Agricultural diversification and policy reform

The impact of risk on agriculture and the alternative ways of dealing with it has captured the attention of economists and policy makers for a long time. In recent years, the issue has gained renewed interest. Many countries have started policy reforms aimed at liberalizing domestic markets, removing quantitative restrictions on trade, and opening up their economies to international trade opportunities. As this process develops, producers in different region of the world will start facing increased price variability arising from world market fluctuations, as up to now, mainly due to government marke interventions, domestic producer prices have varied substantially less than international ones (Hazell et. al., 1990; Schiff and Valdes,1992). Hence, risk,and price risk in particular, will most probably be at the core of the implementation problems associated with policy reform packages. It is well known that diversification of the production mix can be a particularly efficient mechanism for diminishing the impact of risk on producers' welfare. In this regard, different public policies may help to deepen diversification in agriculture, public investment in irrigation being the most important example. However, since many of these policies entail a significant use of resources, an important policy question concerns the impact that trade and macro reform may have on risk in agricultural activities, and on the endogenous diversification response by producers. The main objectives of this paper are to: 1) review the problem of price risk in agriculture, especially in the case of domestic markets facing international price fluctuations; 2) examine the potential role for diversification as a way of diffusing price risk; and 3) analyze the interaction between the process of trade and macro reform; price risk, and agricultural diversification. It is important to mention at the outset that the risk perspective - the one adopted in this paper - is just one of the many angles from which the issue of agricultural diversification and policy reform can be analyzed. Another, would be the wealth impact of adding a new good to the production possibilities of agriculture, under the assumption that a policy reform, by removing many underlying distortions and rigidities in the economy, might encourage the discovery and development of new alternatives of production that before were not available to economic agents. It should be fairly clear that if a policy reform implies adding new production possibilities to agriculture, then that "diversification" by itself - which takes the form of a positive shift in the production possibilities of the economy - should lead to a wealth increase, and that the net wealth effect should be significantly higher than any risk effects, which typically tend to be of second order magnitude when compared with wealth effects. However, it is not completely evident that policy reform should always lead to that result, or that the scope for adding new products to the production possibilities is unlimited and open to any country engaging in a reform process. This issue, although important, is not included in the present paper which concentrates mainly on the interaction between diversification and policy reform from a risk perspective. The rest of the paper is organized as follows. In the next section we review the problem of price risk in agriculture. There, we submit the view that most probably, the welfare effects of price risk are higher than those most common measures would suggest. This puts price risk at the core of the implementation problems associated with policy reform efforts. Section 3 deals with the role of agricultural diversification as a mean of diffusing price risk. As a policy option, we contend that the objective of diversification should play an indirect role, and should be restricted mainly to public expenditure decisions and policie aimed at increasing the integration of domestic with international asset markets. By an endogenous response from producers, we conclude that the alternatives that agricultural diversification offer are somewhat limited to a sizable degree by co-movement of international prices of commodities. Section 4 explores the interaction between diversification and trade and macro reform. We conjecture that, given the available causal evidence, a probable outcome of trade reform will be an increased diversification in an economy-wide sense, although not necessarily an increased diversification at the unit-of-production level. This will probably require a re-focus of agricultural pricing and public expenditure policies.