05
     Domestic Production                         -21                -21                 -33               -52                -51                -29
                                            -28.95/-10.78       -28.75/-12.41       -33.28/-32.79     -53.47/-50.4      -57.34/-41.73       -29.1/-28.18
     Net Exports                                1429                -517                248               306              -2247               3346
                                            1220.9/1609.7      -641.52/-383.89      247.75/247.9     299.78/313.63     -2418.2/-2010.21   3300.67/3387.13
     World Price                                  3                  18                  6                 3                  1                  21
                                               2.3/2.73          13.72/21.66          5.8/5.89          3.02/3.17          1.3/1.56          20.9/21.38
Economic Impacts:                                                                         ~ USD millions ~
  Taxpayers                                       0                2067                 234            16                    377               3286
    of which export subsidies                     0                 941                  0              0                     52                 0
  Consumers                                     1504               11590               6300           1427                  1431               2014
                                           1499.4/1508.41 10825.86/12443.57 6269.83/6331.22 1424.76/1427.96 1430.41/1432.47               1985.33/2044.54
     Farm Households                            -999              -10842               -1192              -545              -824               -1764
                                           -1134.29/-836.62   -12920/-8617.26     -1269.9/-1112.69 -550.66/-538.01 -1003.55/-643.58 -1813.76/-1716.32
      of which dairy capital                    -193               -2728                -664              -265              -291               -1011
                                            -287.67/-92.99    -3861.45/-1531.19    -717.99/-606.63   -269.47/-260.5    -353.83/-225.62    -1065.54/-963.64
      of which farm land                       -107.2              -739.3             -223.7            -168.0             -105.6              -384.2
                                            -133.62/-66.48     -922.1/-498.35      -231.33/-216.18   -169.23/-165.68   -105.87/-104.11     -392.66/-375.28
      of which dairy livestock                  -72.6              -251.1             -304.2            -112.4             -123.4              -368.8
                                            -107.65/-34.68     -373.17/-133.24     -333.68/-276.26   -115.16/-109.43    -149.89/-96.54     -383.5/-356.21
      of which quota rents                     -625.7             -7123.1               0.0               0.0              -304.7               0.0
                                           -937.11/-313.33 -10708.18/-3537.62            0/0               0/0          -567.59/-40.33           0/0
     Input Suppliers                            -44.9             -1127.9              -85.2            -107.6             -126.8             -1639.0
                                            -69.76/-20.24     -1713.32/-577.03      -93.12/-76.8     -111.06/-104.3     -162.64/-90.37    -1674.94/-1599.09
     Net impact                                460.0              1687.5              5256.5             789.2             857.0              1896.8
                                            353.8/593.61      1001.35/2613.11     5176.14/5336.09    785.09/794.03      709.6/1010.93     1880.01/1918.64
     Net impact as % of initial value of
     sector (valued at world price)             36.8                8.7                409.9              51.9             163.6                16.0
                                              28.31/47.5          5.13/13.4        403.67/416.14       51.61/52.2       135.43/192.94        15.88/16.21


Source: OECD PEM model




28
             One may question whether consumer preference for fresh milk would be sufficient to sustain a premium of
             this size over the importable substitutes such as UHT or reconstituted milk. Regardless, this points out the
             potential importance of consumer preference in the effects of reform.


                                                                            30
                                                                         COM/AGR/TD/WP(2004)20/FINAL


99.      Japan is seen as having the greatest potential benefits from liberalisation. The net improvement
in welfare calculated in the experiment is just over four times the initial value of the entire dairy sector,
measured as domestic production before liberalisation multiplied by world price.29 This results from the
disproportionate gain in consumer welfare. Switzerland has the next-greatest potential benefit, at over one
and a half times the initial value of the sector, followed by Mexico at 52% of the value of the sector.
Because of the size of the dairy sector in the European Union, the potential benefits of reform amount to
about 9% of the value of the sector.

                      Table 2. Ranking of impacts of unilateral liberalisation experiments

                                                  Rank of impact of experiment (in % change)

                      %PSE Ranking         Producer      Quantity                            Net Impact
                          (2002)             Price      Produced     World Price             (as % of value)
      Highest     1        Japan          Switzerland     Mexico     United States              Japan
                  2     Switzerland         Mexico      Switzerland       EU                  Switzerland
                  3      Canada             Canada         Japan         Japan                  Mexico
                  4    United States          EU       United States   Canada                  Canada
                  5         EU               Japan          EU          Mexico               United States
      Lowest      6       Mexico         United States   Canada       Switzerland                 EU

Source: OECD PEM model


100.       In this set of experiments, Mexico is seen to consistently rank higher in terms of impact than its
level of support as measured as %PSE or its size would indicate. Nearly all support to dairy producers in
Mexico is in the form of market price support, and there are no quota restrictions in the country. Thus,
elimination of support has a relatively greater impact on producer price, and there are no quantitative
restrictions moderating the production response to this price change. Conversely, Japan, which benefits
from the natural barrier to trade related to fresh milk, sees the highest net benefit to reform with the
second-least impact on producer price relative to other countries.

101.      The next experiment carried out using the PEM model was a liberalisation of the dairy sector in
all regions at the same time (Table 3). The main difference in this experiment when compared with the
previous one-country-at-a-time experiments is that the effect on the world price is more dramatic. All six
regions reduce production and become net importers, for a total change in demand on the world market of
nearly 51 million tonnes. This causes world prices to rise by 42%. By comparison, the most significant
change in world price in the unilateral liberalisation experiments was 21%, related to liberalisation in the
United States.

102.      A key determinant of the world price post-liberalisation is the ability of the rest of the world to
supply additional milk to the market. The “Rest-of-World” is represented in the PEM by a ROW supply
function and a ROW demand function (whose elasticises are estimated using the Aglink model). The 42%
increase in world price is required to draw an increase of 34 million tonnes in net exports from other
countries. Structural change or capacity limitations on exporters could change this result. For example, if
Australia and New Zealand were unable to significantly increase output, the world price would be higher
and net ROW exports lower. On the other hand, if the higher world price resulted in the emergence of new


29
         The initial value of the sector is presented used as a way to find a comparable metric for the benefits of
         reform. Other potential options would be value of consumption or GDP, the point being finding an
         appropriate measure of economic scale to compare against.


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COM/AGR/TD/WP(2004)20/FINAL


major milk exporters (perhaps Brazil and Argentina), the world price could be lower. Caution is warranted
in interpreting the results of a shock of this magnitude.

103.       As was seen in the Aglink results, multilateral reform moderates the changes in the domestic milk
markets of protected countries when compared with a unilateral reduction in support, and results in
reduced gains for consumers as well as reduced losses for producers30, and lower net welfare benefits in
each country. Moreover, the multilateral reform scenario does not include liberalisation of policies in the
countries contained in the ROW component. More widespread liberalisation would have the impact of
moderating the impact on the represented sectors even further. Once again, this effect is most pronounced
in Mexico. Total welfare in all regions increases by some USD 7 billion, an amount equal to about one
fifth of the market value of dairy production in the six regions, valued at world prices before liberalisation.
Total welfare in the Rest of World will also increase because of the change in world price, as the region is
a net exporter.

104.       The results show the effectiveness of the quota in the European Union at restricting supply;
despite a reduction in producer price of 22%, production has reduced only by 4%. Canada, which also
maintains quota restrictions on production, sees a drop in production of only 2%. Switzerland also has
restrictions on production, but the decline in producer price is enough to provoke a decline in production of
40%.31 The decline in production in Japan at 33% may be considered moderate; without the natural
premium (of close to 100% in this scenario) afforded to fluid milk due to its non-tradability, the price
decline there would be closer to 75%. Not shown in the table, net changes in world production and
consumption of dairy products are modest, with production, consumption, and trade changes in the rest of
world being roughly equal in magnitude and opposite in sign to the results in the modelled regions.

105.       The results of the sensitivity analysis show a greater degree of variation for countries which make
use of quota systems. Uncertainty regarding the unit quota rent drives this result. The unit quota rent
determines the marginal cost, which locates the supply function. A high unit quota rent implies a lower
supply function. That is, a high quota rent means the cost structure of production is lower, and so a greater
level of production at a given price once the quota system is removed. Varying unit quota rent (marginal
cost) in the sensitivity analysis effectively varies the location of the supply function.

106.     In Canada and the European Union, this means that domestic production may increase or
decrease as a result of liberalisation, depending on the assumed level of unit quota rent. The price decline
in Switzerland is sufficiently large, so that the change in production is unambiguously downward. The
European Union, moreover, may see its net exports increase or decrease as a result of reform. This has an
impact on net welfare, which may also increase or decrease as a result of reform in these countries.




30
         Bearing in mind that the purpose and result of market price support policies is to create a transfer from
         consumers to producers.
31
         Since under full liberalization, quotas are no longer binding, these results will be sensitive to the estimate
         of quota rent, which locates the supply function.


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                                           Table 3. Simultaneous liberalisation experiment

                                                             European
                                            Canada            Union                Japan           Mexico         Switzerland United States Total 6 regions

Commodity Market Impacts:                                                                  ~ Simulation result, levels ~
   Domestic Production (m tonnes)              8.1             116.2                 5.6              7.9             2.0                 68.0               207.9
                                             7.07/9.27      105.23/128.15         5.59/5.63        7.46/8.38         1.72/2.33         62.63/73.18        202.4/214.19
    Net Exports (m tonnes)                     -1.9             -4.3                -13.0             -4.7             -2.0               -8.0                -33.9
                                            -3.11/-0.53      -14.49/6.66        -13.26/-12.78      -5.25/-4.12      -2.27/-1.61        -14.34/-2.07       -37.11/-30.16
    World Price (USD/tonne)                                                                                                                                  218.2
                                                                                                                                                          209.81/225.67
                                                                                                 ~ Change, % ~
    Domestic Production                        -1.5             -4.4                -33.0           -19.4             -39.0               -11.8               -9.0
                                           -13.81/13.04      -13.43/5.43        -33.18/-32.74    -24.34/-14.99     -47.49/-29.05       -18.83/-5.15        -11.39/-6.23
    Net Exports                               408.4            -162.1              199.7             115.3          -1,660.2            1,006.7
                                           40.12/730.04     -307.39/-4.63       194.64/205.66     90.86/142.89   -1913.51/-1391.25   185.69/1875.31
    World Price                                                                                                                                               41.7
                                                                                                                                                           36.27/46.47
Economic Impacts:                                                                       ~ Change, USD millions ~
   Taxpayers                                   0.0            2,066.8              233.9        15.5          377.0                     3,286.2             5,979.4
   Dairy Consumers                            782.9           7,123.1             5,263.6      635.9         1,143.3                    -532.0              14,416.7
                                          705.85/871.08    6221.95/8142.43     5131.52/5405.97 541.82/742.38     1111.55/1179.44     -1103.28/115.05    12629.36/16442.99
    Crops Consumers                             52              433                 118                85               0                  480               1,167

