I. Introduction

1.1 Objectives of the Study

The general aim of this study is to determine the policy, technical, and environmental factors driving the scaling-up of livestock production in the Philippines and to assess the implications of this process for small-scale producers.

Specific objectives are the following:

• Document the importance of smallholder monogastric livestock production and its development trend in the Philippines.

• Document the extent to which the share of livestock output produced by smallholders is declining.

• Assess the extent to which this displacement of smallholders is due to policy distortions.

• Assess the impact of differences across farms in their ability to capture environmental externalities.

• Assess the extent to which smallholder displacement is due to changing product and production requirements in the marketplace (e.g., animal health, food safety, quality standards).

• Assess the degree to which higher transaction costs facing smallholders reduce their competitiveness.

• Assess the potential to keep small-scale farms competitive within a market economy framework through institutional innovation.

• Assess implications for poverty reduction and environmental strategies.

1.2 Justification

Livestock and poultry were the strongest sources of growth in Philippine agriculture from 1986 to 2000. At the farm level, livestock raising is a major activity in rural areas. For a large proportion of smallholder households engaged in livestock raising, the activity is the primary source of income (UPLB-IFPRI-ILRI livestock household survey, 2000).

Livestock production in the Philippines in general has continued to be the domain of smallholders. In the hog industry, 77 percent of hog inventories remain in backyard production systems. However, significant market and institutional changes are taking place in the major regions where hog and poultry production is undertaken. Within the broiler sector, the large integrators^[39], with their vertically coordinated operations, have come to dominate the industry. Industry players estimate that 80 percent of broiler meat output is now turned out by growers under contract to the large integrators, with the remaining 20 percent produced by independent commercial farmers and a handful of smallholders (focus interviews with broiler industry players, 2002). In the hog industry, a rapid scaling-up is under way in the country's major hog producing regions. Commercial farm inventories have now matched, if not surpassed, backyard hog inventories (Costales, 2002). The scaling-up of broiler and hog production systems raises questions about the continued ability of smallholders to participate in an industry that is experiencing robust growth.

The changing market shares of small-scale and large-scale producers in poultry and pork markets suggests a displacement of smallholders. Yet the poverty implications of such a displacement raises important social questions. To respond to those questions, it is important to determine, and if possible take hold of, the forces driving smallholder displacement.

Increasingly, the impact of industrial livestock production on the environment is becoming an important social concern (Catelo et al., 2001). Social conflicts are emerging over the location of large-scale livestock production close to residential centers. Environmental regulations against pollution, traditionally targeted against heavy and light industries, are now also being trained on industrial livestock production. More recently, regulatory authorities have begun contemplating the regulation of livestock waste, even for smallholder farms (Laguna Lake Development Authority, 2001). As more even-handed enforcement of environmental regulations comes into place, it is necessary to determine how such enforcement would differentially affect the viability of small- and large-scale farms. Which is better able to withstand the costs of adherence to environmental regulations? What are the implications for the continued participation of smallholders in the livestock industry?

1.3 Main Issues and Research Questions to be Investigated

This study investigates seven main issues. Each is introduced below and the relevant research questions put forward.

Issue 1: Smallholders will be displaced if they are not competitive in the marketplace.

If large-scale farms earn higher profits per unit output than small-scale farms, then smallholder farms will disappear. Even if profits per unit output are not higher on large farms, they will still predominate because of their higher output per farm. To have a chance of survival, smallholder farms must achieve a profit per unit output close to that of large farms.

The research question related to this issue is as follows:

1. Is there a systematic difference in profit per unit output between large farms and small farms?

Issue 2: There is anecdotal evidence of higher implicit subsidies to large-scale operations.

Partial trade liberalization allows economic agents in strategic positions to access certain inputs at lower duties while effectively excluding others from the same access. With the implementation of trade agreements covering feed grain, some stakeholders in the livestock sector have access to significantly lower tariffs on imported corn. This is due to the Philippines' compliance with import quotas under minimum access volume (MAV) commitments. Other producers must pay the significantly higher domestic prices of locally produced corn, or import corn at tariffs close to double the in-quota rates.

Two research questions are formulated related to this issue:

1. Is the effective cost of feed, at comparable levels of quality, lower for large-scale producers as compared to others? Is this reflected in higher nominal profits per unit of output?

2. Do large farms pay lower interest rates than small farms?

Issue 3: Environmental issues and policies affect the viability of smallholder involvement in livestock farming, both with regard to profitability and environmental sustainability.

Creation of negative externalities may give some producers an edge. Investigations of economies of scale therefore require determination of whether large-scale producers capture the benefits of negative externalities on a higher basis per unit of output than small-scale producers.

