This study examines the effects of State policies on farmers' incomes and natural resource conditions in central Honduras. We combined dynamic linear programming with a biophysical model and applied this bioeconomic model to a microwatershed where, in recent years, farmers have turned to intensive production of vegetables. We compared the outputs of different model scenarios with historical data over the last 20 years (1975–95). The main results of the simulations are: (1) the 1990 liberalization has had a beneficial impact on the incomes of small farmers who adopted a `vegetable pathway'; (2) the shift from extensive production to intensive vegetable production does not reduce erosion, as the greater opportunity cost of labor increased the cost of investing in land conservation; and (3) small farmers are more likely than ranchers to erode soils, because they are more likely to produce vegetables during the rainy season and usually cultivate steeper slopes. However, small farmers are more likely to invest in land conservation because soil depth becomes a limiting factor for production.