    Farm Households                          -659.1           -8,065.9            -1,197.4          -315.6            -773.1             -882.3            -11,893.4
                                          -760.44/-541.31 -9637.08/-6303.36 -1274.22/-1118.62-371.43/-261.72 -941.24/-598.74         -1296.32/-477.82    -14072/-9436.47
     of which Dairy capital                   -18.5            -685.9              -667.1           -137.4            -256.5             -482.0             -2,247.4
                                           -157.53/-0.53    -2058.42/6.66       -720.15/-12.78   -166.22/-4.12     -333.07/-1.61      -738.42/-2.07      -3476.95/-30.16
     of which dairy pasture land               -7.8            -193.4              -224.7           -119.6            -102.9             -218.1              -866.6
                                          -85.04/114.55    -544.53/275.15       -231.8/-217.67 -138.81/-100.78    -105.46/-96.94     -299.06/-124.14     -1170.44/-454.07
     of which dairy livestock                  -7.1             -63.6              -305.6            -58.5            -108.9             -182.2              -726.0
                                           -59.78/52.21      -197.2/70.45      -334.48/-278.36   -70.17/-47.39    -139.25/-77.31     -268.93/-100.45     -813.53/-620.02
     of which quota rents                    -625.7           -7,123.1               0.0              0.0             -304.7               0.0              -8,053.5
                                          -937.11/-313.33 -10708.18/-3537.62         0/0              0/0         -567.59/-40.33           0/0          -11832.74/-4064.35
    Dairy Input Suppliers                     -31.5            -374.9               -85.7            -64.2            -102.0             -873.3             -1,531.6
                                           -57.64/-2.38    -940.66/170.33       -93.41/-77.17    -74.95/-54.29    -139.44/-66.56     -1126.63/-627.05   -1872.69/-1203.76
    Net Impact                                 92.2            749.1              4,214.4            271.7            645.3              998.6              6,971.2
                                           53.1/180.61     624.89/1084.97      4042.87/4422.39 236.01/315.7       501.56/803.43      955.35/1088.52      6667.48/7380.9
    Net impact as % of initial value of
     sector (valued at world price)            7.38             3.84               328.66            17.86           123.15               8.44                3.27
                                            4.25/14.45         3.2/5.56         315.29/344.89     15.52/20.75      95.72/153.33          8.07/9.2           3.13/3.46


Source: OECD PEM model


107.      Alternative uses of crops compete with dairy producers, who demand grains and oilseed meal for
feed. Eliminating support to dairy can bring significant benefits to these consumers as the reduction in
demand for dairy feed and fodder reduces the prices for these commodities. In the European Union and
the United States, where the dairy sectors are relatively large, these benefits are significant and make up
around half of the net benefits of reform in those countries. In each country, with the exception of the
United States, consumers are the main beneficiaries of reform through lower domestic prices for milk. In
the United States, market price support is relatively less important (though still significant) as a proportion
of total support. Domestic prices to consumers in the United States rise because the elimination of
consumer subsidies combined with the rise in world prices is greater than the price reduction due to the
elimination of domestic price support (plus the fact that 50% of the fluid milk premium is assumed to
remain after liberalisation). On the other hand, US taxpayers benefit from the elimination of these
subsidies. Because of its lack of quota restrictions (which tend to concentrate benefits to producers at the
expense of input suppliers) and relatively large use of purchased inputs, the United States is also the only
country where input suppliers face the same order of welfare change as do farm households. By contrast, in
the European Union, the loss of quota rents results in farm households (and quota holders in particular)
being the main losers in dairy policy reform.



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COM/AGR/TD/WP(2004)20/FINAL


108.      Box 1 described the potential for price transmission along the retail chain to be less than perfect.
This possibility was considered in the Aglink scenarios, where a pass-through of 50% was assumed. This
experiment regarding retail market power is repeated here using the EU as an illustrative example.32 In this
example, domestic producer price and world price are aligned by removal of border measures and other
support policies (this is the shock introduced to the model), but it is assumed that domestic retailers who
purchase from domestic and foreign suppliers are able to alter their margin by an amount equal to half of
any upstream price changes (50% price transmission). The scenario considered here is unilateral
elimination of domestic support in the EU; the results however are quite general and apply equally to the
case of multilateral liberalisation. The results are presented in Table 4.

                                  Table 4. Partial price transmission in the EU


                                                                Unilateral          Unilateral Difference
                                                       liberalisation with liberalisation with  between
                                                         50% retail price         100% price          two
                                                            transmission        transmission scenarios
       Commodity Market Impacts:                           ~ Simulation result, levels ~
         Domestic Production (m tonnes)                       93.0                 95.9              -3%
         Net Exports (m tonnes)                              -25.9                -29.4             -12%
         World Price (USD/tonne)                             184.1                189.4              -3%
                                                                ~ Change, levels ~
          Net Exports (m tonnes)                             -37.6                -42.2
                                                                 ~ Change, % ~
          Domestic Production                                -24%               -21%
          World Price                                         15%                18%
       Economic Impacts:                                    ~ Change, USD millions ~
         Taxpayers                                         2,066.8            2,066.8                 0%
         Dairy Consumers                                   5,398.6           11,566.2               -53%
         Retailer Rents                                    6,606.3                0.0                  -
         Farm Households                                  -11,193.7         -10,876.6                 3%
          of which Dairy capital                           -2,981.3          -2,742.4                 9%
          of which dairy pasture land                       -811.2             -755.8                 7%
          of which dairy livestock                          -274.9             -252.0                 9%
          of which quota rents                             -7,126.4          -7,126.4                 0%
         Dairy Input Suppliers                             -1,163.5          -1,052.6                11%
         Net Impact                                        1,714.5            1,703.8                 1%

Source: OECD PEM model


109.     When support policies are eliminated, partial price transmission through the retail market means
that the consumer price falls less than it would otherwise. This means that fewer dairy products are
imported than would have been the case, with the result that the world price is lower than it would
otherwise have been. Producers, who receive the world price, respond to this by producing less.

110.      Farm households are worse off compared to the full-transmission case because of the relative
decline in producer price; they lose some producer surplus that would have accrued to farm owned inputs

32
         This is not to imply that retail price transmission is different in the EU compared with any other region.
         The basic insights of this experiment are generally applicable to all regions (but note the large-country vs.
         small country difference discussed below).


                                                        34
                                                                            COM/AGR/TD/WP(2004)20/FINAL


in the alternative full-transmission case (all quota rents are lost in both cases). Consumer welfare increases
by half the amount of the previous scenario, owing to the more modest price reduction in the partial price
transmission scenario.

111.      By altering their margin in response to downstream price changes, retail intermediaries are able
to obtain economic rents.33 These rents are defined as the amount of per-unit additional margin times
quantity sold. In this case the additional unit margin is the differential between producer and consumer
prices. These rents amount to USD 6.603 billion, significantly more than the change in consumer welfare
of USD 5.398 billion in this scenario.34 Since consumers and retailers essentially share the price change 50-
50, why are these values not the same? One reason is the slope of the demand function; consumer surplus
has a triangular component reflecting a declining marginal benefit to additional consumption, while
intermediary unit rents are the same for all units sold. Further, it is not just a matter of retailers sharing in
consumer rents. When intermediaries alter their margin and retarding demand, it has the effect of reducing
the price received by domestic and foreign producers (via world prices). Accordingly, some of their rent is
at the expense of domestic and foreign producers and input suppliers. This transfer from foreign producers
notwithstanding, the deadweight losses that arise from intermediaries’ action on their margins results in a
smaller increase in EU welfare compared with the full price transmission scenario (i.e. a relative decrease).

112.     While intermediaries obtain rents at the expense of consumers, domestic and foreign producers,
and input suppliers, it is the domestic consumers that bear the majority of the cost of retail margin
manipulation. Why? Trade movements limit domestic producer losses from the partial transmission of
prices. Consider the case of a small country: if changes in trade had no impact on world price, domestic
producers facing that world price would be indifferent to retailers’ ability to change their margin and the
subsequent effect on consumer demand and trade. Conversely, if there were no possibilities for trade,
domestic supply would need to contract by the same amount as did domestic demand, requiring a larger
reduction in producer price and a larger welfare loss for producers.

113.       The EU is large enough that changes in net trade affect world prices, but this price change is
small relative to the domestic consumer price change. In the scenario shown here, the impact on domestic
producers of the reduction in world price amounts to an additional loss of 3% relative to the alternative
liberalisation scenario. The most significant impact of partial price transmission is the transfer between two
different domestic constituencies: consumers and owners of intermediary enterprises. The difference in the
net production and welfare impacts is small. The effect on net trade is proportionally more significant (a
13% reduction in net imports), as the reduction in domestic consumption compared with the full-
transmission scenario is manifested primarily as a reduction in imports.

V. Summary

114.       The empirical analysis of dairy trade liberalisation presented in this document was carried out
using the Secretariat’s Aglink and PEM models in order to assess the impact of dairy policy reforms on
production, consumption, trade, prices, income and welfare. The empirical results have to be viewed within
the limits of the models used (the model limitations are discussed in the text and are summarised later in
this section). The dairy trade liberalisation results of Aglink and PEM are not strictly comparable as these
models have different structures, country, product and time coverage. The simulation experiments were

33
          Were retailers to maintain a constant margin in terms of percentage of the producer price (for example), the
          same effect would hold. What is important here is that the margin changes in absolute terms.
34
          These rents do not include any change in the intermediaries’ income from any other source, such as
          changes in producer surplus. This market is not represented in the model, which explains both the simple
          structure of price transmission assumed and the absence of any calculations for this sector other than these
          rents.


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COM/AGR/TD/WP(2004)20/FINAL


tailored to each model with the specific strengths of each model in mind. The results of the experiments are
complementary in that the Aglink scenarios provide insights in market and trade outcomes of liberalisation,
while the PEM results enlighten in particular the income and welfare effects. It is also important to bear in
mind that the simulation results have an indicative (normative) rather than definitive character. That is, the
results give broad indications of the nature, possible direction and potential changes in markets, income
and welfare due to liberalisation in the dairy sector, rather than definitive forecasts of the outcomes.

