probability of a bad harvest. Third, this positive term depends positively on the difference (p1-p2).
This point is important because it shows that, under such an "insurance" behavior, there is a cross-
subsidy between in-quota and C sugar even in the long run, without the fixed cost effect described
above. Indeed, the higher p1, the more it becomes profitable to produce C sugar for insurance. Note
that this cross-subsidy is obviously linked to the fact that the quota is binding, otherwise equation (5)
would collapse into the traditional condition Cm=p1.
This relation does not prove that C sugar is formally cross-subsidized in the EU. The incentive to
overshoot is mitigated by the possibility of "carrying over" sugar quotas rights from one year to
another, a feature of the EU CMO. This possibility reduces significantly the cross-subsidy resulting
from (5). Some sugar processors also have private arrangements giving flexibility to beet suppliers to
smooth the supply over several years, so as to prevent overshooting. In addition, empirical evidence
suggests that the insurance behavior is unlikely to explain all the C sugar production in the EU15
(Adenauer et al, 2004). Indeed, the level of EU15 production is only consistent with expectations on
yields that would be unrealistic. However, the "overshooting" factor may explain a share of the C
sugar production, and we believe that the resulting implicit cross-subsidy needs to be included in the
modeling of EU supply response behavior.
Expectations. Projects for a reform of the EU CMO have circulated for decades before 2005. It is
possible that farmers have produced beyond the (static) optimum level, expecting that historical
references will be used in the future. Indeed, in the past reforms of the CAP, many quota allocations,
premium rights or compensations have been given on the basis of historical references. A
precautionary behavior so as to "build up" potential references would be rational under particular
expectations by producers and/or processors regarding future reforms. Assume that producers expect
that future quota mobility across the EU will result in closing sugar plants in some regions. This
assumption is realistic, since some sugar processors closed profitable plants in anticipation of the
reform in 2005 (e.g. in Ireland). Consider an efficient producer who expects that, in his area, local
processors will manage to increase their sugar quota, and that the level of present production of C
sugar will be used as a variable in allocating the new quota between individual beet producers. (Other
patterns of expectation are possible, but it is likely that farmers will end up with the idea that the more
they produce C sugar beet, the more they will be eligible for extra compensation, or future reference
values). Let us use a subscript t+1 to denote expected prices and quantities in future period, a
subscript t for the present period, and the variable τ to represent a discount factor. The profit
maximization problem of a producer like the one described above is:
Maxπ= p1,t.y1,t+p2,t.y2,t-C(y1,t+y2,t;wt;z) +
Иpu+1. У1, t+1+ p 2, t+1. y 2, t+1- C(‰+1+ y 2, t+1 ; w++1 ;z )) (6),
10