TESTIMONY OF ROBERT HALVORSEN

PROFESSOR OF ECONOMICS

DEPARTMENT OF ECONOMICS

UNIVERSITY OF WASHINGTON

SEATTLE, WASHINGTON

PRESENTED TO THE

COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION

UNITED STATES SENATE

HEARING ON ECONOMIC IMPLICATIONS OF SEAFOOD PROCESSOR QUOTAS

FEBRUARY 25, 2004

My testimony discusses the economic implications of processor quotas,
including those recently authorized by the Consolidated Appropriations
Act of 2004 (P.L. 108-199) for the Bering Sea/Aleutian Islands crab
fisheries. I first address the general issue of whether fishery
rationalization programs should include explicit mechanisms to protect
processors from possible adverse effects on them. Next I discuss the
basis for the claim that individual processor quotas are a superior
mechanism, capable of protecting both processors and harvesters from any
adverse effects from a fishery rationalization program. I then discuss
the experience to date with the processor provisions in the
rationalization program for the inshore pollock fishery under the
American Fisheries Act and the implications that can be appropriately
drawn regarding the effects of the individual processor quotas
authorized for the BSAI crab fisheries.

I previously submitted written testimony on these topics to the Senate
Committee on Commerce, Science, and Transportation hearing on Bering
Sea/Aleutian Islands Crab Rationalization on May 20, 2003 (Halvorsen
2003a and 2003b). My testimony in the present statement integrates the
material in the previous statements and includes revisions reflecting
information and analyses that have become available since that time.

**Executive Summary**

My evaluation of whether fishery rationalization programs should include
explicit mechanisms to protect processors from possible adverse effects
begins by reviewing the existing theoretical literature on the effects
of individual fishing quota (IFQ) programs on processors. The review
demonstrates that the effects of IFQ programs depend critically on the
market structure of the fishery being rationalized.

Analyses that conclude that processors would incur losses as a result of
the introduction of an IFQ program (Plesha and Riley 1992, Matulich,
Mittelhammer and Reberte 1996) assume that the hypothetical fishery
being analyzed is perfectly competitive. In addition, it is assumed that
the end of the race for fish creates excess processing capacity with no
alternative uses ("nonmalleable capital"), and the firms in the industry
are not vertically integrated (that is, processors do not own harvesters
or vice versa). Given these assumptions, the introduction of an IFQ
program results in a transition period during which processors would
fail to receive any of the quasi-rents from fish and would also lose
part of the value of the capital. However, even under this extreme set
of assumptions, once the transition period is over remaining processors
might be either better or worse off than they were prior to the
introduction of the IFQ program.

Two independent analyses of actual fisheries that were commissioned by
the North Pacific Fishery Management Council concluded that the
assumption of perfect competition was inappropriate for these fisheries
and that instead processors had sufficient bargaining power to protect
themselves from potential adverse effects of IFQ programs. The first of
these studies, Halvorsen, Khalil, and Lawarrée (2000) analyzed two
alternative rationalization programs that were being considered for the
BSAI inshore pollock fishery under the American Fisheries Act (AFA):
processor-specific cooperatives (an implicit processor compensation
mechanism) and a proposal for non-processor-specific cooperatives (an
approximation to IFQs). The analysis concluded that the IFQ-like
proposal would be more favorable to independent catcher vessels, and
less favorable to processors, than the processor-specific cooperatives,
but that processors were not expected to made worse off by either
rationalization program.

The second study, Milon and Hamilton (2002), analyzed the effects on
processors and harvesters of alternative rationalization programs being
considered for the BSAI crab fisheries. The analysis concluded that both
processors and harvesters were able to gain under an IFQ program. In
contrast, under an alternative program in which processors were
allocated individual processing quotas (IPQs) equal to the total
harvest, processors would capture all of the net benefits from the
fishery and the value of harvester IFQs would be driven to zero.

I then review the available evidence on whether processors have in fact
incurred losses as a result of fishery rationalization programs. There
has been surprisingly little empirical research on this issue. The
strongest conclusion that appears to be supported by the existing
research is that some processors are made worse off and some are made
better off by the implementation of an IFQ program. A recent unpublished
study of the North Pacific halibut and sablefish IFQ program (Matulich
and Clark 2002) does claim that processors in that fishery experienced
large losses. However, a review of this study by the General Accounting
Office concluded that problems with the study's methodology and scope
bring into question the reliability of its results. My own review of
this study leads to the even more negative conclusion that critical
defects in its theoretical and empirical methodology invalidate its
results.

Next I discuss the rationales that have been advanced for compensating
processors for any losses that they may incur as the result of a
rationalization program. My primary emphasis is on the argument that if
processors are not compensated they may block the implementation of a
rationalization program, with the result that the potential efficiency
gains from the program cannot be realized. I note that there are several
problems with this argument. First, attempts to block a program unless
distributive outcomes are altered may simply reflect an attempt to
increase the size of already positive net benefits, rather than to avoid
losses. Second, if harvesters become concerned that the attempt to keep
processors safe from harm will result in losses for harvesters, they may
also try to block implementation. Lastly, when efforts to hinder
implementation are rewarded, an incentive is created for increased
obstructive behavior in the future.

My analysis indicates that there are no general theoretical or empirical
grounds for concluding that processors as a whole are likely to be
adversely affected by the implementation of an IFQ program, nor any
convincing rationale for why they should be compensated for any losses
that do occur. Nevertheless, the concept that some type of compensation
mechanism is required has been influential in the design of
rationalization programs in the North Pacific fisheries. In particular,
one alternative that has received favorable consideration, and has now
been authorized for inclusion in the rationalization program for the
BSAI crab fisheries, is a system in which harvesters receive IFQs and
processors receive IPQs, originally referred to as a "two-pie" system.

There is no previous experience with processor quotas in any real-world
fishery on which to base an evaluation of their economic implications.
Professor Scott C. Matulich of Washington State University and his
co-authors have attempted to establish a theoretical case for the
superiority of a two-pie system but have not succeeded in providing a
coherent analysis. The two-pie system was originally conjectured to be a
"policy superior initial allocation" in the Matulich, Mittelhammer and
Reberte paper that concluded that processors could be harmed by an IFQ
program in a perfectly competitive fishery. However, the subsequent
analysis of the two-pie system by Matulich and Sever (1999) concluded
that it is not capable of providing policy feasible "Pareto safe" (no
loser) outcomes in such a fishery. Matulich and Sever then consider the
case of a bilateral monopoly, even though there had been no
demonstration that processors would be adversely affected by an IFQ
program in a fishery that was a bilateral monopoly. They claim to show
that the two-pie system would be Pareto safe in this case, but this
result is in fact imposed by assumption. Therefore they fail to
establish the case that a two-pie system would be a superior allocation
of rights in any policy relevant situation.

Although processor quotas have not been tested in any real-world
fishery, the BSAI inshore pollock fishery under the American Fisheries
Act does provide experience with the effects of alternative types of
processor provisions, and this experience is potentially relevant to the
assessment of the economic implications of processor quotas. Therefore I
briefly review the major inshore provisions of the AFA.

The AFA made it possible for catcher vessels that joined a cooperative
to obtain pollock allocations. To protect processors from any adverse
effects of rationalization, the AFA required that each cooperative be
tied to a specific processing facility. Qualification for membership in
a cooperative is based on the facility to which a catcher vessel
delivered the largest share of its catch in the previous year. This was
expected to require a catcher vessel to spend a year in open access in
order to switch cooperatives. Because this would be costly, tying the
cooperatives to processing facilities gave the processors a substantial
bargaining advantage.

However, two other provisions of the AFA cooperatives reduce the extent
of this advantage. One is that a cooperative contract can provide for up
to 10% of a cooperative's harvest to be processed by a different
processing facility. This has allowed independent catcher vessels to
credibly threaten to switch to a different processor, because they can
do so without incurring the costs of going through open-access.

The other provision that is favorable for independent catcher vessels is
the rule that a cooperative has to be approved by 80% of the catching
vessels qualified for it. This rule makes it possible for independent
catcher vessels to credibly threaten to dissolve their cooperative by
voting against its continued existence. This would not only deprive the
processor of any claim on the deliveries of the independent catcher
vessels, it would also cause the processor to lose the catch allocations
of any catcher vessels that it owned, because catch allocations can only
be obtained through membership in a cooperative.

The rationalization plan for the BSAI crab fisheries authorized by the
Consolidated Appropriations Act of 2004 includes individual processor
quotas as part of a "three-pie voluntary cooperative program." The
program requires that 90% of total harvesting quotas be Class A shares
that can only be delivered to processors holding IPQs. Class B shares,
which can be delivered to processors that do not hold IPQs, account for
10% of the harvest allocation. The program also includes regional
restrictions on processing and allows for voluntary harvesting
cooperatives.

As noted above, the Milon and Hamilton analysis concluded that if
processors were allocated individual processing quotas equal to the
total harvest, processors would capture all of the net benefits from the
fishery and the value of harvester IFQs would be driven to zero.
Requiring only 90% of the harvest to be delivered to processors holding
IPQs was intended to make the bargaining power of processors and
harvesters more equal in order to avoid adverse effects on independent
catcher vessels.