115.      The results of the dairy trade liberalisation scenario in which market price support is removed
shows that for countries currently applying MPS support the unilateral policy reform has a strong negative
impact on domestic prices and production (positive for consumption). As other countries join the dairy
policy reform process the impact of the MPS elimination diminishes substantially. On the other hand, for
countries that currently operate without MPS policy the results are equivalent, though obviously going in
the opposite direction. That is, in general the results of the scenarios for countries that currently operate
without MPS policy indicate that a policy reform in a single reformed country brings them only a modest
increase in producer prices and production (decrease in consumption). As other countries join the dairy
policy reform process these impacts become more profound.

116.      As expected, the removal of all market price support measures is estimated to have a substantial
impact on world dairy markets. The results indicate that world prices for all dairy products would increase
significantly. In the multilateral scenario where policies are reformed in countries covered in Aglink, world
butter prices would increase by 57%, cheese prices by 35%, WMP prices by 17% and those for SMP by
21.5%. PEM results show that the implicit world price of milk would increase in the PEM multilateral
scenario by 46%. The Aglink results also suggest that market price support not only artificially depresses
world market prices but also creates considerable distortion within the dairy market milk components
balance. That is, the policy decision in heavily protected countries to tilt butter/SMP support prices in
favour of butter, depresses world fat (butter) prices more than those for non-fat solids. Following the
removal of market price support policies the relative fat/non-fat solids balance is re-established in dairy
markets.

117.      Total world production of milk and dairy products is estimated not to be altered significantly
following the reform process, but a shift occurs to more efficient regions. The results indicate that world
milk production would be reduced by only 0.2%. Butter production would remain virtually unchanged
while WMP production would be reduced by 2.7%. SMP and cheese production would increase by 1.2%
and 2.1% respectively. Following the reform, less butter and WMP would be traded. The reduction in
butter trade stems primarily from large cuts in subsidised exports from countries where MPS is eliminated,
while the drop in WMP trade reflects an increase in WMP prices and lower demand from NMEs where
WMP is used for reconstitution. Cheese trade and consumption in countries where MPS is eliminated
would increase significantly following the reform.

118.      Potential welfare gains from liberalisation estimated with the PEM model are in the order of USD
8 billion for the six countries included in the model. The beneficiaries of liberalisation are taxpayers and
consumers, from whom dairy policies are designed to provide transfers to producers. Efficiency losses
from these transfers mean that eliminating them provides a net social welfare gain, of the amount
mentioned above. Japan stands out as a region where this gain is particularly pronounced. The welfare
gains to consumers in that country are four times the amount lost to producers by eliminating transfers
caused by price support. The PEM cannot pronounce on welfare changes in other regions, but it seems
likely that the increase in world prices would be welfare-improving for producers in regions without border
protection, and welfare-reducing for consumers in such regions.

119.     While the results of the international dairy liberalisation scenarios in this document are to some
extent comparable to results of other studies, the analyses itself is subject to caveats and shortcomings.


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                                                                       COM/AGR/TD/WP(2004)20/FINAL


Some of the caveats were addressed via a sensitivity analysis and through production of an alternative
scenario. Other caveats, often common to large world agricultural commodity models, remain. Some of the
caveats relate to model specification, some to the scenario design and others to the complexity of milk
production and trade.

120.      First, while scrutinising the results it is important to keep in mind that the policy reform analysed
here relates to the dairy sector only. The support in other sectors remains at baseline levels and this may
have an important bearing on the final outcomes of the reform scenarios presented in this report, in
particular where beef and dairy production are closely integrated, as is the case for many European
countries. It follows that in the context of multilateral and multi-commodity agricultural policy reform, the
polarisation of results between reformed countries and countries currently without any market price
support might be different and in fact very likely reduced. In theory, it might be argued that the loss in
relative profitability of the dairy sector would be smaller if all sectors are reformed compared to the case
were support is only eliminated for dairy. That is, the increase in relative profitability would stem not only
from a reduction in commodity prices that are competing with the dairy sector but also from cost
reductions likely to be associated with the reduction in feed prices. In the case of countries currently
without market price support the opposite could be expected. As the world prices of feed and other
commodities rise, the dairy sector would become relatively less profitable when compared to the scenario
assessing dairy reform only. Further study would be required to give more insights into the impacts of a
multi-commodity reform.

121.       It should also be kept in mind that the dairy products produced, consumed and traded in the
Aglink and PEM models are assumed to be homogeneous. No account has been taken of different product
attributes, sanitary standards or different production practices such as environmentally friendly farming,
respecting animal welfare etc., which can influence costs of production, product prices and consumer
choice. Moreover, although results of the analysis show that adjustment in milk production in reformed
countries is not excessive and their dairy sectors would continue to remain in business, the results focus on
country or regional aggregates. At this level of aggregation it is not possible to infer the level of
adjustments required at the farm level. Structural changes at the farm level might be indeed substantial.

122.      Another limitation concerns the absence of risk in the analysis. Producers in countries which are
not currently exposed to world price fluctuations and are protected by a minimum price program would
probably consider the market conditions of the post-reform as being more risky and prices relatively more
unstable. The opposite might be true from the perspective of producers not currently protected by MPS
measures, although the future stability of world market prices after trade liberalisation remains subject to
debate.

123.       The impact of trade liberalisation depends heavily on the production response subsequent to the
removal of milk production restrictions in countries that employ a milk quota. This is even more important
as dairy markets are relatively thin and some of the countries operating a quota system are major players
on the international milk and dairy product markets. Thus, effectively the results of international dairy
liberalisation are influenced by the milk supply response assumptions in quota operating countries, notably
those on quota rent and supply elasticities.

124.     Another caveat is the fact that the rest of the world is treated as a single block in the models.
Many countries that are implicitly represented in the ROW module use market price support and other
policy measures. Given the size of the ROW, in terms of milk and dairy product production and
consumption, the response of this region to trade liberalisation is crucial for the results of such a scenario.
If the multilateral reform simulation would include the impact of liberalisation in a large number of
developing countries which are currently represented in the single “rest of the World” module, the
adjustment needed in the represented countries in this paper might be even smaller. Unfortunately, to


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disaggregate the developing world into smaller regions is very costly due to the lack of consistent and
reliable data for these countries.

125.      Finally, given the high level of protection in dairy sector the scenario of full trade liberalisation
create a shock to the model beyond what many would consider “marginal” or small.35 Price movements
outside a certain range can call into question the continuing validity of the elasticity parameters in the
model, with a corresponding impact on accuracy. As an example, in the case of demand functions, the
issue of market saturation might become important. Moreover, the models do not allow for structural
change. That is, while relative factor intensity may be varied according to relative price changes, the
underlying production functions do not change. Thus, the results presented here do not represent a long-
term equilibrium, but rather a medium-term perspective on reform. However, as such they do provide a
useful indication of the winners and losers from reform, as well as an idea of the potential scale of its
benefits.

VI. Main conclusions

126.     The market, trade and welfare effects of international dairy trade liberalisation have been
analysed empirically using the Secretariat’s models, Aglink and PEM. The empirical results have to be
viewed within the limits of the models and are subject to the usual modelling caveats. Nevertheless they do
provide important insights into the potential of liberalising dairy markets. Thus, the results should be
viewed as conveying something about the nature, possible direction and potential changes in markets,
income and welfare due to liberalisation in the dairy sector, rather than offering definitive forecasts. The
main findings and lessons that could be drawn from the analysis of international trade liberalisation
presented in this paper can be summarised as follows:

     •   Dairy trade liberalisation would have the potential for significant net welfare improvements, with
         consumers being the main beneficiaries and taxpayers also realising gains. The size of benefits to
         consumers, however, is subject to the degree of price transmission along the supply chain.

     •   The elimination of distorting market price support policies results in only little change in total
         world milk production, but world dairy prices would be lifted substantially (by 17 to 54%) while
         supply would shift towards more efficient areas.

     •   Supply adjustments in milk supply in reformed countries would be relatively not large. However,
         while their dairy sectors would not be affected greatly at the aggregate level, substantial
         structural adjustment may take place at the farm level.

     •   Producers and exporters in developing countries would gain large benefits from the reform, while
         consumers in these countries would face a substantial increase in prices.

     •   The price and supply adjustment would be higher if a country reforms its dairy policy
         unilaterally. As more countries would join the reform process, adjustment would be smaller and
         would be least in the case of multilateral reform.

     •   World-wide multi-commodity reform would likely result in further reductions in adjustment
         pressures in the dairy sector.

     •   Distortions in price formation of dairy products (tilt) would be eliminated.

35
         It is unclear exactly what the size of this critical band is; acceptable price changes of from +- 10% to +-
         35% have been cited. See Market Effects of Agricultural Policies (OECD 2001) for a discussion.


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                                                               COM/AGR/TD/WP(2004)20/FINAL


•   The assumption concerning the production potential in quota operating countries plays an
    important role in the analysis. However, sensitivity tests confirm the results, and do not lead to
    fundamentally different conclusions.




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                                                                     ANNEX 1



                   Aglink results of dairy trade liberalisation scenarios- Evaluating the market and trade impacts

                                                              Legend for the tables

The tables show results in percentage changes from baseline levels for prices, production and consumption of milk and dairy products. The trade
figures are shown in thousand tons. The baseline levels refer to the last year values (2008) of the Agricultural Outlook baseline 2003-2008
published in OECD (2003a). The columns following the baseline levels illustrate the results of dairy policy reform for a particular country or group
of countries. The name of the reformed country or region appears always in the columns’ headings. Thus the results show what would be the
market impact if only that country or region would removed its market price support while all the other countries would keep their policies at
baseline levels.

The reformed regions (group of countries) in the tables are defined as follows:

    •   Europe − a scenario of a dairy policy reform in all the European components of Aglink (a scenario of a complete elimination of all market
        price support measures in the EU-15, Poland, Hungary and Russia )
    •   NAFTA − a scenario of a dairy policy reform in all NAFTA countries (United States, Canada, Mexico)
    •   Atlantic − a scenario which combines reform in Europe and NAFTA countries.
    •   ALL − a scenario involving reforms in all Aglink countries was produced, the results are highlighted in bold.
    •   ..&NAFTA and .&Europe (Table A1.4) are scenarios of Japan reform combined with reforms in respective regions.
    •   For countries not applying MPS (such as New Zealand) the scenarios indicate an impact on these countries of reform in specific region.

