Breeding can result in more output per unit of inputs as well as improved quality of outputs. A genetic-based technical change component is introduced into the Malmquist index, and productivity growth due to genetic and nongenetic factors is estimated for Icelandic dairy farms with quality adjusted output. Only about 4 percent of the productivity growth has been genetic-based. More than a third of this growth can be attributed to better milk quality. Adoption of new nongenetic-based technologies explains most of the productivity growth.

Breeding goals for dairy cows have typically emphasized production traits such as milk and meat yields. We estimate the effects of genetic progress in different traits on variable costs of production. A variable cost function that is augmented with indices of dairy cows' genetic merit in different groups of traits is estimated by using farm-level panel data. Our results show that a genetic progress of one standard deviation in production and functional traits reduces variable costs by 0.4 and 0.6 %, respectively. The cumulative variable cost reduction from genetic progress in functional traits between 1999 and 2007 is about 1 % for the average farm. Genetic change is permanent, and the discounted perpetual cost reduction because of genetic progress in functional traits is about NOK 160 million for Norwegian dairy farms.

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Under multiple component pricing schemes, the price of milk depends on its content of components such as fat, protein, and lactose. A theoretical model for component supply under a tradable quota regime is developed. A system of component supply and input demand equations is derived and estimated for a panel of Icelandic dairy farms. Overall, results show that milk component supply responds to price incentives in the short run despite rigidities in component production technology. The own-price supply elasticities of fat and protein are 0.26 and 0.23 in the quota milk market and 0.02 and 0.25 in the surplus milk market.