Industry dynamics under production constraints - The case of the EU dairy sector

- A dynamic stochastic framework is developed that accounts for entry and exit of firms under a sectoral production quota.
- The impact of a production quota on long-run industry dynamics is assessed with respect to the Western German dairy sector.
- We find that a tradable production quota does not necessarily slow down structural change within an industry.
- Farms' average productivity level under a tradable milk quota regime is higher than in the case without quota.
- The abolishment of the quota regime may lead to a significant price drop.

In 2015 the EU terminated its milk quota regime that was part of the Common Agricultural Policy for three decades. Against this background our paper analyses how a tradable/non-tradable production quota influences firm entry and exit in the agricultural industry. To this end we develop a dynamic stochastic equilibrium framework considering that a release of production capacity by exiting firms affects the investment options for entrants. Firms' investment and exit decisions depend on future output and quota prices, which in turn will be affected by the evolution of industry structures. Contrary to static models, we find that a quota system does not necessarily reduce the speed of adjustment within the industry since a tradable quota increases the liquidation value and provides an incentive for inefficient firms to cease production.