Supplemental scenario is defined as follows:

    •   Retail − is an imperfect transmission scenario where it was assumed that consumers of countries affected by the reform would only benefit
        from half of the decline in price recorded in the scenario of simultaneous dairy policy reforms.

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Table A1.1 Dairy policy reforms - Impact on the European Union

   Dairy policy reforms     Baseline          EU           Europe           Atlantic           All    Retail


Internal prices EUR/t                                               % changes from baseline
  Milk                         256           -16.5          -16.0            -12.3            -9.8    -12.1
  Butter                      2917           -33.5          -31.0            -22.0            -25.3   -26.6
  Cheese                      3899           -17.0          -15.9            -10.6            -10.0   -12.5
  WMP                         2280           -14.4          -14.2             -9.2            -7.5     -9.2
  SMP                         1943            4.8            3.4              1.1             7.5      5.3
Production kt                                                       % changes from baseline
  Milk                       122023          -10.7          -10.4             -8.9            -7.3     -9.7
  Butter                      1718           -46.9          -45.8            -40.3            -33.7   -38.6
  Cheese                      7665            -0.5           0.1              1.6             1.1      -0.2
  WMP                          915           -10.4          -10.3             -2.8            -5.0     -4.5
  SMP                          803           -87.5          -87.5            -87.5            -87.5   -87.5
Consumption kt                                                      % changes from baseline
  Fresh dairy prd.            40935           7.9            7.7              5.7             4.5      2.7
  Butter                      1730            4.0            3.7              2.4             2.9      1.4
  Cheese                      7407           15.4           14.2              9.0             8.4      5.1
  WMP                          450            2.1            2.1              1.3             1.1      0.6
  SMP                          769           -31.7          -31.2            -30.4            -32.7   -31.9
Net imports kt                                                          Thousand tons
  Butter                       -23            851            827              711             606      665
  Cheese                      -257            920            784              290             288      135
  WMP                         -465           -360           -361             -433             -414    -420
  SMP(a)                       -34            981            976              875             417     725
a) SMP net imports include imports of non-fat solids (such as WPC, MPC)


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Table A1.2 Dairy policy reforms - Impact on Canada

Dairy policy reforms        Baseline        Canada           NAFTA           Atlantic           All       Retail


Internal prices CAND$/t                                              % changes from baseline
 Milk                          648           -46.9           -30.5            -28.5            -27.9       -29.7
 Butter                       6712           -61.8           -51.4            -42.9            -45.3       -46.2
 Cheese                       8826           -47.3           -36.3            -34.0            -33.5       -35.3
 Other dairy products         4380           -21.5           -17.4            -14.9            -15.0       -15.4
 SMP                          5465           -46.9           -49.0            -45.2            -41.7       -42.9
Production kt                                                        % changes from baseline
 Milk                         8233           -15.8            -5.3             -1.2            -0.8        -2.6
 Butter                        85            -55.3           -33.9            -26.8            -25.3       -24.8
 Cheese                        344           -47.0            -5.6             -5.0            -5.1        -5.7
 Other dairy products          894           20.1             45.1            42.7             40.4        45.6
 SMP                           104           -90.4           -61.2            -52.8            -47.0       -31.5
Consumption kt                                                       % changes from baseline
 Fresh dairy products         2877           23.2             13.9            12.9             12.6        5.8
 Butter                        93            93.5             64.7            47.0             51.6        20.4
 Cheese                        355           37.7             25.1            23.3             22.6        10.3
 Other dairy products          877           22.7             4.8              3.5             3.7         1.2
 SMP                           90            -47.0           -45.9            -46.1            -46.4       -46.9
Net imports kt                                                           Thousand tons
 Butter                         8             141             96               74               77          48
 Cheese                        12             307             120              112             110          68
 Other dairy products          -17             2             -378             -368             -347        -414
 SMP(a)                        -15            80               3                -6             -12         -28
 Milk                           0              0              392              125             145         168
a) SMP net imports include imports of non-fat solids (such as WPC, MPC)

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       Table A1.3 Dairy policy reforms - Impact on the United States

       Dairy policy reforms        Baseline         USA             NAFTA             Atlantic           All    Retail


       Internal prices USD/t                                                  % changes from baseline
        Milk                          321           -17.1           -15.6              -13.3            -12.7   -14.6
        Butter                       3115           -39.4           -35.3              -23.9            -27.1   -28.4
        Cheese                       3141           -16.3           -14.2              -11.1            -10.5   -13.0
        Whey powder                   646           17.2             11.0              14.5             21.4    25.0
        SMP                          2091           -12.4           -13.5               -2.2            4.0      1.9
       Production kt                                                          % changes from baseline
        Milk                         81326          -11.6           -10.3               -5.1            -4.6     -6.9
        Butter                        573           -33.0           -31.9              -16.2            -13.7   -15.8
        Cheese                       4635           -15.0           -12.7               -6.4            -6.2     -9.3
        Whey powder                   632           -10.1              -8.6             -4.2            -4.1     -6.2
        SMP                           489           -48.5           -47.4              -24.2            -20.4   -24.0
       Consumption kt                                                         % changes from baseline
        Fresh dairy products         25969           4.1               3.8              3.4             3.3      1.7
        Butter                        567           24.0             20.7              12.9             14.9     7.2
        Cheese                       4786            6.7               5.8              4.4             4.1      2.5
        Whey powder                   499           -11.9           -10.3               -6.7            -6.6     -8.5
        SMP                           434            9.9             10.8               1.6             -2.8     -0.7
       Net imports kt                                                             Thousand tons
        Butter                         -4            319               294              160             157      126
        Cheese                        152           1168            1018                658             636      703
        Whey powder                  -133           -128            -130               -140             -140    -136
        SMP                           -65            225             224                70               33      60

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Table A1.4 Dairy policy reforms - Impact on Japan

Dairy policy reforms       Baseline        Japan     ..& NAFTA         ..& Europe           All       Retail


Internal prices Y/t                                              % changes from baseline
 Milk, all                   80529          -52.3        -53.8            -54.3            -55.0       -63.2
 Milk, fluid                 85399          -55.0        -56.4            -56.8            -57.5       -64.4
 Butter                     954618          -85.1        -78.4            -76.9            -73.7       -74.2
 Cheese                     429835          -22.8        -9.9             -11.2            -8.1        -9.6
 SMP                        520839          -60.7        -60.9            -58.4            -59.1       -59.8
Production kt                                                    % changes from baseline
 Milk                        8422           -20.7        -20.1            -19.7            -19.4       -19.3
 Butter                       87            -99.9        -99.9            -98.8            -98.8       -82.7
 Cheese                       37            -99.7        -99.7            -99.7            -99.7       -99.7
 Other dairy products         412           -99.8        -99.8            -99.8            -99.8       2.9
 SMP                          175           -99.7        -99.7            -98.6            -98.6       -82.6
Consumption kt                                                   % changes from baseline
 Fresh dairy products        5419           21.1         22.0             22.3             22.8        9.7
 Butter                       88            92.0         68.0             64.3             57.0        16.4
 Cheese                       264           19.7          7.6              8.7              6.0        3.5
 SMP                          231           142.7        143.9            127.7            132.4       34.5
Net imports kt                                                       Thousand tons
 Butter                        0            168          147               143             136          86
 Cheese                       227           315          283               286             279         273
 WMP                           0             45           45                45              45          45
 SMP                          56            559          562               523             534         280




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       Table A1.5 Dairy policy reforms - Impact on Mexico

       Dairy policy reforms       Baseline        Mexico         NAFTA           Atlantic           All     Retail


       Internal prices MXN/t                                             % changes from baseline
        Milk                        3543           -58.6         -51.5            -50.2            -49.6    -50.9
        Butter                      33798          -46.8         -33.5            -21.8            -25.1    -26.4
        Cheese                      48335          -49.6         -37.8            -35.6            -35.1    -36.9
        WMP                         61828          -63.5         -61.5            -61.1            -60.4    -61.1
       Production kt                                                     % changes from baseline
        Milk                        10266          -30.0         -26.3            -23.7            -23.3    -24.6
        Butter                       20           -100.0         -100.0          -100.0            -100.0   -100.0
        Cheese                       175           -57.0         -46.9            -38.4            -37.3    -35.1
        Milk powders                 229           -81.0         -77.3            -72.6            -71.6    -70.0
       Consumption kt                                                    % changes from baseline
        Fresh dairy products        4252            9.2           7.4              7.1              7.0      2.9
        Butter                       74           101.5           57.9            32.1             38.5     17.5
        Cheese                       238           23.1           15.6            14.2             14.0      6.3
        Milk powders                 390            7.1           5.7              3.6              2.5      -6.1
       Net imports kt                                                        Thousand tons
        Butter                       54           148.9          116.7            97.6             102.3    86.8
        Cheese                       63           217.9          182.4            164.1            161.7    139.7
        Milk powders                 163          375.6          361.7            342.7            336.2    298.7




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Table A1.6 Dairy policy reforms - Impact on Australia

Dairy policy reforms        Baseline       Europe            NAFTA           Atlantic           All       Retail


Internal prices AUSD/t                                               % changes from baseline
 Milk                         356            26.8             12.5            30.4             33.6        30.6
 Butter                       2682           37.1             32.0            52.2             46.6        44.3
 Cheese                       4323           21.9             22.6            27.4             28.2        25.0
 SMP                          2949           20.0             0.9             16.8             25.0        21.7
Production kt                                                        % changes from baseline
 Milk                        12909           11.8             4.4             12.6             13.8        12.1
 Butter                       163            33.8             -1.3            31.4             36.7        33.3
 Cheese                       423            18.0             16.9            20.5             19.4        16.8
 WMP                          281            -4.0             2.6              0.9             2.7         1.1
 SMP                          272            32.4             -0.2            29.9             34.3        31.2
Consumption kt                                                       % changes from baseline
 Fresh dairy products         2240           -6.4             -3.2             -7.1            -7.7        -7.1
 Butter                        56            -6.0             -5.2             -7.9            -7.3        -6.9
 Cheese                       222            -18.2           -18.7            -21.9            -22.4       -20.3
 WMP                           65            0.0              0.0              0.0             0.0         0.0
 SMP                           50            -3.0             -0.1             -2.6            -3.7        -3.2
Net exports kt                                                           Thousand tons
 Butter                       107            166              108              163             171         165
 Cheese                       202            318              315              337             334         318
 WMP                          216            205              223              218             223         219
 SMP                          223            312              222              305             318         309




