Abandonment of milk production under uncertainty and inefficiency: The case of West German farms

This paper examines the impact of technical efficiency on the optimal exit timing of farms in a stochastic dynamic framework. Starting from a standard real options approach, we incorporate technical efficiency via a production function and derive an optimal price trigger at which farms irreversibly exit production. Assuming separability of efficiency on the primal technology, we show that higher efficiency and higher returns to scale make the farm more reluctant to irreversibly exit production. We extend this model to a non-separable case, test it with West German farm-level data (2000 to 2008), and find evidence that efficiency is non–separable. We find that higher volatility of milk prices and higher efficiency delay farms' exit from the market. Volatility, however, interacts with time-varying efficiency: the propensity of inefficient farms to exit the milk market attenuates under more volatile market conditions.