Agricultural Arbitrage, Adjustment Costs, and the Intensive Margin

Farmland and capital are an important and rapidly expanding component of the agriculturaleconomy, and empirical evidence suggests that these assets are quasi-fixed in that adjustment costs are incurred when holdings are altered. Increased interest in the rate of return for investing in farmland suggests that an important consideration is the effect of adjustment costs on this return. A novel theoretical modelis developed that ties together contributions from the farmland pricing and adjustment cost literatures, andthe first order conditions for a utility maximizing decision maker are rearranged into intertemporal arbitrageequations that are similar in spirit to traditional finance models. The common assumptions that land andcapital are quasi-fixed assets, and that production is characterized by constant returns to scale are testedand the evidence supports these assumptions. An empirical application of the arbitrage equations providesevidence that risk aversion and adjustment costs are jointly significant components of agricultural production,and that adjustment costs generate significant changes in the rate of return to farmland. The results haveimportant policy implications as sluggish supply response due to quasi-fixity can lead to dramatically inflatedcommodity prices, and an accurate measure of the farmland return can help determine how far the extensivemargin will expand or contract in response to a variety of policy scenarios, such as the subsidization of cornfor ethanol, an increase in the variety of subsidized crop insurance products, or the introduction of newrevenue support programs such as ACRE.