DED Economic Theories for Developing Countries Take Home Assignment Case Study 1____

Economic Consultants Report to the Economic Council on Agricultural Product Prices

1. Identification of Issues and Problems

Background

The farmers in Aralaganwila have started a hunger strike demanding the government to
intervene to increase the price for their agricultural product. They allege that the prices they
are getting at the Dambulla Economic Centre do not even cover their costs. In the meantime
the consumers in Colombo complain that the vegetable prices are high and unaffordable.

Although this problem has surfaced with the hunger strike in Aralaganwila and the consumer
grievances in Colombo, this shows a serious problem that the entire country is faced with.
The rural populations of the country who are the main producers of the agricultural product
are not getting a satisfactory price for their product whereas the urban consumers find the
prices of those agricultural goods too high such that they can hardly afford it. The general
public opinion is that the prices are being manipulated by the wholesale buyers and that they
earn extremely high profits. This idea has been highlighted by the media as well. However,
the wholesale buyers discard this view and claim that they earn very little profits from their
business. They claim that their profits are largely limited due to high transportation costs and
high wastage. Also they allege that there are various types of commissions and bribes that
add to the cost. The ministries concerned, viz. the Ministry of Agriculture and the Ministry of
Trade have put forward their individual proposals to purchase vegetables through Co-op City
and to import vegetables respectively, in order to address the issues but they clearly
demonstrate the conflict of interest of these two arms of the government.

Constraints

In the meantime, the country is facing a serious budget deficit and is heading to a serious
balance of payment problem. Therefore decisions on subsidies or vegetable imports should be
taken only after careful consideration.

Adding to the problem is that fact that the rural farmers and employees in both public and
private sector are the key stakeholders of the ruling party (these facts are given in the case
study). Their goodwill is essential for the government at the time of elections and to carry out
the development work.

As it is evident, this problem is multifaceted and requires action from different quarters. No
single party or ministry would be able to present a solution to this problem. Therefore, a
concerted effort from the entire government mechanism is essential to address this issue at a
national level.

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Problem Identification

According to stakeholder views that have come up at the governments opinion survey, the
major problems and their causes can be identified and summarized as follows:

1. The agricultural producers from rural areas are getting low prices for their product,
even lower than their cost of production. This is mainly due to the low bargaining
power of the agricultural producers in the market where the wholesaler buyers
dominate. The number of buyers is few but they are large in size and thus powerful. If,
in the absence of antitrust laws, the wholesalers act in unison then the agricultural
producers who are small and scattered will have no other option but to lower their
prices.

2. The consumers from urban areas have to pay high prices for agricultural products in a
market where the prices are set according to the wishes of the dominating wholesalers
who supply to the relatively small sized retailers. These retailers are small and
scattered and are not in a position to bargain lower prices with the wholesalers and
therefore the high price burden is passed on to the consumers of agricultural products
and that leads to high vegetable prices in urban areas.

3. Incorrect market price information reaching the agricultural fields, especially during
harvesting causes the farmers to incur loses as they do not get the anticipated prices at
the market. This could be due to the unavailability of price and consumer demand
related information to the farmers and also can be due to misleading incorrect
information emanating within the system possibly with the knowledge of the
wholesalers who could thereby manipulate the market.

The above three major issues can be directly attributed to the Market Power and Asymmetric
Information problems caused by the fact that the supply chain is controlled by the
Wholesalers who are a few in number with their high financial and information power.

Other than that, the following also cause the prices to rise.

4. High post-harvest wastage of agricultural products occurs especially during

transportation. Traditionally the vegetables are loaded in to the Lorries and trucks in
sacks and the wholesalers claim that nearly 25% of the vegetables are wasted in
transport and that leads to increase in vegetable prices at the destination. As a remedy
to this problem the government has encouraged using boxes and crates and has even
brought in new laws. However, because of the costs associated with this method it has
not become popular. This can be identified as a problems arising from lack of
employing best practice in the industry.

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5. Commissions and Bribes of various types have to be offered to various quarters and
that adds to the cost, according to the wholesalers. Normally such bribes are offered to
get something done that is not possible through rightful ways and means. In other
words such malpractices exist because of the weaknesses in the systems and processes
that are already in place.
Commissions may be paid for coordinating supply chain activities such as passing
product availability information during the harvesting season to the collection arms of
the wholesalers. Normally this is paid to the brokers who are individuals with some
knowledge about a particular geographical region. Commission can be legal but they
add no value to the final product and they result in increasing the price of the final
product. To avoid this, supermarket chains like Cargills have started to send their own
employees to the fields. These issues are the results of Rent Seeking.

6. High transportation cost (fuel cost, boxes and crates cost) adds to the total cost and
causes to prices to rise. This issue has been highlighted by the wholesalers. A major
part of the transportation cost is the fuel cost and this increases as the fuel prices and
the amount of travel increase. Fuel prices increase with the rising crude oil prices in
the world market and the depreciation of Rupee, which is partly due to the balance of
payment problem that the country is faced with. The amount of travel cannot be
reduced unless geographical locations of producers and consumers are changed;
which is a major overhaul.
The cost of boxes and create used in transportation should be viewed as an investment
as it reduces wastage. These can be used again and again and therefore in the long run,
using them will be profitable. However, at the initial stages the farmers and the
wholesaler will have to find extra funds to invest in boxes and crates and that problem
has to be addressed.