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       Table A1.7 Dairy policy reforms - Impact on New Zealand

       Dairy policy reforms       Baseline       Europe           NAFTA           Atlantic          All    Retail


       Internal prices NZD/t                                              % changes from baseline
        Milk                        520            19.1            12.5            24.6             25.7   23.1
        Butter                      3719           25.3            30.0            42.5             36.3   33.5
        Cheese                      4559           24.0            24.8            30.2             31.1   27.5
        WMP                         4546           7.9             11.4            13.1             15.0   13.0
        SMP                         4490           14.7            0.7             12.4             18.4   16.0
       Production kt                                                      % changes from baseline
        Milk                       17388           7.5             4.7              9.2             9.7     8.4
        Butter                      497            12.6            0.4             14.0             14.7   13.2
        Cheese                      394            21.2            26.0            24.2             23.2   20.2
        WMP                         610           -11.4            0.4              -8.8            -7.4    -7.7
        SMP                         441            11.5            -0.4            11.7             12.6   11.4
       Consumption kt                                                     % changes from baseline
        Butter                       30            -5.8            -6.7             -8.9            -7.9    -7.4
        Cheese                       37            -5.6            -5.8             -6.9            -7.0    -6.3
        WMP                           4            0.0             0.0              0.0             0.0     0.0
        SMP                          34            -3.4            -0.2             -2.9            -4.1    -3.6
       Net exports kt                                                         Thousand tons
        Butter                      447            512             451              519             523     515
        Cheese                      361            446             465              458             454     442
        WMP                         606            537             608              553             561     559
        SMP                         407            458             405              459             464     458




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Table A1.8 Dairy policy reforms - Impact on Argentina

Dairy policy reforms        Baseline       Europe            NAFTA           Atlantic           All       Retail


Internal prices Pesos/t                                              % changes from baseline
 Milk                         558           19.6              9.3             22.3             24.9        22.9
 Butter                      14805          23.6              20.7            33.5             29.9        28.4
 Cheese                      10220          28.1              31.6            36.7             37.7        33.6
 WMP                         10956           7.8              12.4            13.6             15.5        13.6
 SMP                         9677           16.6              1.0             14.1             21.3        18.8
Production kt                                                        % changes from baseline
 Milk                        9842           11.6              4.6             12.6             14.0        12.4
 Butter                        47           11.6              -4.0            10.1             12.6        11.5
 Cheese                       454           19.2              14.8            22.3             23.4        20.6
 WMP                          202            3.2              -1.9             4.1             6.0         5.0
 SMP                           45           19.7              -2.7            17.0             19.7        18.3
Consumption kt                                                       % changes from baseline
 Butter                        41           -16.3            -14.5            -21.6            -19.8       -19.0
 Cheese                       430           -14.6            -16.0            -18.0            -18.4       -16.8
 WMP                          121            -5.7             -8.7             -9.4            -10.5       -9.4
 SMP                           24           -11.6             -0.8            -10.1            -14.3       -12.9
Net exports kt                                                           Thousand tons
 Butter                        6             18               10               19               20          19
 Cheese                        24            174              160              203             209         190
 WMP                           81            94               88               101             106         102
 SMP                           22            33               21                32              34          33




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       Table A1.9 Dairy policy reforms - Impact on Brazil

       Dairy policy reforms        Baseline        Europe        NAFTA           Atlantic           All    Retail


       Internal prices R/t                                               % changes from baseline
       Milk producer price           458             7.8          6.7             10.0             11.0    10.1
       Production kt                                                     % changes from baseline
        Milk                        25005            7.8          4.2              8.8             9.6      8.2
        Fresh dairy products        14704           -0.6          -1.4             -1.1            -1.1     -1.1
        Butter                        95            18.3          2.2             18.3             21.1    18.8
        Cheese                       540            26.4          19.9            30.8             32.3    28.1
        WMP                          329             7.7          4.6             10.5             12.6    10.5
        SMP                           69            64.2          7.4             63.1             75.0    66.7
       Consumption kt                                                    % changes from baseline
        Fresh dairy products        14694            0.6          -1.7             0.0             0.2      0.1
        Butter                        98            -15.6        -13.9            -20.7            -19.0   -18.2
        Cheese                       570            -15.1        -16.6            -18.7            -19.1   -17.5
        WMP                          385            -8.0          -7.5            -11.4            -13.2   -11.6
        SMP                           91            -14.2         1.6             -11.6            -16.8   -15.0
       Net exports kt                                                        Thousand tons
        Butter                        -2             30           13               35               36      33
        Cheese                        -30           199           173              243             254      222
        WMP                           -56            0            -12              22               36      23
        SMP                           -22            35           -19              32               44      37




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Table A1.10 Dairy policy reforms - Impact on Rest of the World

Dairy policy reforms        Baseline       Europe           NAFTA           Atlantic           All       Retail


Production kt                                                       % changes from baseline
 Milk                        219153          2.6             1.2              2.9              3.1        2.9
 Butter                       4132           10.8            4.7             12.0             13.0        12.0
 Cheese                       2308           12.3            9.9             14.6             15.1        13.8
 WMP                          496            6.8             5.6              9.0              9.9        9.0
 SMP                          427           165.6            67.4            180.3            199.6      184.6
Consumption kt                                                      % changes from baseline
 Fresh dairy products        113691          -5.0            -2.8             -5.8             -6.2       -5.8
 Skim milk                   61471           -1.1            -0.1             -0.9             -1.3       -1.2
 Butter                       4534           -3.7            -3.3             -4.8             -4.4       -4.3
 Cheese                       2549          -11.4            -9.4            -12.9            -13.2       -11.6
 WMP                          1734           -2.2            -3.4             -3.7             -4.2       -3.7
 SMP                          1094           -2.2            -0.4             -2.1             -2.7       -2.5
Net exports kt                                                          Thousand tons
 Butter                       -401           211             -58              313              336        289
 Cheese                       -241           333             227              425              445        372
 WMP                         -1,238         -1,166          -1,151          -1,129            -1,116     -1,129
 SMP                          -667            64             -375            125               215        148




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         Table A1.11 Dairy policy reforms - WORLD

         Dairy policy reforms        Baseline       Europe        NAFTA           Atlantic          All    Retail


         World prices USD/t                                               % changes from baseline
          Butter                      1374           45.3          39.7            64.3             57.4   54.6
          Cheese                      1991           25.7          28.9            33.6             34.5   30.8
          WMP                         1789           8.5           13.6            14.8             16.9   14.8
          SMP                         1705           16.8          1.0             14.2             21.5   19.1
          Wheat                        145           -1.6          -0.3            -1.6             -1.5   -1.8
          Maize                        110           -0.1          -0.9            -0.8             -1.0   -1.0
          Rice                         256           -0.3          -0.2            -0.4             -0.4   -0.5
          Oilseeds                     243           -1.0          -0.3            -1.2             -1.1   -1.6
          Oilseed meals                164           -3.3          -2.2            -4.3             -4.1   -4.9
          Vegetable oils               559            2.9           2.9             4.2             3.4     3.5
          Beef, USA                   2577           -0.7          1.1              0.0             0.4     0.4
          Beef, EU (E/t)              2641           -0.6          -0.1            -0.7             -0.5   -1.1
          Beef, Mercosur (pesos/t)    1038           -1.9          -1.2            -2.3             -2.4   -2.3
          Pork, USA                   1287           -0.9          -0.7            -1.1             -1.0   -1.4
          Poultry, USA                 874           -0.7          -0.6            -1.0             -1.0   -1.3
         Production kt                                                    % changes from baseline
          Milk                       615016          0.0           -0.8             -0.6            -0.2    -1.3
          Fresh dairy products       246658          -1.3          -1.0             -1.5            -1.5    -2.2
          Butter                      8470           -1.4          0.2              -1.1            0.1     -1.6
          Cheese                      19095          3.0           -0.5             2.3             2.1     0.3
          WMP                         4002           -2.1          -1.7             -2.2            -2.7    -3.1
          SMP                         3390           6.8           -0.8             2.3             1.2     -0.6
         World exports kt                                                 % changes from baseline
          Butter                       816           -3.8          -0.5             -3.0            -1.3    -3.3
          Cheese                      1345           9.1           33.1            23.4             25.3   19.7
          WMP                         1435           -12.4         1.1              -3.5            -3.0    -3.9
          SMP                         1049            6.0          -8.1              0.4            4.5      3.0


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                                                                               ANNEX 2.



T a b le A 2 .1 S e n s itiv ity a n a lys is o f m ilk s u p p ly e la s tic ity a s s u m p tio n s - re s u lts fo r th e E u ro p e a n U n io n

D a iry p o lic y re fo rm s                 B a s e lin e           B ase               B ase+10%             B a s e -1 0 %   B ase+10%              B a s e -1 0 %
                                                                  s c e n a rio           e la s t. E U         e la s t. E U   e la s t. C A N        e la s t. C A N
In te rn a l p ric e s E /t                                                    % c h a n g e s fro m b a s e lin e
  M ilk                                          256                  -9 .8                    -9 .1                 -1 0 .6         -9 .8                  -9 .8
  B u tte r                                     2917                 -2 5 .3                  -2 5 .0                -2 5 .5        -2 5 .3                -2 5 .3
  C heese                                       3899                 -1 0 .0                   -9 .8                 -1 0 .2        -1 0 .0                -1 0 .0
  WMP                                           2280                  -7 .5                    -7 .2                  -7 .8          -7 .5                  -7 .5
  SM P                                          1943                   7 .5                     8 .5                   6 .5           7 .5                   7 .5
P ro d u c tio n k t                                                           % c h a n g e s fro m b a s e lin e
  M ilk                                       122023                  -7 .3                    -8 .1                  -6 .5          -7 .3                  -7 .3
  B u tte r                                    1718                  -3 3 .7                  -3 5 .5                -3 1 .9        -3 3 .7                -3 3 .8
  C heese                                      7665                    1 .1                     0 .6                   1 .5          1 .1                   1 .0
  WMP                                           915                   -5 .0                    -5 .9                  -4 .2          -5 .0                  -5 .0
  SM P                                          803                  -8 7 .5                  -8 7 .5                -8 7 .5        -8 7 .5                -8 7 .5
C o n s u m p tio n k t                                                        % c h a n g e s fro m b a s e lin e
  F re s h d a iry p ro d u c ts               40935                  4 .5                     4 .1                   4 .9           4 .5                   4 .5
  B u tte r                                     1730                  2 .9                     2 .8                   2 .9           2 .8                   2 .9
  C heese                                       7407                  8 .4                      8 .2                  8 .7           8 .4                   8 .5
  WMP                                            450                  1 .1                     1 .0                   1 .1           1 .1                   1 .1
  SM P                                          769                  -3 2 .7                  -3 3 .0                -3 2 .4        -3 2 .7                -3 2 .7
N e t im p o rts k t                                                                 T h o u s a n d to n s
  B u tte r                                      -2 3                 606                      635                    575            606                    606
  C heese                                       -2 5 7                288                      309                    266            285                    291
  WMP                                           -4 6 5               -4 1 4                   -4 0 6                 -4 2 2         -4 1 4                 -4 1 4
  SM P                                           -3 4                 417                      415                    420            417                    417
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    Table A2.2 Sensitivity analysis of milk supply elasticity assumptions - results for Canada