The basis for the conclusion that a 90%-10% program would balance the
interests of both processors and harvesters is not clear. Some
proponents of the IPQ program have based their arguments in its favor on
an analogy with the AFA inshore pollock cooperatives, which are
generally agreed to have resulted in positive outcomes for both
processors and harvesters. But the 90%-10% IPQ program is fundamentally
different from the AFA. The only apparent similarity is that a
cooperative can deliver 10% of its harvest to an eligible processing
facility other than the one it is qualified for under the AFA, and
harvesters can deliver 10% of their harvests to processors without IPQs
under the program for the BSAI crab fisheries.

This apparent similarity is purely superficial. Under the three-pie
program processing companies are guaranteed 90% of their historic
processing shares, whereas under the AFA program a processing facility
is not guaranteed to retain any of its claim on its cooperative's
original total harvest. In addition, other differences between the AFA
and the BSAI crab rationalization program contradict the supposed
analogy.

There is in fact no basis for believing that the rationalization program
for the BSAI crab fisheries will have similar outcomes to those obtained
under the AFA cooperatives for the inshore pollock fishery. Instead, the
crab rationalization program is much more advantageous for processors
both because of the guarantee of 90% of their processing history and
because of the regionalization restrictions. The program is also far
more complex, making it problematic that market processes can be relied
on for the determination of appropriate prices. And there is less of a
margin for error in case of unintended distributional effects because
the net benefits to the fishery as a whole are expected to be
substantially smaller than under the AFA. Some of the major differences
between the two programs are summarized in the Appendix.

**1. Theoretical Analysis of the Effects of IFQ Programs on Processors**

Unless specified otherwise, the phrase "IFQ program" will refer to a
rationalization program based on the allocation of quota shares for
harvesting only, and in which the IFQs are allocated only to harvesters.
This is in contrast to possible rationalization programs that include
IFQs but also make explicit provision for compensating processors for
possible negative effects on them, either by allocating part of the
total harvesting quota shares to them or by incorporating processing
quotas as well, as in a "two-pie" system.

Also, the phrase "processors" will refer to the processors that have
been operating in the fishery prior to the time that it is rationalized.
One common result of rationalization is the entry of new processors, who
are obviously made better off by the opportunities created by
rationalization. An appraisal of the overall effect of a rationalization
program on the processing sector should clearly take the positive
effects on new processors into account as well. However, my review of
the theoretical analysis of the effects of IFQ programs on processors
will concentrate on the effects on previously operating processors only.

In analyzing and predicting the effects of an IFQ program on the
well-being of incumbent processors, it is critical to take into account
the specific conditions of the fishery being considered. One important
set of conditions concerns the market structure of the fishery.

[Implications of alternative models of market structure]{.underline}

Analyses that conclude that processors would incur losses as a result of
the introduction of an IFQ program (Plesha and Riley 1992, Matulich,
Mittelhammer and Reberte 1996) assume that the hypothetical fishery
being analyzed is perfectly competitive, the end of the race for fish
creates excess processing capacity with no alternative uses
("nonmalleable capital"), and the firms in the industry are not
vertically integrated (that is, processors do not own harvesters or vice
versa). Given these assumptions, the introduction of an IFQ program
would result in a transition period during which processors would fail
to receive any of the quasi-rents from fish and would also lose part of
the value of the capital.

However, as Matulich, Mittelhammer and Reberte (1996) note, once the
transition period is over, remaining processors might be either better
or worse off than they were prior to the introduction of the IFQ
program. Therefore, even under this extreme set of assumptions, this
theoretical analysis would support the need for processor compensation
only in the short-run, as recently noted by the North Pacific Fishery
Management Council's Scientific Statistical Committee (2004).

Furthermore, if all other circumstances were the same, but processors
and harvesters were vertically integrated (as for example in a fishery
comprising only catcher/processors), then processors could not be made
worse even during the short-run because they would receive the full
benefits of the rationalization program (Matulich and Sever 1999). In a
mixed case, with some processors vertically integrated and others not,
the incidence of short-run gains and losses might differ by type of
entity, with non-integrated processors being more susceptible to
suffering losses than integrated ones (Halvorsen, Khalil, and Lawarrée
2000).

Perfect competition is one of the standard models used in economic
analyses, in large part because of its analytical simplicity. However,
it is not in general directly applicable to the analysis of an IFQ
program in a real-world fishery, because actual fisheries tend to have
more complex market structures.

Examples of other standard models familiar from economic theory include
monopoly (a single harvester facing perfectly competitive processors), a
monopsony (a single processor facing perfectly competitive harvesters),
and a bilateral monopoly (a single harvester facing a single processor).
In the first case, the monopolist would obtain all the net benefits of
the fishery, in the second case the monopsonist would, and in the third
case the division of net benefits would depend, among other things, on
the alternative opportunities available to the participants.

These models also have the advantage of analytical simplicity, but are
also not in general directly applicable to the analysis of the effects
of IFQ programs for two reasons. First, the characteristics of the
market structures of real-world fisheries are more complex than such
simple theoretical models imply. And second, if a fishery did conform to
one of these model specifications, then it would be expected to be
capable of maximizing aggregate net benefits on its own, which would
preclude the development of a race for fish. For instance, a monopolist
harvester would optimally allocate its fleet over time rather than
engaging in a race to fish between its own vessels. Accordingly,
rationalization programs such as an IFQ program would be redundant.

However, consideration of these standard models does illustrate the wide
range of results possible with respect to the division of the net
benefits of a fishery, and therefore the need to take market structure
into account when assessing the effects of an IFQ program on the
participants in the fishery. Also, to the extent that a fishery being
considered for an IFQ program has characteristics similar to a standard
model; some inferences may be drawn about the probability that
processors could be adversely affected by the implementation of the
program. For example, other things equal, implementing an IFQ program in
a fishery with very few processors and many harvesters is less likely to
result in processor losses than in a fishery with many processors and
harvesters.

As suggested by these examples, market structure is important because it
affects the relative bargaining power of harvesters and processors.
Because bargaining power is critical in determining the distributive
outcomes of IFQ programs, and the characteristics of market structure
differ greatly across fisheries, evaluation of the distributive effects
of rationalization policies requires fishery specific analyses. Two
recent examples of such analyses with direct implications for the
evaluation of processor quotas are Halvorsen, Khalil, and Lawarrée's
(2000) analysis of rationalization programs for the BSAI inshore pollock
fishery and Milon and Hamilton's (2002) analysis of rationalization
programs for the BSAI crab fisheries.

[Halvorsen, Khalil, and Lawarrée study]{.underline}

The analysis by Halvorsen, Khalil, and Lawarrée was conducted on behalf
of the North Pacific Fishery Management Council and considered the
prospective distribution of net benefits from rationalization of the
inshore sector of the Bering Sea/Aleutian Islands (BSAI) fishery under
the American Fisheries Act (AFA). The study evaluated, and rejected, the
suitability of several standard economic models that had been proposed
for application in this fishery and stressed the need to employ the
tools of game theory (e.g., Nash 1953, Osborne and Rubinstein 1990) to
evaluate the possible outcomes of alternative rationalization policies.

*Applicability of standard economic models:*

Halvorsen, Khalil, and Lawarrée noted that the inshore fishery was
unsuitable for analysis using a model of perfect competition as in
Plesha and Riley (1992) and Matulich, Mittelhammer and Reberte (1996).
Three companies dominated the processing sector, while the harvesting
sector could legally negotiate under the umbrella of a bargaining
association. Therefore the perfectly competitive model, in which each
participant takes price as given by the market, and does not pay
attention to what others in the industry are doing, did not apply to
this fishery.

Wilen (1998) had argued that the inshore fishery was best characterized
as a single monopsony, in part because of the dominant position of two
firms in the main market for surimi products. Halvorsen, Khalil, and
Lawarrée concluded that Wilen's analysis substantiated the hypothesis
that processors had significant market power, but that the fishery was
not a monopsony.

One reason given for rejecting the conclusion of monopsony was that for
the processors to behave as a monopsony they would have to overcome
serious economic and legal difficulties associated with being a
successful cartel. Also, there was evidence that the processors had not
always acted in a united way, as they would have if they were a
monopsony. For example, when the Bering Sea Marketing Association (BSMA)
went on strike against several processors in 1999, the largest processor
in the fishery, which was not a party to the negotiations, required its
fleet to continue fishing, making prolongation of the strike too costly
to both the members of the BSMA and their processors. The existence of
the BSMA also argued against the conclusion that the inshore sector was
a monopsony, because its collective bargaining is not consistent with
harvesters acting as passive price takers. Lastly, as noted above, an
effective monopsony would have been capable of substantially
rationalizing the fishery without the intervention of the AFA.

The existence of the BSMA was considered especially important by
Matulich and Sever (1999), who argued that it implied that the inshore
sector was a single bilateral monopoly. They claimed that the
dissemination of price information to each processor by the marketing
association during the course of negotiations allowed the processors to
unify even though they were not sharing information among themselves. In
other words, Matulich and Sever were claiming that the BSMA, acting as
the representative of independent catcher vessels, unwittingly made it
possible for the processors to unite against its own clients.

