Economic Hysteresis in German Hog Production

Background and objective Intensive livestock farming in Germany is characterized by two facts. First, the production seems hardly to respond to the considerable price changes that occurred during the past decades. Second, the spatial allocation of production is rather unequal, though no special natural conditions are required for this business. Such an unequal distribution is not desired by agricultural policy makers. Regions with a high concentration of hog production suffer environmental problems and farmers face several restrictions when enlarging their capacity. On the other hand there are also weakly developed regions where investments in livestock farming are appreciated in order to stabilize the rural economy. The question rises how the observed inertia in hog production can be understood. A promising explanation is offered by the real options theory (new investment theory) (Dixit and Pindyck, 1994). This theory analyses investments in a dynamic and stochastic environment. An important finding is that the optimal range of inaction widens when uncertainty and irreversibility are present. Both features are given in the case of hog production due to a volatile hog market and very specific investments in production facilities. In fact, Odening, Musshoff and Balmann (2005) apply the real options approach to investments in hog finishing and demonstrate that investment triggers are much higher than the traditional investment theory (i.e. the net present value) suggests. Moreover, it is shown that it may even be rational to tolerate temporary operative losses before giving up production. However, their results are derived from a normative model and therefore little can be concluded about the actual explanatory power of the new investment theory. In contrast, our paper analyses the investment behavior of German hog producers empirically. Dynamic adjustments in the pork industry have recently been studied by Pietola and Myers (2000) and Gardebroek (2004) by means of a stochastic adjustment cost model. They find that uncertainty slows down structural adjustments, but their model does not allow to estimate investment and disinvestment hurdles explicitly. The objective of our analysis is twofold. First, we want to identify determinants that influence capacity adjustments in hog production. An understanding of the adjustment behavior of hog producers is essential to predict or to control the structural change in this industry. Second, from a more theoretical viewpoint we wish to contribute to the empirical validation of real options models. Although more and more applications of this approach are emerging in agricultural economics, only few papers try to test its hypotheses empirically (see for example Richards and Green, 2003, Wossink, 2000, Schatzki, 2003).