    Dairy policy reforms           Baseline         Base           Base+10%     Base -10%    Base+10%     Base-10%
                                                  scenario          elast. EU    elast. EU   elast. CAN   elast. CAN
    Internal prices CAND/t                                 % changes from baseline
      Milk                            648          -27.9            -27.8            -28.1       -27.9      -28.0
      Butter                         6712          -45.3            -45.1            -45.4       -45.2      -45.3
      Cheese                         8826          -33.5            -33.3            -33.7       -33.5      -33.5
      Other dairy products           4380          -15.0            -14.9            -15.1       -15.0      -15.0
      SMP                            5465          -41.7            -41.2            -42.2       -41.7      -41.7
    Production kt                                          % changes from baseline
      Milk                           8233           -0.8             -0.7             -0.9        -1.5       0.0
      Butter                           85          -25.3            -24.9            -25.8       -25.4      -25.3
      Cheese                          344           -5.1             -5.1             -5.2        -5.1       -5.1
      Other dairy products            894          40.4             40.2             40.7        40.4       40.5
      SMP                             104          -47.0            -46.1            -47.9       -47.1      -47.0
    Consumption kt                                         % changes from baseline
      Fresh dairy products           2877          12.6             12.6             12.7        12.6       12.7
      Butter                           93          51.6             51.3             52.0        51.6       51.7
      Cheese                          355          22.6             22.5             22.8        22.6       22.7
      Other dairy products            877           3.7              3.6              3.7         3.7        3.7
      SMP                              90          -46.4            -46.4            -46.3       -46.4      -46.4
    Net imports kt                                             Thousand tons
      Butter                            8             77              76               78         77          77
      Cheese                           12            110             109             110         110         110
      Other dairy products            -17           -347            -345             -349        -346        -347
      SMP                             -15            -12             -13              -11         -12         -12
      Milk                             0            145              144             145         204          80

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Table A2.3 Sensitivity analysis of milk supply elasticity assumptions - World dairy prices

Dairy policy reforms           Baseline         Base           Base+10%     Base -10%    Base+10%     Base-10%
                                              scenario          elast. EU    elast. EU   elast. CAN   elast. CAN
World prices US$/t                                     % changes from baseline
 Butter                          1374           57.4            57.9             56.8        57.4        57.4
 Cheese                          1991           34.5            34.9             34.2        34.6        34.5
 WMP                             1789           16.9            17.3             16.5        16.9        16.9
 SMP                             1705           21.5            22.6             20.4        21.5        21.5




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    Table A2.4 Sensitivity analysis of quota rent assumptions - results for the European Union

    Dairy policy reforms           Baseline        Base             EU quota      EU quota     CAN quota     CAN quota
                                                 scenario          rent of 17%   rent of 23%   rent of 20%   rent of 26%
    Internal prices E/t                                    % changes from baseline
      Milk                           256            -9.8            -11.1             -8.6         -9.9          -9.8
      Butter                        2917           -25.3            -25.7            -24.9        -25.3         -25.2
      Cheese                        3899           -10.0            -10.4             -9.6        -10.0          -9.9
      WMP                           2280            -7.5             -8.0             -7.0         -7.5          -7.5
      SMP                           1943             7.5              6.0              9.0          7.5           7.5
    Production kt                                          % changes from baseline
      Milk                         122023           -7.3             -5.9             -8.6         -7.3          -7.3
      Butter                        1718           -33.7            -30.8            -36.6        -33.8         -33.7
      Cheese                        7665             1.1              1.8              0.3          1.0           1.1
      WMP                            915            -5.0             -3.6             -6.4         -5.0          -5.1
      SMP                            803           -87.5            -87.5            -87.5        -87.5         -87.5
    Consumption kt                                         % changes from baseline
      Fresh dairy products          40935           4.5               5.1             3.9          4.5           4.5
      Butter                         1730           2.9               2.9             2.8          2.9           2.8
      Cheese                         7407           8.4               8.8             8.1          8.5           8.4
      WMP                             450           1.1               1.1             1.0          1.1           1.1
      SMP                             769          -32.7            -32.2            -33.2        -32.7         -32.7
    Net imports kt                                             Thousand tons
      Butter                          -23          606               557             653          606           605
      Cheese                         -257          288               253             321          294           282
      WMP                            -465          -414             -426             -402         -414          -414
      SMP                             -34           417              421             414          417           417




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Table A2.5 Sensitivity analysis of quota rent assumptions - results for Canada

Dairy policy reforms           Baseline        Base             EU quota      EU quota     CAN quota     CAN quota
                                             scenario          rent of 17%   rent of 23%   rent of 20%   rent of 26%
Internal prices CAND/t                                 % changes from baseline
  Milk                           648           -27.9            -28.2            -27.7        -28.0         -27.8
  Butter                        6712           -45.3            -45.5            -45.0        -45.3         -45.2
  Cheese                        8826           -33.5            -33.8            -33.2        -33.5         -33.4
  Other dairy products          4380           -15.0            -15.2            -14.8        -15.0         -15.0
  SMP                           5465           -41.7            -42.6            -40.9        -41.7         -41.7
Production kt                                          % changes from baseline
  Milk                          8233            -0.8             -1.0             -0.6          1.0          -2.6
  Butter                          85           -25.3            -26.1            -24.6        -25.3         -25.4
  Cheese                         344            -5.1             -5.2             -5.1         -5.1          -5.1
  Other dairy products           894            40.4             40.9             40.0         40.6         40.3
  SMP                            104           -47.0            -48.5            -45.6        -47.0         -47.1
Consumption kt                                         % changes from baseline
  Fresh dairy products          2877           12.6              12.8            12.5         12.7          12.6
  Butter                          93           51.6              52.2            51.1         51.7          51.6
  Cheese                         355           22.6              22.9            22.4         22.7          22.6
  Other dairy products           877            3.7               3.8             3.6          3.7           3.7
  SMP                             90           -46.4            -46.3            -46.4        -46.4         -46.4
Net imports kt                                             Thousand tons
  Butter                          8             77                78              76           77            77
  Cheese                         12            110               111             109          110           110
  Other dairy products           -17           -347             -350             -343         -348          -346
  SMP                            -15            -12              -10              -13          -12           -12
  Milk                            0             145              146             144           0.2          286


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    Table A2.6 Sensitivity analysis of quota rent assumptions - World dairy prices

    Dairy policy reforms           Baseline        Base            EU quota      EU quota     CAN quota     CAN quota
                                                 scenario         rent of 17%   rent of 23%   rent of 20%   rent of 26%
    World prices US$/t                                    % changes from baseline
     Butter                         1374           57.4            56.5             58.2         57.3          57.4
     Cheese                         1991           34.5            34.0             35.1         34.5          34.6
     WMP                            1789           16.9            16.3             17.6         16.9          17.0
     SMP                            1705           21.5            19.8             23.2         21.5          21.6




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                                                 ANNEX 3

                      A DESCRIPTION OF THE AGLINK AND PEM MODELS



AGLINK MODEL

127.        Aglink is a partial equilibrium dynamic supply-demand model of world agriculture, developed
by the OECD Secretariat in close co-operation with member countries. It represents annual supply, demand
and prices for the principal agricultural commodities produced, consumed and traded in member countries.
The overall design of the model focuses particular attention to the potential influence of agricultural policy
on agricultural markets in the medium term. Development on the basis of the agricultural economics
literature, existing member country models, and on formal Bilateral Reviews has resulted in a model
specification which reflects the views of participating member countries, subject to constraints which
uniformity across country modules requires. Thus, agricultural markets are modelled specifically to best
capture individual policies and particular market settings relevant for each country.

128.      Individual country modules modelled in Aglink are calibrated on baseline projections, received
from member countries via a so called questionnaire reply system. The country modules are then merged
and the entire model (~ 2800 equations) is solved simultaneously to generate the commodity baseline.
Model characteristics, key factors and model assumptions related to the Aglink model used in the
development of the Agricultural Outlook 2003-2008 baseline (OECD, 2003b) and in empirical simulations
carried out in this report are described below.

General characteristics and assumptions

129.      Aglink is a partial equilibrium model for the main OECD agricultural commodity markets
relative to supply, consumption and prices. Non-agricultural markets are not modelled, and are treated
exogenously to the model. Feedback to the macro-economy is not accounted for. This may be particularly
important for Rest of World countries in which agriculture is often a significant part of the domestic
economy. Certain markets, such as sheepmeat, fish and wool are also not modelled or incompletely
modelled.

130.      World markets for agricultural commodities are competitive. Buyers and sellers do not behave as
if they had market power, and market prices are determined through a global equilibrium in supply and
demand. Domestically produced and traded commodities are viewed to be perfect substitutes by buyers and
sellers. In particular, importers do not distinguish commodities by country of origin.

131.      Countries/regions modelled endogenously in Aglink are: Argentina, Australia, Brazil, Canada,
China, the European Union 15, Hungary, Japan, Korea, Mexico, New Zealand, Poland, Russia, Rest of
World, Uruguay, and the United States. Rest of World module is specified without any policy measures in
place. Countries/regions accounted for exogenously are: Czech Republic, Norway, Other Independent
States, Slovakia, Switzerland and Turkey.

132.     The main commodities modelled by Aglink are: Barley, Feed barley, Beef and veal, Butter oil ,
Butter, Casein, Coarse grains, Cheese, Eggs, Fresh dairy products, Lamb, Maize, Milk, Concentrated milk,
Manioc, Milk powder, Mutton, Non ruminant meat, Other cereals, Other dairy products, Vegetable oils,

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Oilseed oil, Oilseed meal, Oilseeds, Oats, Pigmeat, Palm oil, Potatoes, Poultry meat, Rice, Rapeseed oil,
Rapeseed, Ruminant meat, Rye, Soybean, Special crops, Sunflower, Sunflower oil, Sunflower meal,
Sheepmeat, Soybean oil, Soybean meal, Skim milk, Skim milk powder, Sorghum, Vegetable oil, Whole
milk powder, Wool, Wheat and Whey powder.