One serious factual problem with Matulich and Sever's analysis is that
the BSMA did not represent all of the independent catcher vessels, and
the largest processor was not a party to the negotiations. Also, the
theoretical analysis left two critical questions unanswered. First, why
would the marketing association not take advantage of the processors'
lack of communication and play one against the other by misrepresenting
received price offers? Second, even if it did not do so, why would
information on prices be sufficient to allow the processors to overcome
the other economic and legal difficulties hindering their behavior as a
single agent?

Another critical factual problem with Matulich and Sever's analysis is
that it ignored the existence of substantial vertical integration in the
fishery. Based on National Marine Fishery Service data, processor
controlled vessels harvested approximately half the total allocation of
catch to the inshore sector. This makes the existence of a united
harvesting sector implausible, because processor controlled vessels
would be subject to conflict of interest issues and could not be
expected to consider only the effects on harvesters of the results of
negotiations with processors.

Furthermore, the degree of vertical integration was not uniform across
processors. For example, two of the largest processors, which together
accounted for about two-fifths of the total inshore catch, were
estimated to obtain more than eighty percent of their fish from their
own processor controlled vessels, whereas another large processor, with
about one-fourth of the total inshore allocation, obtained virtually all
of its fish from independent catcher vessels. The differences in the
degree of vertical integration implied differences in the effects of a
given negotiated outcome, complicating any effort of the processors or
harvesters to act in unison.

*Bargaining power:*

Because these standard economic models could not be directly applied to
the inshore fishery, Halvorsen, Khalil, and Lawarrée (2000) used
concepts from game theory to evaluate the nature of competition in the
industry, and the resulting balance of bargaining power. They concluded
that the processors had a number of important bargaining advantages. The
large portion of the harvest caught by processor controlled vessels
reduced the reliance of the vertically integrated processors on supply
from independent catcher vessels, while also providing processors an
informational advantage because the independent catcher vessels they
bargained with did not own inshore processing plants. Also, because the
processing sector was highly concentrated and new entry was prohibited
under the AFA, processors would be expected to realize that aggressive
tactics yielding short-term gains were unlikely to be profitable in the
long-run. Independent catcher vessels did have one bargaining advantage
in that they were able to legally bargain as a group. However, it was
concluded that on balance the processors had substantially more
bargaining power than independent catcher vessels.

The Halvorsen, Khalil, and Lawarrée analysis noted that rationalization
of the inshore pollock fishery was expected to result in a large
increase in the effective amount of processing capacity, which would
provide more opportunities for processors to engage in aggressive
competition, but the long-term incentives for refraining from doing so
would remain. Therefore they concluded that the rationalized fishery
would be characterized by "moderate but not cutthroat competition" among
processors.

These conclusions concerning bargaining power were then applied to
analyze two alternative rationalization programs being considered by the
Council: processor-specific cooperatives (an implicit processor
compensation mechanism) and the Dooley-Hall proposal for
non-processor-specific cooperatives (an approximation to IFQs).
Halvorsen, Khalil, and Lawarrée concluded that there was a significant
probability that some independent catcher vessels would be adversely
affected by the requirement of processor-specific cooperatives, but the
positive net benefits from the reallocation aspect of the AFA, as well
as the potential net economic benefits from rationalization of the
fishery, decreased the likelihood that they would be adversely affected
relative to the situation pre-AFA. They also concluded that the
Dooley-Hall proposal would be more favorable to independent catcher
vessels, and less favorable to processors, than the processor-specific
cooperatives. This did not imply that processors were expected to be
harmed by a rationalization program based on the Dooley-Hall proposal,
only that they would not be as well off as under the AFA provisions for
cooperatives.

[Milon and Hamilton study]{.underline}

In its deliberations concerning rationalization of the BSAI crab
fisheries, the North Pacific Fishery Management Council considered the
use of a program similar to the AFA cooperatives in the inshore pollock
fishery, as well as a fundamentally different type of rationalization
program based on the use of both IFQs for harvesters and individual
processing quotas (IPQs) for processors. As in the case of the inshore
pollock fishery, the Council commissioned an independent economic
analysis of the proposed alternatives.

The study, Milon and Hamilton (2002), draws conclusions for economic
performance under the assumptions that the harvesting sector is
perfectly competitive and the processing sector contains few enough
firms that it might be able to exercise market power. One of the
rationalization programs analyzed is a two-pie system in which
processors are allocated IPQs for the entire harvest. Milon and Hamilton
conclude that each processor would maximize profits by paying the lowest
ex vessel price that is required to support harvester delivery. The
result would be that processors capture all of the net economic benefits
from the fishery. The allocation of IFQs in such a program would be
redundant, and the value of harvester IFQs would be driven to zero.

Milon and Hamilton also consider a program with both Class A harvesting
quotas that must be delivered to processors that hold IPQs, and Class B
harvesting quotas that may be delivered to any processor. If all
harvesting quotas are Class B, the outcome is the same as for an IFQ
only program, with the likelihood that both harvesters and processors
would benefit from rationalization. As the ratio of A to B quotas
increases, processors are expected to fare better, and harvesters to
fare worse. And when all the quotas are Class A, processors capture all
of the net economic benefits from the fishery.

The study also considers the effects of regionalization of the
fisheries. It concludes that regionalization reduces cost efficiency by
imposing constraints that prevent harvest within a region being
transferable to other regions. In addition, regionalization increases
the market power of processors, resulting in lower ex vessel prices.

Milon and Hamilton's assumption that the harvesting sector is perfectly
competitive is not completely accurate, because catcher vessels have
negotiated prices collectively through the Alaska Marketing Association,
and have engaged in strikes. However, the effectiveness of strikes has
been undermined because catcher processors have continued to fish during
them. Also, the lengthening of fishing seasons under rationalization is
expected to decrease the effectiveness of collective bargaining (North
Pacific Fishery Management Council, 2002, page 376). Therefore, the
assumption that the harvesting sector is competitive does not invalidate
their conclusions concerning the qualitative effects of IPQs and
regionalization.

[Summary]{.underline}

Theoretical analyses of hypothetical fisheries characterized by perfect
competition, nonmalleable capital, and no vertical integration have
concluded that processors will be adversely affected during the
transition to an IFQ program. The analyses do not provide a basis for
expecting negative effects on processors in any real-world fishery that
does not share these same characteristics.

In general, the market structures of real-world fisheries are more
complex than the simple perfect competition model. This was found to be
the case in independent analyses of the BSAI inshore pollock fishery and
the BSAI crab fisheries that were commissioned by the North Pacific
Fishery Management Council. Both of these studies concluded that
processors had sufficient bargaining power to protect themselves from
potential adverse effects of IFQ programs.

**2. Empirical Analysis of the Effects of IFQ Programs on Processors**

There has been surprisingly little empirical research on the actual
effects of IFQ programs on the processing sector. However, there are
three studies that have examined the effects of IFQ programs in the
United States and British Columbia halibut fisheries. All three studies
document the fact that there were many winners from the programs in the
form of new processors who entered the fisheries in order to benefit
from the opportunities created by the IFQ programs. However, one study
differs from the others with respect to its conclusions concerning the
effects of the IFQ programs on processors that had been operating in the
fishery before the programs were adopted.

[British Columbia Study]{.underline}

The British Columbia halibut fishery was studied by Casey et al*.*
(1995). The IFQ program was implemented in May 1991 and the study is
based on the results of in-person interviews with processors in
September 1993 and a mail survey of harvesters in May 1994. The study
documents large net economic benefits from rationalization of this
fishery, including the ability to switch from mostly frozen products to
more highly valued fresh fish. Ex vessel price is estimated to have
increased by more than half. The survey of processors indicated that
some of the processors that had been operating prior to the IFQ program
felt that it had made them better off while some felt it had made them
worse off.

[General Accounting Office Study]{.underline}

The GAO study (United States General Accounting Office 2002) based its
determination of the effect of IFQ programs on processors on an
assessment of the economic effects of the North Pacific halibut and
sablefish IFQ program. The study methodology included analysis of data
from the National Marine Fisheries Service and the Alaskan Department of
Fish and Game, interviews with fishery participants, and a review of a
study commissioned by the Alaskan Department of Fish and Game (Matulich
and Clark 2002).

The GAO's summary of its main conclusions was (page 20): "Some
processors were adversely affected by the implementation of the halibut
and sablefish IFQ program while others benefited. However, quantifying
the economic effects of the IFQ program on processors is difficult
because much of the data needed to measure changes in profitability are
proprietary. Furthermore, other factors besides the IFQ program may lead
to changes in processors' economic situation."

The GAO's review noted that the Matulich and Clark study of the halibut
and sablefish IFQ program had concluded that processors were hurt
significantly by the IFQ program. However, the GAO also noted that it
could not validate or replicate the study's results, and that it had
identified a number of problems with the study's methodology and scope
that brought into question the reliability of the study's estimates.
Among the problems identified by the GAO were: the study's assumption
that all costs except labor and material inputs were constant over a
seven year period was clearly unjustified, the choice of base year
exaggerated the size of any negative effect, the results might not be
representative of the industry as a whole, and the document requesting
economic information from processors might have biased participant
responses.