The extent to which environmental costs are captured by the producing units is important in judging whether the economic activity is performing at a level that is deemed efficient from a social viewpoint. The capacity of farms to remain competitive while mitigating environmental externalities depends on how efficiently they are able to capture associated environmental costs. This ability may differ among farms according to the commodity in question or the scale of operations.

Three research questions relate to this issue:

1. Do farms vary in their expenditures on mitigation of environmental damage?

2. Is this related to scale or location (e.g., proximity to residential centers or to centers of economic activity)?

3. Are profits affected by internalization measures?

Issue 4: Price differentials have been observed between products of large- and small-scale producers.

Farm-gate prices for products are not uniform across all farms. Even after controlling for distance from farm to market and whether the product is picked up by the buyer or delivered by the farmer, differences in farm-gate product prices remain. Possibly, economies of scale are realized in the assembly of products by buyers (traders) of livestock. But there might be still other factors that affect differences in output prices.

Here the research questions are two:

1. Do large farms systematically receive higher prices for output than small farms?

2. If so, is this price differential due to scale, or some other factors?

Issue 5: Changes in the product attributes required in the market (food safety, product consistency, reliability of supply, etc.) may be difficult for smallholder farmers to meet.

Although the market for meat is growing rapidly, this does not automatically result in growth in the market for smallholders. Smallholders' survival in a market that is also becoming more sophisticated in tastes and preferences (due to increasing per capita incomes and urbanization) depends on their ability to effectively meet changing product requirements.

Although the Philippines has not gained competitive edge to export pork or broiler chicken meat (exports must meet HACCP-compatible standards), domestic consumers are beginning to put a premium on particular attributes of meat products.

Attention at the farm level to the link between perceived product quality and price of output is new in livestock markets in the Philippines. How are consumer preferences for certain meat product attributes (e.g., sanitation, free of disease, leanness, size, color, etc.) translated to farm production and farm-gate prices?

The related research questions are two:

1. How is the market in fact changing and what product attributes are required at the farm production level?

2. How do changing preferences in retail markets affect producers?

Issue 6: Where transaction costs matter, they tend to exclude the asset-poor and information-poor.

Whether smallholders can gain access to increasingly defined and demanding markets for meat remains a question. Smallholders may be relegated to certain levels of the market chain or to particular stages of the meat supply chain. Differences in transaction costs might underlie the differences in prices received for output by smaller and larger sized farms. The challenge is to show the extent to which transaction-cost differences explain the price differentials.

Once this is done, entry points can be identified for reducing policy distortions and facilitating the development of market organizations for smallholder livestock producers. Subsequently, directions can be mapped for reducing the specific transaction costs through public policy, with as a result unambiguous societal welfare improvement.

The related research questions are three:

1. How can the transaction costs faced by different producers be measured?

2. How are these transaction costs related to differences in profitability outcomes among producers?

3. What options are there for reducing transaction costs? Are they changeable by policy in a free market context?

Issue 7: Vertical coordination may impact on cost structures of farms.

The dominant firms in the broiler industry have vertically coordinated operations encompassing the breeding of day-old chicks, feed milling, animal health programs, contract growing, toll dressing, and distribution of labeled products.

If vertical integration works for large firms-presumably resulting in the reduction of transaction costs associated with unreliable supply and product quality-can such organization be replicated to accommodate the production activities of smallholders? If smallholders do not get formally and successfully integrated into the market chain, they are likely to be further excluded from the rapidly developing markets for sophisticated meat products.

The research questions related to this issue are as follows:

1. How does vertical coordination affect the transaction costs faced by different scales of farmers?

2. Does participation in contract growing or cooperative membership also help producers capture environmental costs and realize higher profitability per unit output?

3. What is the net impact of contract farming and cooperative membership on environmental mitigation expenditures and on profitability per unit output?

1.4 Specific Hypotheses to be Tested

Seven hypotheses were formulated related to the issues sketched above. These hypotheses were tested separately for the broiler and hog industries of the Philippine meat market. The hypotheses are the following:

1. Small-scale producers have lower profits per unit of output than large producers.

2. The higher profitability of large-scale operations is due in part to subsidies received by the integrating institution.

3. Small-scale farmers expend more effort/investment in pollution abatement per unit of output than large-scale farmers; this results in a lower capture of environmental externalities per unit of output by small-scale farms.

4. Prices received per kilogram of output are systematically higher for independent large-scale producers compared to small-scale farmers.

5. Small-scale contract farmers receive consistently higher prices per kilogram than independent small-scale farmers delivering a comparable product.

6. Profits of small-scale producers are more sensitive to transaction costs than those of large-scale producers.

7. Contract and cooperative farmers have higher nominal profits per unit output compared to independents operating on a similar scale.