133.     Aglink simulates market determination of equilibrium prices for most of its commodities. For
these commodities it is assumed that a market price must adjust to equate exactly total demand, including
carry-over, to total supplies, including carry-in. Each market uses a specific world reference price. In
Aglink, considerable effort was made to retain a calendar year basis for all data. This was not possible for
many series, particularly for crops and for dairy.

134.       The functional relationships linking supply and demand to prices in Aglink are in most cases
linear in the logarithms of the variables. Equation coefficients are partial elasticities. In developing Aglink,
an attempt has been made to obtain up-to-date estimates of these elasticities. Many of these new elasticities
come from, or are based on, models currently in use in member countries. Some are the result of
econometric analysis initiated by the Secretariat, through consultants or by Secretariat staff. Where world
market and domestic producer and consumer prices are linked, that link is represented through price
equations which are linear in world market prices, converted to local currency terms, margins
approximating transportation costs and quality differentials, and border measures -- tariffs, taxes, subsidies
etc.

135.      In Aglink, trade for each country by commodity pairing is given one of three possible treatments.
In a few cases, the level of imports or exports, either bilateral or in total, can be set exogenously. This may
be the case, for example, where a trade quota or an access agreement applies. In a few other cases certain
bilateral trade links are reflected, for example, poultry trade between the United States and Canada.
Finally, and most commonly, trade is the residual of a supply-utilisation identity equation. In these cases it
is the modeller’s responsibility to identify simulated exports or imports above export limits or below
import access.

Dairy markets specific characteristics and assumptions

136.      The dairy component of Aglink covers production and consumption of milk and main dairy
products in major OECD and several non-member economies markets, covering both importers and
exporters. Thus, the Aglink representation of the dairy sector allows the analysis of impacts on world
markets for tradable dairy products where those markets are explicitly modelled. As for other commodities
in Aglink, dairy markets are modelled specifically to best capture individual policies and particular market
settings relevant for each country.

137.      Milk production in Aglink is expressed as the product of milk cow inventory and milk yield. In
Canada and the EU, milk production is determined by the setting of the production quota. Since output
prices do not guide producer decisions, price elasticities of milk supply have not been defined for these
countries. A 'shadow price' of milk supply in quota countries has to be identified in order to specify an
underlying supply function in these countries. This is essential for modelling a scenario which involves a
substantial policy change or, alternatively, a total elimination of a quota system (this is discussed in the
main text of the report).

138.     The milk production link to the beef sector in Aglink is based on a theory of supply in which
producers invest in breeding stock by retaining cows and heifers from slaughter when the capital value of
these animals exceeds their current market value. The capital value of a beef-breeding cow is a function of
the expected income stream earned from future sales of calves. The higher the expected value of future
beef and milk production the greater the investment in the breeding herd. The retention for breeding lowers


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the availability of animals for slaughter in the short run. Thus, to the extent that current beef prices
influence expectations of future beef prices, there exists the possibility of a negative elasticity of beef
supply response in the short run.

139.      In Aglink, the equations corresponding to investment demand for beef cows link ending
inventories to expected producer prices, feed costs and other factors. The beef and milk production
equations link supply in a particular year to the breeding inventories in earlier years and to producer prices
for beef and competing products and to costs.

140.      Dairy supply is modelled on the assumption that the value of milk components (fat, non-fat
solids) will tend to equalise across products. Thus, if demand for a product made primarily from one of the
components grows relative to demand for products made from the other then the relative value of
components would adjust. That is a unit of fat in cheese would have the same value as unit of fat in WMP
or butter, after adjusting for processing costs. Thus, only butter and SMP prices are typically used as
proxies for fat and non-fat solids prices.

141.      Typically in Aglink, butter production and SMP production are residuals of the market-clearing
for milkfat and non-fat solids, respectively. The production of cheese and WMP are logit functions that
depend on the price of that good relative to the input cost. This last term is calculated on the basis of the
butter and SMP prices and the shares of milkfat and non-fat solids in the various products.

142.      In the dairy market, as is the case for other commodities, where world dairy prices and domestic
producer and consumer prices are linked, that link is represented through price (transmission) equations
which are linear in world market prices, converted to local currency terms, margins approximating
transportation costs and quality differentials, and border measures. In several countries, that have a large
domestic dairy market and operate with border protection measures, a domestic market clearing price is
assumed. In these cases, typically, the trade equations are linked to the evolution of domestic policy and
market prices and limits set by the WTO.

143.      The world market reference prices for dairy sector are specified as follows: the world prices of
butter, cheese, SMP and WMP are the FOB Northern Europe prices denominated in US dollars. The world
casein price is approximated by New Zealand casein export price. The world whey powder price is
approximated by the US whey powder wholesale price.

PEM MODEL

144.       The Policy Evaluation Model (PEM) provides a stylized representation of production,
consumption, and trade of milk, and major cereal and oilseeds crops in six OECD countries: Canada, the
European Union, Japan, Mexico, Switzerland, and the United States.36 The PEM allows for a stylised
version of existing and hypothetical policies in the participant countries. The purpose of the PEM is to
provide a closer connection between measurement of support as done using the PSE and quantitative
analysis of the impacts and distribution of such support. In constructing the PEM, three main sets of
assumptions were required: 1) those relating to the basic structure of supply and demand response, 2) those
relating to the underlying data and the elasticities, and 3) those relating to the primary incidence of support
measures on prices and quantities. Economic theory and results of previous studies guided analysts’
choices about the structure of the model, the data and economic parameters to use. The classification of
support measures in the PSE guided choices about their primary incidence.


36
         The European Union is treated in the model as a single region. A version of the PEM model incorporating
         beef production and trade is currently under development by the Secretariat.


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COM/AGR/TD/WP(2004)20/FINAL


145.      The starting point for analysis of policy effects for the PEM is the Producer Support Estimate
(PSE). There are eight main categories in the PSE, one for market price support and seven for different
kinds of budgetary payments, distinguished by implementation criteria. The PSE data conveys two kinds of
information necessary for PEM analyses. First, the PSE indicates the level of, and changes over time in the
level of monetary transfers from consumers and taxpayers to farmers resulting from agricultural policies.
Second, support estimates are classified according to the way the associated policy measure is
implemented thereby highlighting the ‘initial incidence’ of the support measure for analytical purposes.
Each of the main kinds of support defined in this classification appears in the model with a specific
differentiated “initial incidence” on producer and consumer incentive prices.

146.      The country ‘modules’ of the PEM were all developed according to a common structure. Policy
experiments were carried out using a model linking these individual modules through world price and trade
effects. Commodity supply is represented through a system of factor demand and factor supply equations.
Excepting the rest of world module, there are equations representing demand and supply response and
prices for at least four categories of inputs used to produce these crops in the study countries. The factor
demand equations reflect the usual assumptions of profit maximisation constrained by the production
relationship. Supply response corresponding to a medium term adjustment horizon of approximately five
years is reflected in the values assumed for the price elasticities of factor supplies and the parameters
measuring the substitutability of factors in production as well as the factor shares.

147.      No factor is assumed to be completely fixed in production, but land and the other farm-owned
factors are assumed to be relatively more fixed (have lower price elasticities of supply) than the purchased
factors. Likewise, no factor is assumed freely mobile, but purchased inputs are assumed relatively more
mobile (a higher elasticity of supply) than the farm-owned factors. Most supply parameters needed for the
model come from systematic reviews of the empirical literature by external consultants. (see D. Abler
(2000) and K. Salhofer (2000)). Both reviews were commissioned by the Secretariat to obtain objectively
plausible values of the parameters. 37

148.      Each of the country modules has two farm-owned factors: land and a residual “other farm owned
factors”. The set of purchased factors covered in each country includes, at the least, fertiliser and a residual
“other purchased factors”.

149.      In the PEM, land is assumed heterogeneous, but transformable between one use and another. The
farmer acts to maximize profits by allocating land across its possible uses (wheat, coarse grains, oilseeds,
rice, other arable uses, milk or beef pasture, other agricultural uses) according to a transformation function.

150.      The land transformation function is assumed separable for different categories of use such that
the land allocation problem facing the farmer is solved in successive stages. First, the producer chooses to
allocate land to rice, other agricultural uses, or to a group of uses including all other arable and pasture
uses. This group is then allocated in the second stage between pasture, cereals and oilseeds, and other
arable uses. Finally, the cereals and oilseeds group is allocated between wheat, coarse grains, and oilseeds
(Figure A3.1).




37.       Although the own and cross-price elasticities of crop supply are not explicit parameters in the PEM crop
          models, their values can be calculated from knowledge of the elasticities of factor supply, factor
          substitution and factor shares.


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                                                                                       COM/AGR/TD/WP(2004)20/FINAL


                                    Figure A3.1 PEM Land Allocation Structure


                                                                               All land

                                                                       σ1                 σ1
                                                                                σ1



                                  Pasture, field crops            Rice                    Other/misc.
                                                       σ2
                                         σ2       σ2


                        Pasture               Other Arable         Cereals/Oilseeds
                                                                                          σ3
                                                                  σ3          σ3


                                                Wheat                  Coarse Grains             Oilseeds



151.      At each of these stages a constant elasticity of transformation (CET) function is used to describe
how uses may be allocated. That is, at each level in this decision-making process the transformability of
land is the same, but this rate differs between levels. The parameter of the CET function, σ, determines the
mobility of land between uses at each stage. As we move downward through this land allocation
framework, land becomes more similar in use and therefore more easily fungible between uses. We expect
σ3>σ2>σ1 in general.

152.      Commodity demand equations in the PEM models relate domestic consumption of outputs to
prices (at the farm level). Co-movement of prices may occur even when policy measures are targeted
directly to only one or two commodities because wheat, coarse grain, oilseeds and rice may be substitutes
in both production and consumption.38 Moreover, depending on the degree to which crops are substitutes
in demand, co-movement in their prices may lead to small ‘net’ changes in quantity demanded for any one
crop and thus in their total. That is, the total demand for crops may be highly price inelastic.