In April 2002 I presented a critique of the Matulich and Clark study in
public testimony before the North Pacific Fishery Management Council.
The conclusions I reached concerning the reliability of the study's
results were even more negative than those reached by the GAO. My
analysis of the study is summarized in the following sub-section.

[Matulich and Clark Study]{.underline}

The Matulich and Clark study assumes that the effect of the IFQ program
on processors' economic welfare can be measured as the change in "quasi
rents" retained by processors, which they define as the change in
revenues in excess of all variable processing costs. However, the use of
this measure to evaluate welfare changes is not consistent with economic
theory and would not provide reliable estimates of changes in welfare
even if it were estimated accurately. Furthermore, their empirical
methodology is deeply flawed and would be incapable of providing
reliable estimates of welfare change even if a theoretically correct
measure were being used. In short, the study measures the wrong thing,
and measures it poorly.

*Theoretical assumptions:*

Quasi-rents are fundamentally a short-run concept. The short-run is
defined as the period of time during which at least one of the firm's
input quantities cannot be changed. It should be noted that, although it
is customary for expository reasons to use capital inputs as examples of
fixed inputs, and labor and materials inputs as examples of variable
inputs, some capital inputs may in fact be variable in the short-run
(e.g., motor vehicles, personal computers), and some labor and materials
inputs may be fixed (e.g., because of transportation costs, job-specific
human capital, or contractual commitments).

The difference in the short-run between the firm's total revenue and
total expenditures on variable inputs is defined as the quasi-rent to
the fixed inputs. That is, the amount in excess of the amount required
to keep the fixed inputs in their current use. Thus a decrease in
quasi-rents would indicate a decrease in the firms' welfare in the
short-run.

In the long-run, by definition, all inputs are variable, and the amount
required to keep inputs in their current use is equal to what they could
earn elsewhere, including a normal rate of return to capital. Therefore
the relevant concept for measuring a firm's welfare change in the
long-run is that of economic profit. Quasi-rents would have no
operational meaning, being simply equal to economic profit if correctly
measured.

There is no direct connection between the economic concepts of the
short- and long-run and calendar time. Instead, the amount of time
required before all inputs can be considered variable will vary across
industries, although it is plausible that in any given industry the
number of inputs that are fixed will decrease with the length of time
being considered.

Thus the first-step in attempting to use quasi-rent data to measure
changes in a firm's welfare should be a careful evaluation of which, if
any, inputs are fixed, given the period of time over which changes are
being evaluated. Simply assuming that labor and material inputs are
variable and all other inputs are fixed, as done by Matulich and Clark,
is not adequate even for a period as short as a year, and is clearly
unjustified for the seven-year period over which they evaluated changes.

To illustrate the type of error their assumption can introduce in the
measurement of welfare change, consider the results of applying Matulich
and Clark's definition of quasi-rents to evaluate changes that are
distant enough in time for all inputs to be variable. Further suppose
for ease of exposition that in both periods the price of processed fish
is \$1.00, the cost of raw fish is \$0.40, and average cost is \$0.50.
Thus economic profit per unit would be equal to \$0.10 in both periods
and the firm's welfare would be unchanged. Nevertheless, if the firm had
become more labor intensive over time, the unit quasi-rent as calculated
by Matulich and Clark would have indicated a decrease in welfare. For
example, if average costs were split equally between capital and labor
costs in the first period, but labor costs accounted for 80% of average
costs in the second period, the unit quasi-rent as calculated by
Matulich and Clark would have decreased from \$0.35 to \$0.20, a
decrease of 43%.

While this example is hypothetical, it does illustrate that quasi-rent
as evaluated by Matulich and Clark does not provide reliable estimates
of changes in welfare over longer periods of time. More specifically,
increases in labor intensity, other things equal, will result in
decreases in welfare as evaluated by their measure.

Lastly, even if reliable estimates of welfare changes were obtained,
their normative significance would depend in part on the benchmark on
which they were based. Matulich and Clark choose as their benchmark the
welfare of processors in 1992-1993, asserting that this period
represented an open-access long-run equilibrium. One reason for doubting
this assumption is that it is not clear that the fishery would have
stabilized at the 1992 levels in the absence of an IFQ program. If not,
then a more appropriate benchmark would be the counterfactual case of
how the fishery would have developed in the absence of a program.

More directly, the 1992-1993 experience reflected the fact that fishery
participants expected an IFQ program to be implemented, and this
provided incentives for different behavior than would have occurred in
an open-access equilibrium. For example, harvesters might have
considered it worthwhile to fish at a loss in order to try to capture or
protect catch history.

*Empirical methodology:*

Matulich and Clark obtained the data used to estimate changes in
quasi-rents from a questionnaire distributed to a sample of processors.
The principal types of data requested were total revenue, total raw fish
cost, and total variable processing costs, defined as the aggregate of
several specific cost elements, including custom processing fees, wage
and housing costs for direct labor, and packaging and freight costs.
Data on total revenue and total raw fish cost were verifiable from
Alaska Department of Fish and Game data, the data for variable
processing costs were not.

Economists using survey research techniques have noted that the design
of a questionnaire can result in a number of different types of biases.
In particular, respondents may engage in strategic misrepresentation of
the data if it is clearly in their economic interests to do so.
Therefore, one of the most important protocols for survey design is to
avoid providing material that establishes a clear link between a
participant's responses and his or her economic interests.

The survey design used by Matulich and Clark clearly violates this
protocol. The material accompanying the questionnaire noted that
Professor Matulich was the principal investigator, that he had written
an article showing that the type of program used for halibut and
sablefish transfers wealth from processors to harvesters, and that the
purpose of this survey was to see if that was true empirically. It was
further noted that the purpose of the study was to obtain information
for use in evaluating future rationalization programs; in particular to
help policy makers to avoid unintended distributive effects, and that
distributional impacts would be based on measuring changes in
processors' total revenue minus various processing costs.

This material would have made it clear to the processors how their
responses could benefit or harm them in the future when other fisheries
in which they participated were rationalized, and this would have
provided an incentive for strategic misrepresentation. At a minimum,
processors that had benefited from the IFQ program would realize that
reporting this might be harmful to their future interests, and therefore
have simply not participated in the survey.

An important difficulty in assessing the treatment of a number of
empirical issues is that the discussion in the report is often
qualitative where it would normally be expected to be quantitative.
Examples include the section on data problems where it is noted that it
was "not uncommon" for aggregation problems to prevent accurately
measuring variable processing costs, and that "some" firms were unable
to access historical data. No information is provided on the number of
firms that were eliminated from the sample for these reasons. Similarly,
they report that there were a "few" instances where inventory issues
were "problematic".

In addition, Matulich and Clark report that some firms were considered
to be outliers, usually by exhibiting unrealistically high quasi-rents.
These firms were contacted for an explanation, and if it was not
satisfactory, the firm was dropped from the sample or its data replaced
by the sample average. The number of firms considered outliers, how many
were considered to report too high quasi-rents, how many justified their
data, were dropped, or had their data replaced by sample averages, is
not specified.

Lastly, and most surprisingly, Matulich and Clark do not report the
number of participants included in the final data. They report that the
number of buyers/processors asked to participate in the survey was 53
for halibut and 46 for sablefish, accounting for 88% to 96% of all fish
purchased, and that the retained survey data accounts for 52% to 61% of
fish purchased. Given the degree of concentration in these fisheries,
this may or may not represent a substantial percentage of the number of
total firms.

Matulich and Clark do note that the final sample does not include data
for any firms that exited the fisheries, which accounted for one-fifth
of the total 1992-1993 catch in both fisheries. Although these firms
might be expected to have been less profitable than the surviving firms,
they are assumed to have had the same quasi-rent share in 1992-1993 as
the surviving firms. Similarly, surviving firms that lost market share
are assumed to have had the same quasi-rent share as the firms
increasing market share.

Matulich and Clark conclude from their analysis that 82% of the halibut
processing sector (as measured by raw fish weight rather than number of
firms) lost quasi-rents relative to the pre-IFQ period, with the average
loss being 56%. Even more dramatic results are reported for the
sablefish processing sector. However these results cannot be considered
to be reflective of the actual effects on the economic welfare of
processors. The basic problem with their approach is that the results
depend on the estimates of total variable processing costs, which in
turn depend on arbitrary, and unrealistic, assumptions concerning which
inputs are variable over a seven-year time span. In addition, the
empirical methodology is deeply flawed, not least because estimation of
total variable costs depends on survey data from processors, who can be
expected to clearly realize that there are incentives for strategic
misrepresentation.

[Summary]{.underline}

All three empirical studies of the actual effects of IFQ programs on the
processing sector document the fact that there were many winners from
the programs in the form of new processors who entered the fisheries in
order to benefit from the opportunities created by the IFQ programs.
This suggests that if processors that had been operating in the
fisheries before the programs were introduced suffered losses, as
claimed by Matulich and Clark, the reason is unlikely to have been
simply that ending the race for fish created excess capacity, as assumed
in the Matulich, Mittelhammer and Reberte (1996) model.

**3. Rationales for Compensation**

As discussed in the previous two sections, there are no general
theoretical or empirical grounds for concluding that processors as a
whole are likely to be adversely affected by the implementation of an
IFQ program. However, it is possible that situations could arise where
processors would be adversely affected, at least in the short-run.
Therefore it is useful to consider whether it would be desirable to
incorporate measures to prevent such adverse effects from occurring, or
to compensate processors if they do occur. Arguments have been put
forward for preventing processors from being harmed by rationalization
programs based on considerations of both efficiency and equity. Each
type of rationale will be considered in turn.

[Efficiency]{.underline}

One rationale advanced for compensating processors for possible losses
is that not doing so could have adverse consequences for economic
efficiency by creating impediments to the implementation of
efficiency-enhancing rationalization programs. This possible source of
inefficiency is emphasized by Matulich, Mittelhammer, and Reberte
(1996). Having concluded that processors could suffer losses as the
result of the introduction of IFQs in a perfectly competitive fishery,
they note (page 112), "These losses could promote political gridlock and
jeopardize adoption of an I(F)Q policy unless they are fully compensated
or redistribution is avoided by a policy-superior initial allocation of
rights to both harvesters and processors."

This argument assumes that processors do not have enough economic
bargaining power in rationalized fisheries to avoid losses, but do have
enough political bargaining power to block efficiency-enhancing
rationalization programs. However, as the Halvorsen, Khalil, and
Lawarrée analysis of the BSAI pollock fishery indicated, processors may
in fact have more bargaining power than harvesters in real-world
fisheries.

Therefore, a situation in which processors seek rent-enhancing
mechanisms as the price of agreeing to rationalization programs may
simply reflect the desire of processors to obtain a larger share of the
net benefits the program would create, rather than that they are seeking
to protect themselves from suffering losses. Under these circumstances,
utilizing mechanisms to enhance the processors' share of the net
benefits could actually create new impediments to the implementation of
rationalization programs by causing harvesters to fear that they would
lose out from the implementation of the program.

The history of the American Fisheries Act is instructive in this regard.
Rationalization of the BSAI pollock fishery was based on the creation of
harvesting cooperatives. Processors in the inshore sector expressed
concern that cooperatives might put them at a bargaining disadvantage.
In response, the AFA rules for cooperatives required that they be
processor-specific, and that membership in the cooperative for each
processor was limited to vessels that were qualified for that processor,
as determined by where a catcher vessel had previously delivered the
largest share of its total catch.

In response, an association of independent catcher vessel owners
expressed concern that the AFA rules for inshore cooperatives would harm
them because of the restrictions placed on where they could market their
fish, and proposed an alternative set of rules. Resolution of this
conflict required extensive hearings before the North Pacific Fishery
Management Council. In addition, concerns were raised about the effects
of processor-specific cooperatives on small entities as defined in the
Regulatory Flexibility Act.

Another possible disadvantage of responding to processors' resistance to
the adoption of a rationalization program by incorporating mechanisms to
enhance their position is that doing so might have adverse efficiency
consequences in the longer run. If it appears that policy makers are
willing to appease opponents of rationalization by enhancing their
rewards, this will provide incentives for increased obstructive behavior
in the future, and thereby imperil the implementation of rationalization
programs in other fisheries.

[Equity]{.underline}

The other principle rationale for compensating processors against
possible losses is that it would be inequitable not to do so. For
example, Plesha and Riley (1992) and Matulich, Mittelhammer, and Reberte
(1996) argue that there is a Fifth Amendment "taking" issue if the
rationalization of a fishery results in losses for processors.

Without attempting to address the implied legal issues, some
observations can be made on whether investment losses from
rationalization are inequitable from an economic point of view. It seems
unlikely that the investments assumed to be at risk from rationalization
were made with the anticipation that the race for fish was certain to be
the long-run equilibrium outcome for the fishery in question. Faced with
an uncertain future, processors' investment decisions can be assumed to
have taken into account the possibility of various alternative
scenarios, including regulatory policies to end the race for fish.
Accordingly, investment decisions would be optimized to reflect
trade-offs between the various possible future outcomes. For example,
there might be a trade-off between further increasing investment in
capacity in order to secure competitive advantages by, for example,
deterring the entry of new processing firms into the fishery, versus the
advantage of having the smaller amount of capacity that would be optimal
if the race for fish were ended. It is not clear why losses that had
been anticipated to occur under a particular scenario should instead be
compensated on equity grounds when that scenario turns out to be the
actual outcome.

Another equity issue concerns the distribution of net benefits within
the processing sector. For example, in a processing sector comprising
some firms that are vertically-integrated and some that are not, the
non-integrated processors would be more susceptible to suffering losses
from rationalization than would the integrated processors. But the
choice to not be vertically-integrated presumably reflects a judgment by
these firms that they obtained enough economic advantages by refraining
from acquiring harvesting capacity to compensate for the increased risk
of losses if the fishery were rationalized. Adopting a policy to
compensate all processing firms for possible losses would change the
anticipated benefits and costs of these business decisions after the
fact and thereby effectively discriminate in favor of the non-integrated
firms, partly at the cost of harvesters.

**4. Processor Compensation Mechanisms**

Although there are no general theoretical or empirical grounds for
concluding that processors as a whole are likely to be adversely
affected by the implementation of an IFQ program, nor any convincing
rationale for why they should be compensated for any losses that do
occur, the concept that some type of compensation mechanism is required
has been influential in the design of rationalization programs in the
North Pacific fisheries.

The National Research Council (1999) heard considerable testimony from
processors in the North Pacific region concerning the potential adverse
effects on them of IFQ programs. The NRC considered the desirability of
either allocating some initial quota to processors or establishing a
separate, complementary processor quota system (the "two-pie" system),
and found no compelling reason to recommend the inclusion of either. It
also noted that quota allocation would be a long-term arrangement,
whereas processor' losses occur only once, and suggested the
consideration of compensating processors through other means, such as
buyouts.

# However, consideration of compensation programs in the North Pacific fisheries has focused on programs incorporating processor quota. For example, in June 1995 the North Pacific Fishery Management Council identified the BSAI pollock fishery as the next rationalization program following the halibut/sablefish IFQ program. One of the alternatives explicitly considered was a "two-pie" system, in which harvesters would receive individual fishing quotas and processors would receive individual processing quotas. However work on developing the program was abandoned when the 1996 appropriations bill prohibited the expenditure of federal funds for development of new IFQ programs.

# 

# A four-year moratorium on submission of new IFQs was imposed as part of the Sustainable Fisheries Act of 1996, but rationalization of the BSAI pollock fishery was made possible by the American Fisheries Act of 1998 (AFA). Because IFQ programs were not allowed, the rationalization program for the BSAI fishery was based on harvesting cooperatives. In order to protect processors in the inshore sector from claimed possible adverse effects from the rationalization program, the inshore harvesting cooperatives were tied to individual processing facilities. In addition, the AFA protected existing processors from the entry of new processors to the inshore sector.

In its deliberations concerning rationalization of the BSAI crab
fisheries, the Council considered the use of a program similar to the
AFA cooperatives in the inshore pollock fishery, but decided instead to
recommend a program based on the allocation of both processing and
harvesting quotas. The "three-pie voluntary cooperative program"
proposed by the Council, and authorized by the Consolidated
Appropriations Act of 2004, also includes regional restrictions on
processing and allows for voluntary harvesting cooperatives.

As background for the discussion of the economic implications of
processor quotas in the BSAI crab fisheries it is useful to first
briefly consider the theoretical case that has been put forward in favor
of the use of a two-pie system incorporating processor quotas. As will
be discussed, this theory in fact provides no basis for evaluating the
economic implications of processor quotas. Accordingly, it is useful to
consider the experience to date in the inshore pollock fishery under the
AFA to evaluate the implications of the processor provisions in this
program for the expected performance of processor quotas in the BSAI
crab fisheries.

**5. The Two-Pie Theory**

The theoretical case for the use of processor quotas in a two-pie system
has been developed by Professor Scott C. Matulich of Washington State
University and his co-authors with the financial support of North
Pacific processors. As noted earlier in my testimony, Matulich,
Mittelhammer and Reberte (1996) show that under certain assumptions an
IFQ program in a perfectly competitive fishery could result in
transitional losses to processors. They then conjecture (page 126) that
there might be a "policy-superior initial allocation in which
symmetrical rights are issued to both sectors" such that neither sector
loses from the rationalization program. They then suggest "a 'two-pie'
allocation, in which catching rights are awarded to fishers and
processing rights are awarded to processors," as a candidate worthy of
consideration.

Matulich and Sever (1999) consider the application of a two-pie
allocation to a fishery that is perfectly competitive and conclude that
it is not capable of providing policy feasible "Pareto safe" (no loser)
outcomes. Since the existence of perfect competition was one of the
necessary conditions for the Matulich, Mittelhammer and Reberte
demonstration that processors could lose under an IFQ program, the most
direct conclusion from this analysis would be that a two-pie allocation
was not in fact "policy-superior." However, Matulich and Sever then
consider the application of a two-pie allocation in a fishery that is
assumed to be a bilateral monopoly, for which there had been no analysis
of processor losses under an IFQ program. They then claim to show that
the two-pie system is guaranteed to be Pareto safe not only at the
aggregate level but also at the level of individual participants.