153.      The PEM does not represent in a fully comprehensive manner the specifics of support programs
applying to each individual commodity in each one of the participant countries. Rather, the aim is to
represent the ‘incidence’ of support measures in the same way that ‘incidence’ is implied by the
classification of support measures for the PSEs. In this system, support measures are classified according
to the main or primary condition that producers must meet in order to be eligible for the support. Usually,
knowledge of the conditions of eligibility of a particular support measure, as revealed by its classification
in the PSE, will be enough to infer its “initial incidence”.

154.      In order to undertake policy simulation experiments the model must be calibrated for a specific
base year using the data in the PSE database. This calibration includes all quantities produced, consumed
and exported in each country and each commodity of the model, the set of world and domestic prices and
the amounts of the different kinds of support creating price wedges. Land quantities are taken from FAO
data and other inputs quantities are defined using quantity or constant price volume indexes. Input prices
are derived then from cost shares and factor quantities.



38.      Cross-elasticities of demand are assumed to exist between the crop commodities, but not between milk and
         beef or between these livestock commodities and crops. This assumption is driven primarily by data
         availability.


                                                             65
COM/AGR/TD/WP(2004)20/FINAL




                              ANNEX 4.




                                 66
                                                                                      COM/AGR/TD/WP(2004)20/FINAL


          Table 4.1: Main policy assumptions for dairy markets (Agricultural Outlook 2003-2008)

                                                     Average
                                                     1997-01    2000     2001     2002     2003     2004     2005     2006     2007     2008
ARGENTINA
Dairy export tax                        %                  0         0       0        5        5        5        5        5        5        5
AUSTRALIA (a)
Domestic support payment (b)            AUDc/kg          1.1      0.0      0.0      0.0      0.0      0.0      0.0      0.0      0.0      0.0
CANADA
Milk target price (b)                   CADc/litre        56       57       58       59       60       61       62       64       65       66
Butter support price                    CAD/t          5,491    5,558    5,711    5,870    5,986    6,104    6,230    6,354    6,480    6,608
SMP support price                       CAD/t          4,533    4,670    4,826    4,945    5,038    5,083    5,225    5,321    5,415    5,507
Dairy subsidy                           CADc/hltr       2.46     1.58     1.50     0.33     0.00     0.00     0.00     0.00     0.00     0.00
Cheese tariff-quota                     kt pw             20       20       20       20       20       20       20       20       20       20
  in-quota tariff                       %                  2        1        1        1        1        1        1        1        1        1
  out-of-quota tariff                   %                254      246      246      246      246      246      246      246      246      246
Subsidised export limits
 cheese                                 kt pw             10        9        9        9        9        9        9        9        9        9
 SMP                                    kt pw             47       45       45       45       45       45       45       45       45       45
EU15 (c) (d)
Milk quota (e)                          mt pw            118      119      120      120      120      120      121      122      122      122
Milk target price                       EUR/litre      0.319    0.319    0.319    0.319    0.319    0.319    0.310    0.292    0.274    0.265
Butter intervention price               EUR/t          3,282    3,282    3,282    3,282    3,282    3,282    3,200    3,036    2,872    2,790
SMP intervention price                  EUR/t          2,055    2,055    2,055    2,055    2,055    2,055    2,004    1,901    1,798    1,747
Tariff-quotas
 butter                                 kt pw             85      87        87       87       87       87       87       87      87       87
  in-quota tariff                       %                 63      66        66       66       66       66       66       66      66       66
  out-of-quota tariff                   %                153     144       144      144      144      144      144      144     144      144
 cheese (f)                             kt pw             77     102       102      102      102      102      102      102     102      102
  in-quota tariff                       %                 43      42        42       42       42       42       42       42      42       42
  out-of-quota tariff                   %                108      96        96       96       96       96       96       96      96       96
 SMP                                    kt pw             59      68        68       68       68       68       68       68      68       68
  in-quota tariff                       %                 36      35        35       35       35       35       35       35      35       35
  out-of-quota tariff                   %                 95      88        88       88       88       88       88       88      88       88
Subsidised export limits (a)
 butter                                 kt pw            420     399       399      399      399      399      399      399     399      399
 cheese                                 kt pw            346     321       321      321      321      321      321      321     321      321
 SMP                                    kt pw            288     273       273      273      273      273      273      273     273      273
 other milk products                    kt pw          1,013     958       958      958      958      958      958      958     958      959
JAPAN (c)
Direct payments (m)                     JPY/kg             ..       ..      10       10       10       10       10       10       10       10
Deficiency/direct payment ceiling (g)   kt pw          2,374    2,400    2,270    2,270    2,270    2,270    2,270    2,270    2,270    2,270
Milk guaranteed price (b)               JPY/litre          ..      74        ..       ..       ..       ..       ..       ..       ..       ..
 standard transaction price (h)         JPY/litre          ..      64        ..       ..       ..       ..       ..       ..       ..       ..
 deficiency payment (i)                 JPY/litre          ..      11        ..       ..       ..       ..       ..       ..       ..       ..
Butter stab. indicative price           '000 JPY/t         ..     910        ..       ..       ..       ..       ..       ..       ..       ..
SMP stab. indicative price              '000 JPY/t         ..     524        ..       ..       ..       ..       ..       ..       ..       ..
Cheese tariff (j)                       %                 34       31       31       30       30       30       30       30       30       30
Tariff-quotas
 Butter                                 kt pw              2       2         2        2        2        2        2        2       2        2
  in-quota tariff                       %                 35      35        35       35       35       35       35       35      35       35
  out-of-quota tariff                   %                605     679       679      679      679      679      679      679     679      679
 SMP                                    kt pw            116     116       116      116      116      116      116      116     116      116
  in-quota tariff                       %                 17      16        16       16       16       16       16       16      16       16
  out-of-quota tariff                   %                260     275       275      275      275      275      275      275     275      275
 WMP                                    kt pw              0       0         0        0        0        0        0        0       0        0
  in-quota tariff                       %                 24      24        24       24       24       24       24       24      24       24
  out-of-quota tariff                   %                345     377       377      377      377      377      377      377     377      377
For notes, see end of the table.




                                                                67
COM/AGR/TD/WP(2004)20/FINAL


                                                                 Table 4.1: (cont’d)

                                                               Average
                                                               1997-01        2000       2001       2002       2003       2004       2005       2006       2007      2008
   KOREA
   Tariff-quotas
    Butter                                   kt pw                    0.3        0.3       0.4       0.4        0.4        0.4        0.4        0.4        0.4         0.4
     in-quota tariff                         %                         40         40        40        40         40         40         40         40         40          40
     out-of-quota tariff                     %                         89         89        89        89         89         89         89         89         89          89
    SMP                                      kt pw                    0.8        0.9       0.9       0.9        1.0        1.0        1.0        1.0        1.0         1.0
     in-quota tariff                         %                         20         20        20        20         20         20         20         20         20          20
     out-of-quota tariff                     %                       176        176        176       176        176        176        176        176        176        176
    WMP                                      kt pw                    0.4        0.5       0.5       0.5        0.5        0.6        0.6        0.6        0.6         0.6
     in-quota tariff                         %                         40         40        40        40         40         40         40         40         40          40
     out-of-quota tariff                     %                       176        176        176       176        176        176        176        176        176        176
   MEXICO
   Butter tariff                             %                         8          6          4          2          0          0          0          0          0          0
   Tariff-quotas
    cheese                                   kt pw                     9          9          9          9          9         9          9          9          9          9
     in-quota tariff                         %                        50         50         50         50         50        50         50         50         50         50
     out-of-quota tariff                     %                       132        131        129        128        126       125        125        125        125        125
    SMP                                      kt pw                    90         90         90         90         90        90         90         90         90         90
     in-quota tariff                         %                         0          0          0          0          0         0          0          0          0          0
     out-of-quota tariff                     %                       132        131        129        128        126       125        125        125        125        125
   Liconsa social program                    MXN mn                3,195      3,334      3,425      3,410      3,395     3,380      3,364      3,349      3,334      3,319
   RUSSIA
   Butter tariff                             %                        20         20         20         20         20         20         20         20        20         20
   Cheese tariff                             %                        15         15         15         15         15         15         15         15        15         15
   UNITED STATES (k)
   Milk support price (b)                    USDc/litre               23         22         22         22         22        22         22         22         22          22
   Target price (l)                          USDc/litre               0.0        0.0        0.0      38.5       38.5      38.5       38.5        0.0        0.0         0.0
   Butter support price                      USD/t                 1,492      1,454      1,701      1,957      2,315     2,315      2,315      2,315      2,315      2,315
   SMP support price                         USD/t                 2,228      2,227      2,079      1,947      1,764     1,764      1,764      1,764      1,764      1,764
   Butter tariff-quota                       kt pw                    12         13         13         13         13        13         13         13         13          13
     in-quota tariff                         %                          9          9          9         9          9         9          9          9          9           9
     out-of-quota tariff                     %                       112        117        117        117        117       117        117        117        117        117
   Cheese tariff-quota                       kt pw                   132        135        135        135        135       135        135        135        135        135
     in-quota tariff                         %                        12         12         12         12         12        12         12         12         12          12
     out-of-quota tariff                     %                        84         84         84         84         84        84         84         84         84          84
   Subsidised export limits (a)
    butter                                   kt pw                    26         21         21         21         21         21         21         21        21         21
    SMP                                      kt pw                    78         68         68         68         68         68         68         68        68         68


   a) Year ending 30 June. b) For manufacturing milk. c) Year beginning 1 April. d) Prices and payments in market Euro's -see Glossary of Terms. e) Total quota, EU15
   starting in 1995. f) Calendar year minimum access for Australia, New Zealand and Canada before 1995. g) Manufacturing milk eligible for deficiency/direct
   payments. h) Paid to producers. i) Difference between transaction price and guaranteed price. j) Excludes processed cheese. k) Year beginning 1 January. l) The
   counter-cyclical payment is determined as a 45% difference between the target price and the Boston class I price. m) In addition to direct payments, a compensation
   payment is paid - equal to 80% difference between the market price and the base price (the average price of the past three years).


   Note : The source for tariffs and Tariff Rate Quotas (except Russia) is AMAD (Agricultural market access database). The tariff and TRQ data are based on Most
   Favoured Nation rates scheduled with the WTO and exclude those under preferential or regional agreements, which may be substantially different. Tariffs are averages
   of several product lines. Specific rates are converted to ad valorem rates using world prices in the Outlook. Import quotas are based on global commitments scheduled in
   the WTO rather than those allocated to preferential partners under regional or other agreements.
                                                                                                                                                  Source: OECD Secretariat.




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