Matulich and Sever's attempt to demonstrate that a two-pie allocation
would be Pareto safe in a bilateral monopoly is based on a series of
dubious assumptions. The first is their assumption that the bilateral
monopoly would be able to negotiate an ex vessel price that maximized
joint profits under conditions of a race for fish, but would be unable
to negotiate rationalization measures that would end the race for fish
and thereby increase the potential joint profits. No explanation is
given for this assumed constraint on the bilateral monopoly's ability to
maximize joint profits. Instead it is simply implicitly assumed that the
race for fish can be ended only by an externally imposed rationalization
program.

In their analysis of the two-pie allocation, efficiency is assumed to be
attained through quota trading, and to be independent of the bargained
ex vessel price. In particular, they note that the ex vessel price might
be outside of the Pareto safe range. However, they argue that the actual
price will fall within the Pareto safe range because (page 214):

> *"While the efficient price does not guarantee Pareto safety,
> intrinsic bargaining behavior should, provided the bargaining
> association is responsive to the well being of its entire membership.
> Bargaining agents have internal incentives to negotiate a price that
> not only maximizes joint profits (efficiency) but also leaves no
> member worse off. ...at least one Pareto-safe price exists -- the open
> access exvessel price, P^0^...As long as the parties desire to reach a
> Pareto-safe agreement, they can do so by settling on a rent share that
> implies P^0^ as the ex vessel price. Thus, there are no functional
> impediments to achieving an efficient price that is also Pareto
> safe."*

Matulich and Sever then use the Nash (1953) bargaining solution concept
to indicate how the rent shares might be determined, given that "the
bargaining agents are assumed to act so as to leave no member worse off
under ITQs relative to open access" (page 214). The solution of the Nash
model does not strengthen the claim that the two-pie allocation is
Pareto safe, but instead is performed under the assumption that the
price must fall within the Pareto-safe range.

In short, Matulich and Sever's claim that "\[e\]ach sector is guaranteed
sufficient quasi-rents to make all members Pareto safe" (page 214) is
based simply on the assumption that bargaining agents will want and be
able to set prices that are Pareto safe for all their members. This
assumption is merely asserted, rather than derived from economic theory,
and is unlikely to be satisfied in a real-world fishery, in which each
side would contain heterogeneous participants. It is not obvious, and
Matulich and Sever do not suggest, how such a difficult principal-agent
problem in each sector could be structured so that the agent is
constrained to leave no member worse off.

Even if it is assumed for the sake of argument that both sides of the
bilateral monopoly desire agreements that are Pareto safe as among their
own members, a Pareto safe price need not be the outcome of the
bilateral monopoly negotiation. This can be demonstrated using a Nash
bargaining model with the outside options for both sides correctly
specified.

To determine the outside option for the harvester sector of the
bilateral monopoly, consider what its alternative would be if it did not
reach an agreement with the processor sector. Because it would have IFQs
it could harvest the fish, but the processor sector could simply refuse
to process the harvest. Therefore the outside option for the harvester
sector is zero rent. Similarly, the harvester sector could threaten to
not fish, so that the outside option for the processor sector is also
zero rent, assuming that it has no processor controlled vessels. With
these outside options, there is no reason to assume that the bargaining
outcome would be Pareto safe. And if the processor sector also owns some
catcher vessels, the outcome could be very unfavorable for harvesters,
as shown in Halvorsen, Khalil, and Lawarrée (2000).

To summarize, Matulich and Sever's claim that they have shown that a
two-pie allocation is guaranteed to be Pareto safe under bilateral
monopoly is incorrect, and there is no other market structure for which
this claim has even been made. Therefore, no credence should be given to
claims that a two-pie system is a "policy-superior initial allocation."
Instead, the inclusion of processor quotas in a fishery rationalization
program should be viewed as simply one possible mechanism for enhancing
outcomes for processors, bearing in mind that the possible outcomes
under processor quotas have received very little credible economic
analysis and are untested by experience in any real-world fishery.

**6. American Fisheries Act**

Although processor quotas have not been tested in any real-world
fishery, the BSAI inshore pollock fishery under the American Fisheries
Act does provide experience with the effects of alternative types of
processor provisions. This section of my testimony briefly reviews the
major inshore provisions of the AFA as background for an evaluation of
the implications of the processor provisions in this program for the
expected performance of processor quotas in the BSAI crab fisheries.

The AFA increased total net economic benefits in the inshore sector of
the BSAI pollock fishery in two major ways; it increased the inshore
sector's share of the total allowable catch from 35% to 50%, and it made
rationalization of the fishery possible through the formation of
harvesting cooperatives. Each cooperative was allocated a share of the
inshore sector's total allowable catch (TAC) based on the catch history
of the vessels belonging to the cooperative. Therefore, the AFA made it
possible for catcher vessels that joined a cooperative to obtain pollock
harvest allocations despite the moratorium on new IFQ programs. Because
inshore processors had expressed concern that this might put them at a
bargaining disadvantage, the AFA required that each cooperative be tied
to a specific processing facility.

Under the AFA cooperative provisions, qualification for membership in a
cooperative is based on the facility to which a catcher vessel delivered
the largest share of its total catch in the previous year. If a catcher
vessel does not join a cooperative it can fish for the share of the
total inshore allocation not apportioned to the cooperatives. The term
"open access fishery" is used to refer to this part of the inshore
pollock fishery, with the understanding that access of catcher vessels
and processing facilities is limited by the AFA. A catcher vessel
fishing in open access can chose to remain in open access and deliver
its fish to the eligible processing facility, or facilities, offering
the best price. Alternatively, it can chose in any year to join the
cooperative associated with the processing facility to which it
delivered the largest share of its fish in the previous year.

Halvorsen, Khalil, and Lawarrée (2000) concluded that the balance of
bargaining power in the fishery under the AFA provisions for
cooperatives favored processors, because the apparent necessity of
spending a year in open access in order to change processing facilities
could be very costly for a catcher vessel. Therefore there was a
significant probability that independent catcher vessels would be
adversely affected by the AFA's provisions for cooperatives. However,
they also noted that the positive net benefits from the reallocation
aspect of the AFA, as well as the potential net economic benefits from
rationalization of the fishery, decreased the likelihood that catcher
vessels would be adversely affected relative to the situation pre-AFA.

They also concluded that two other provisions of the AFA would decrease
the probability that independent catcher vessel owners would be
adversely affected. One is the rule that the cooperative contract can
provide for up to 10% of a cooperative's harvest to be processed by a
different processing facility, which was expected to make it possible
for cooperatives to be able to negotiate a higher price for this part of
their deliveries.

Although not recognized at the time, it has turned out that there is a
more important way in which the 10% rule improved an independent catcher
vessel's bargaining power. The principal reason for expecting that
independent catcher vessels might be adversely affected by the AFA
provisions for cooperatives was that the apparent necessity of spending
a year in open access in order to change processing facilities could be
very costly. However, by utilizing the 10% of the cooperative's harvest
that could be delivered to another eligible processing facility, catcher
vessels have been able to qualify for a new cooperative without having
to spend a year in open access. This has been possible because the 10%
applies to the cooperative's collective deliveries, not to each
individual vessel's deliveries. Therefore the 10% rule freed up enough
fish to make it feasible for even a relatively large vessel to deliver
more of its harvest to a new processing facility than to its existing
facility and therefore to be able to switch processors without incurring
the cost of going through open access.

This has improved the bargaining power of independent catcher vessels
because if they are not satisfied with the outcome of price negotiations
they can credibly threaten to switch processors in the following year.
If switching does occur, a processing facility's claim on its
cooperative's original total harvest could decrease cumulatively over
time at a rate of up to 10% per year, so that by the end of the original
five year life of the AFA it might have lost more than 40% of its
original processing share. And the process of erosion could continue
into subsequent years if, as happened, the life of the AFA was extended.
From the point of view of the affected processing facility, the
experience in the first five years would be the equivalent in the BSAI
crab rationalization plan to having its individual processing quota
decrease from 90% of its processing history to less than 50%.

The other provision that is favorable for independent catcher vessels is
the rule that a cooperative has to be approved by 80% of the catching
vessels qualified for it. This rule is even more important for the
bargaining power of independent catcher vessels than the 10% rule,
because it involves the possibility of a processing facility losing its
entire claim on its cooperative's original total harvest. The rule makes
it possible for independent catcher vessels to credibly threaten to
dissolve their cooperative by voting against its continued existence.
This would not only deprive the processor of any claim on the deliveries
of the independent catcher vessels, it would also cause the processor to
lose the catch allocations of any catcher vessels that it owned, because
catch allocations can only be obtained through membership in a
cooperative.

The 80% rule makes the continued existence of a cooperative from year to
year quite uncertain. As a result, the National Marine Fisheries service
required that each in-shore cooperative apply for its allocation on an
annual basis. Each cooperative must apply for its allocation annually
and must certify annually that the cooperative meets all the
requirements in the AFA and its associated regulations. If it is not
able to do so, the processing facility will lose its entire claim on its
processing share.

The actual experience of the fishery subsequent to rationalization has
been consistent with the overall economic analysis of Halvorsen, Khalil,
and Lawarrée. Total net economic benefits in the inshore sector have
been increased as a result of the increase in the sector's share of the
TAC, as well as substantial increases in the TAC itself. In addition,
implementation of the cooperatives has resulted in increased efficiency.
Improved targeting of pollock during the peak roe season has contributed
to greatly increased ex vessel prices during this season. The value of
output has also increased because slowing the race for fish has
permitted an increase in the recovery rate and a shift to higher valued
products. Harvesting costs have been reduced by the transfer of quota
shares from less efficient vessels to more efficient vessels, and easy
transferability of allocation within a cooperative has facilitated the
full harvesting of the available allocations. As a result, the net
effects of the AFA on both harvesters and processors is generally agreed
to have been positive, although the relative size of the benefits
remains a matter of contention.

**7. Processor Quotas in the BSAI Crab Fisheries**

The "three-pie voluntary cooperative program" proposed by the North
Pacific Fishery Management Council and authorized by the Consolidated
Appropriations Act of 2004 for the BSAI crab fisheries includes the
requirement that 90% of total harvesting quotas be Class A shares that
can only be delivered to processors holding individual processing quotas
(IPQs). Class B shares, which can be delivered to processors that do not
hold IPQs, account for 10% of the harvest allocation. The program also
includes regional restrictions on processing and allows for voluntary
harvesting cooperatives.

As noted earlier in my testimony, the Milon and Hamilton (2002) study
concludes that a program in which processors receive IPQs equal to the
total harvest would benefit only processors, with the value of harvester
IFQs being driven to zero. They also conclude that as the ratio of IPQs
to IFQs decreases, harvesters will fare better. However, there is no
reason to believe that reducing the IPQ share from 100% to 90% is
sufficient to allow independent catcher vessels to avoid adverse effects
from the rationalization program.

The basis for the Council's conclusion that a 90%-10% program will
balance the interests of both processors and harvesters is not clear.
Some proponents of the IPQ program have based their arguments in its
favor on an analogy with the AFA inshore pollock cooperatives, which are
generally agreed to have resulted in positive outcomes for both
processors and harvesters. But the 90%-10% IPQ program is fundamentally
different from the AFA. The only apparent similarity is that a
cooperative can deliver 10% of its harvest to an eligible processing
facility other than the one it is qualified for under the AFA, and
harvesters can deliver 10% of their harvests to processors without IPQs
under the program for the BSAI crab fisheries.

This apparent similarity is purely superficial. Under the three-pie
program processing companies are guaranteed 90% of their historic
processing shares, whereas under the AFA program a processing facility
is not guaranteed to retain any of its claim on its cooperative's
original total harvest. In addition, other differences between the AFA
and the BSAI crab rationalization program contradict the supposed
analogy. The following section summarizes some of the major differences
between the two programs.

**8. Differences between the AFA and Crab Rationalization Programs**

[Protection of processors' market shares]{.underline}

Under the rationalization program for the crab fisheries, a processor
will receive processor quota share equal to 90% of its historic
processing share. This amount will be guaranteed to the processor
because harvesters can deliver their Class A allocation only to
processors holding processing share. Therefore the only way that a
processor can lose more than 10% of its historic market share is if it
sets the ex vessel price so low that vessels would prefer to forego
fishing rather than deliver fish to it, because that will be their only
alternative.

Under the AFA, each processing facility has the right to process 90% of
its cooperative's total harvest, but this does not guarantee that it
will receive 90% of its historic processing share, because vessels have
alternatives to remaining in the cooperative. One alternative for a
vessel is to fish in the open access portion of the fishery and deliver
its fish to another eligible processing facility. It could then either
remain in open access or join the cooperative of the new processing
facility. Another option is to qualify for another cooperative without
going through open access by delivering its fish to the alternative
processing facility as part of the 10% of the cooperative's total
harvest that can be delivered to any eligible facility. And the
existence of a cooperative requires the approval of at least 80% of the
vessels qualified for it. As a result, a processing facility is faced
with the possibility of losing all of its processing rights if more than
20% of the vessels in the cooperative decide that it should be
dissolved.

Therefore protection of processors' market shares will be much greater
under the rationalization program for the crab fisheries than under the
AFA, thereby giving the processors much greater bargaining power. In
particular, under the AFA a processor will retain market share only if
it offers an ex vessel price that is competitive with the price being
offered by other processors, whereas under the BSAI crab rationalization
program a processor can retain 90% of its market share even if it offers
a price so low that the catcher vessel is barely able to cover the
average variable costs of harvesting the fish.

[Regionalization]{.underline}

Under the rationalization program for the BSAI crab fisheries, Class A
harvest shares and processor shares for each crab fishery will be
regionally designated, whereas under the AFA the entire inshore sector
is treated as a single region. This difference has important
implications both for the net economic benefits that can be realized
from rationalization and for the distributional consequences of
rationalization.

The Council itself recognizes that regionalization reduces net economic
benefits by restricting consolidation of activities that are desirable
for reducing capacity and gaining efficiency in both the harvesting and
processing sectors under rationalization (Report to Congress, August
2002, page 18). The lack of such constraints under the AFA increased the
total net economic benefits that were available to be shared by
harvesters and processors.

The rationale for the regionalization requirements is the protection of
communities dependent on the crab harvests. However, regionalization
also has implications for the distribution of benefits between
harvesters and processors because it subdivides the markets for crab and
thereby increases the already high degree of concentration among
processors. It also creates an incentive for processors to consolidate
their market shares on a regional basis, which would increase the degree
of concentration still more. The greater bargaining power attained by
processors can be expected to adversely affect the price received by
harvesters for Class B allocations as well as for Class A allocations,
both because it might be difficult logistically to deliver to different
markets and because processors might be able to require bundling
deliveries of the two classes of fish.

Similarly, while the rationale for processor quotas is the protection of
processors, it has been claimed to also protect communities because they
will have a right of first refusal to purchase processing quota share if
a processor offers them for sale to another processor. However, as noted
by the North Pacific Fishery Management Council (2003, page 4-193), the
right of first refusal does not apply to movement of quota share between
plants owned by a common firm. Therefore an entity owning multiple
plants in a region could consolidate all its crab processing in one
location without triggering any right of first refusal provisions in the
communities losing the processing activities.

[Complexity]{.underline}

The "three-pie voluntary cooperative program" authorized for the BSAI
crab fisheries is much more complex than the rationalization program
implemented under the AFA. The greater complexity can be expected to
have serious negative consequences both with respect to the cost of
management and with respect to the functioning of the market for fish
and for quota shares.

Implementation of the rationalization program for the BSAI crab
fisheries will require the determination of share allocations in each
region of each fishery for each individual vessel and processor. Ongoing
management measures will include annual monitoring and enforcement
measures at the same level of detail. Eventual formation of voluntary
cooperatives might reduce some of the management costs with respect to
harvesting, but the extra costs of managing processing activities will
continue.

More importantly, the increased complexity of the system might make the
determination of prices through a decentralized market structure
impracticable. For each regional market in each fishery the prices that
will have to be determined include the ex vessel price of Class A fish,
the ex vessel price of Class B fish, the price of Class A harvesting
quota, the price of Class B harvesting quota, and the price of
processing quota.

Attaining equilibrium prices in such a complex system would be difficult
even in large, well-functioning, markets, and the markets in the crab
fisheries will be both thin and imperfectly competitive. In addition,
the large fluctuations in total allowable catch will complicate the
determination of equilibrium prices and hinder the ability of the system
to converge to stable values. In recognition of the possibility of the
price system breaking down, the rationalization plan includes a binding
arbitration program. However, the necessity of such a procedure
increases the cost of managing the fisheries under the proposed
rationalization plan, and even if the arbitration procedure is well
designed, it will not be an adequate substitute for a well-functioning
market.

[Net benefits from rationalization]{.underline}

Rationalization of the pollock fishery under the AFA created large net
economic benefits for the inshore sector, which facilitated outcomes
benefiting both the harvesting and processing sectors. As already noted,
the regionalization requirement under the rationalization plan for the
BSAI crab fisheries decreases the potential net economic benefits to be
obtained by rationalization. But even if this provision did not exist,
the total net economic benefits of rationalization in the crab fisheries
can not be expected to be as large as they were under the AFA, because
participants in the inshore pollock fishery benefited both from a large
increase in the sector's total allocation and from large rationalization
benefits from the formation of cooperatives.

The sector's total allocation was increased first by an increase in its
share of the total directed pollock fishery from 35% to 50%, and
subsequently by an increase in the total allowable catch for the pollock
fishery. The combined result was that the inshore sector's total
allocation has increased by 80% from the pre-AFA level in 1998 to the
present.

Large efficiency benefits were realized from the formation of the AFA
cooperatives. Rationalization under the AFA permitted improved targeting
of pollock during the peak roe season, resulting in greatly increased ex
vessel prices during this season. The value of output was also increased
because slowing the race for fish permitted an increase in the recovery
rate and a shift to higher valued products. Harvesting costs have been
reduced by the transfer of quota shares from less efficient vessels to
more efficient vessels, and easy transferability of allocation within a
cooperative has facilitated the full harvesting of the available
allocations.

In contrast, the rationalization program for the BSAI crab fisheries
does not include an increase in the total allocations available to these
fisheries. Similarly, increases in the value of output due to
rationalization are not anticipated to be as large for the crab
fisheries, and increases in harvesting efficiency are likely to be
hindered by the regionalization and processor quota restrictions imposed
by the program.

[Summary]{.underline}

There is no basis for believing that the rationalization program
authorized for the BSAI crab fisheries will have similar outcomes to
those obtained under the AFA cooperatives for the inshore pollock
fishery. Instead, the crab rationalization program is much more
advantageous for processors both because of the guarantee of 90% of each
processing company's processing history and because of regionalization.
The program is also far more complex, making it problematic whether
market processes can be relied on for the determination of appropriate
prices. And there is less of a margin for error in case of unintended
distributional effects because the net benefits to the fishery as a
whole are expected to be substantially smaller. Therefore the generally
favorable outcomes under the AFA provide no assurance of favorable
outcomes under the rationalization program for the BSAI crab fisheries.

**9. Conclusion**

The rationale for including processor quotas in a rationalization
program is that they are required to protect processors from adverse
results that would otherwise occur. However, there is no convincing
theoretical or empirical evidence that an IFQ program that did not
include processor quotas would in fact have adverse effects on
processors. And there is no clear economic rationale for protecting
processors from losses even if they were expected to occur.

Because there is no previous experience with processor quotas in any
real-world fishery, nor any credible theoretical analysis of their
effects, it is not possible to predict with any precision how they would
alter the outcomes of a rationalization program. However, it is clear
that in general inclusion of processor quotas in a rationalization
program will benefit processors while having negative effects on both
harvesters and economic efficiency.

The rationalization of the BSAI inshore pollock fishery under the
American Fisheries Act does provide experience with the effects of
alternative types of provisions intended to benefit processors. The
processing quotas recently authorized by the Consolidated Appropriations
Act of 2004 for the BSAI crab rationalization plan are superficially
similar to the AFA provisions for inshore cooperatives, which are
generally agreed to have resulted in positive outcomes for both
processors and harvesters. However, the two programs are in fact very
different, and the "three-pie voluntary cooperative" program authorized
for the crab fisheries is both more problematic, and more advantageous
for processors, than the AFA program.

**References**

Casey, Keith E., Christopher M. Dewees, Bruce R. Turris, and James E.
Wilen (1995), "The Effects of Individual Vessel Quotas in the British
Columbia Halibut Industry," *Marine Resource Economics*, 10 (5):
211-230.

Halvorsen, Robert (2003a), "On Implications of the American Fisheries
Act for Bering Sea/Aleutian Islands Crab Rationalization," Written
Testimony Submitted to the Record of the May 20, 2003 Hearing on Bering
Sea/Aleutian Islands Crab Rationalization before the Committee on
Commerce, Science, and Transportation of the United States Senate.

Halvorsen, Robert (2003b), "On the Economic Analysis of Individual
Processor Quotas," Written Testimony Submitted to the Record of the May
20, 2003 Hearing on Bering Sea/Aleutian Islands Crab Rationalization
before the Committee on Commerce, Science, and Transportation of the
United States Senate.

Halvorsen, Robert, Fahad Khalil, and Jacques Lawarrée (2000), "Inshore
Sector Catcher Vessel Cooperatives in the Bering Sea/Aleutian Islands
Pollock Fisheries," discussion paper prepared for the North Pacific
Fishery Management Council, February 7.

Matulich, Scott C. and Michael Clark (2002), "Efficiency and Equity
Choices in Fishery Rationalization Policy Design: An Examination of the
North Pacific Halibut and Sablefish IFQ Policy Impacts on Processors,"
Regional Information Report No. 5J02-02, Alaska Department of Fish and
Game, January 24.

Matulich, Scott C., Ron C. Mittelhammer, and Carlos Reberte (1996),
"Toward a More Complete Model of Individual Transferable Fishing Quotas:
Implications of Incorporating the Processing Sector," *Journal of
Environmental Economics and Management*, 31 (1): 112-28.

Matulich, Scott C. and Murat Sever (1999), "Reconsidering the Initial
Allocation of ITQs: The Search for a Pareto-Safe Allocation Between
Fishing and Processing Sectors," *Land Economics*, 75 (2): 203-19.

Milon, J. Walter and Stephen F. Hamilton (2002), "A Comparative Analysis
of Alternative Rationalization Models for the Bering Sea/Aleutian
Islands (BSAI) Crab Fisheries," discussion paper prepared for the North
Pacific Fishery Management Council, March.

Nash, John F. (1953), "Two-Person Cooperative Games," *Econometrica*, 21
(1): 128-40.

National Research Council (1999), *Sharing the Fish: Toward a National
Policy on Individual Fishing Quotas*, National Academy Press.

North Pacific Fishery Management Council (2002), "Bering Sea and
Aleutian Islands Crab Rationalization Program," Report to Congress,
August.

North Pacific Fishery Management Council (2003), "Preliminary Draft of
the Environmental Impact Statement for Bering Sea and Aleutian Islands
Crab Fisheries: Initial Council Review," November.

North Pacific Fishery Management Council, Scientific Statistical
Committee (2004), "Draft Minutes, February 2-4, 2004."

Osborne, Martin and Ariel Rubinstein, *Bargaining and Markets*, Academic
Press, 1990

Plesha, Joseph T. and Christopher C. Riley (1992), "The Allocation of
Individual Transferable Quotas to Investors in the Seafood Industry of
the North Pacific," photocopied.

United States General Accounting Office (2002), "Individual Fishing
Quotas: Better Information Could Improve Program Management," December.

Wilen, James E. (1998), "Testimony to be Presented to the North Pacific
Fishery Management Council Regarding Inshore/Offshore III, Bering Sea --
Aleutian Islands Pollock Allocation," photocopied.

  ------------------------ -- -- ----------------------------- --------------------- -- -------------------------------- ----------------------
  **APPENDIX**                                                                                                           

                                                                                                                         

  **MAJOR DIFFERENCES                                                                                                    
  BETWEEN AFA INSHORE                                                                                                    
  COOPERATIVES AND BSAI                                                                                                  
  CRAB RATIONALIZATION                                                                                                   
  PROGRAM**                                                                                                              

                                                                                                                         

                                                                                                                         

                                 **[AFA Inshore Pollock                                 **[BSAI Crab                     
                                 Cooperatives]{.underline}**                            Rationalization]{.underline}**   

  **Allocation of                                                                                                        
  processing history:**                                                                                                  

                                                                                                                         

  Initial allocation             90% of previous year's                                 90% of historic share of         
                                 deliveries                                             deliveries                       

                                                                                                                         

  Guaranteed percent             Zero                                                   100%                             

                                                                                                                         

  Individual vessels'            10% per year, cumulative                               Zero                             
  ability to reallocate                                                                                                  

                                                                                                                         

  Percent of vessels'            80%                                                    Zero                             
  approval required to                                                                                                   
  retain                                                                                                                 

                                                                                                                         

  **Regionalization:**                                                                                                   

                                                                                                                         

  Decreased efficiency           No                                                     Yes                              
  gains                                                                                                                  

                                                                                                                         

  Increased processor            No                                                     Yes                              
  concentration                                                                                                          

                                                                                                                         

  **Complexity:**                                                                                                        

                                                                                                                         

  Number of markets              7 cooperatives                                         15 regional fisheries            

                                                                                                                         

  Number of prices               Maximum of 14                                          Maximum of 75                    

                                                                                                                         

  Need for price                 No                                                     Yes                              
  arbitration                                                                                                            

                                                                                                                         

  Monitoring and                 Much less than in IFQ program                          Much more than in IFQ program    
  enforcement costs                                                                                                      

                                                                                                                         

  Large fluctuations in          No                                                     Yes                              
  TAC                                                                                                                    

                                 **[AFA Inshore Pollock                                 **[BSAI Crab                     
                                 Cooperatives]{.underline}**                            Rationalization]{.underline}**   

  **Total benefits from                                                                                                  
  rationalization:**                                                                                                     

                                                                                                                         

  Increase in total TAC          Yes                                                    No                               

                                                                                                                         

  Increase in value of           Large                                                  Moderate                         
  product                                                                                                                

                                                                                                                         

  Efficiency benefits from       Scheduling, avoidance of                               None if cooperatives do not form 
  cooperatives                   under harvesting                                                                        

                                                                                                                         

  **Information base for                                                                                                 
  program evaluation**                                                                                                   

                                                                                                                         

  Experience in other            Whiting and offshore pollock                           IPQs never before used in any    
  fisheries                      cooperatives                                           fishery                          

                                                                                                                         

  Experience in other            Agricultural cooperatives                              None                             
  markets                                                                                                                

                                                                                                                         

  Previous theoretical           Extensive for IFQs and                                 Very little                      
  analysis                       cooperatives                                                                            

                                                                                                                         

  Previous empirical             Extensive for IFQs and                                 None                             
  analysis                       cooperatives                                                                            
  ------------------------ -- -- ----------------------------- --------------------- -- -------------------------------- ----------------------