7. High cost of production is felt by the farmers because of the low prices that they get
for their product which leads to lower margins. This is due to the fact that more
powerful players in the supply chain earn high margins while the scattered and small
scale farmers who do not have much power are incapable of demanding higher prices
for their produce. Apart from that the other major cost burden on farmers is the
fertilizer cost. Fertilizer is an import to Sri Lanka and therefore the cost is a function
of the value of the Rupee and depreciation of Rupee adversely affects the farmers.
In the recent years initiatives have been taken to popularize organic fertilizer and
organic food production. However it is a separate market and at the moment more
export oriented. It has its own problems such as lower yield.

The issues 6 and 7 are caused by the Rupee depreciation and the negative balance of
payment problem.
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2. Theoretical Explanation

The agricultural product (vegetables) supply chain (a simplified version only the main
players are included) can be diagrammatically shown as given below. Here the arrows show
the flow of agricultural products. There are few instances where the wholesaler and the
retailer are the two divisions of the same company such as in the case of supermarket chains
(ex. Cargills) but apart from that the vast majority of the industry can be represented by the
diagram below:

Producers Wholesalers Retailers Consumers

Between each node in the supply chain, there exists a separate market. For example there is a
market between the producers and wholesalers and there is another market between the
wholesalers and the retailers. These markets have different structures and thus have different
characteristics as shown below:

Producers Wholesalers Retailers Consumers

Market 1 Market 2 Market 3

Oligopsony Oligopoly Monopolistic

competition

The producers and consumers in this agricultural products supply chain do not get fair prices
due to market failure that occur in these markets. Here, the market failure occurs as a result of
two reasons; market power of the wholesalers and asymmetric information, according to
Pindyck and Rubinfeld(2003: 592).

Market Power

The market between the producers and the wholesalers is an Oligopsony where a relatively
few major buyers (Wholesalers) and many suppliers (Producers) meet. This market is
dominated by the Wholesalers who set the price. At the same time the market between the
Wholesalers and the retailers is an oligopoly. In this market there are relatively few major
suppliers (Wholesalers) and many buyers (Retailers). This market too is dominated by the
same Wholesalers who set the price. In the monopolistic competition market between the
Retailers and the Consumers, since there are a large number of buyers and sellers and there is
a high competition among the sellers, the sellers (Retailers) attempt to differentiate their

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products but a single seller cannot charge higher prices from the consumers than any other
seller (Retailers). This results in low market power of Retailers.

As it is evident from the above analysis the Wholesaler is the member with highest market
power in the supply chain and therefore can control the supply chain. This justifies the notion
that wholesalers manipulate the market price as they have to power to do so if they wish to.
When they intend to earn higher income the consumer-prices increase.

Asymmetric Information

The Wholesalers have an information advantage over the Producers and the Retailers. The
Wholesalers are financially well established and they have gathered the knowledge about the
supply chain over the time. At the same time they operate in a large scale. The Producers and
Retailers are scattered and not organized. Producers have very little information on the
consumer prices in the urban areas and both Producers and Retailers are not aware of the
costs in the supply chain. Moreover they are not in a position to collect and process such data
largely due to the small scale at which they operate. Therefore, they are incapable of
bargaining with the Wholesalers for better margins.

The consumers are also affected by the Market power and asymmetric information advantage
of the wholesalers as they keep high margins and thereby indirectly set high consumer-prices.
Apart from that the following increase the price:

Rent Seeking

According to Pasour, rent seeking is attempting to obtain an economic rent / wealth transfer
by manipulating the social and political environment of economic activities rather than by
engaging in a wealth creating activity. An economic rent is defined as the additional income
paid to a factor of production other than the amount that is needed to keep it in its current use.
Rent seeking is different from profit seeking where actual wealth creation takes place. The
net effect of rent seeking is reduced total wealth as the resources are spent on unproductive
activities. It is a wealth redistribution process and it can be legal or illegal, according to Khan
and Jomo (2000). Bribery is one of the illegal forms of rent seeking. Commission can be legal
but it does not add any value to the product being sold in the market and increases the price.

Depreciation of Rupee and the Negative Balance of Payment

Depreciation of the Rupee causes the amount of Rupees to be paid for imports to rise. There
can be a variety of reasons for this including loss of exports competitiveness. When the
balance of payment is negative that means the country has a trade deficit and the country
needs to pay more for the imports. That means demand for foreign exchange increases and
that leads to an increase in the amount of Rupees required to get a certain sum of foreign
exchange. The cumulative effect of these is the increase in the prices of imports in the local
markets including inputs such as fuel and fertilizer thereby increasing the cost of production.
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3. Solutions

As mentioned earlier in this report the solutions to this problem should be sought at a national
level with a concerted effort of the entire state mechanism. In doing so, various kinds of
structural changes will need to be made in the economy of the country.

Asymmetric information problem can be sorted out to a certain extent by providing

the access to information to various parties in the supply chain. With the now
available information technology solutions such as inexpensive computers and mobile
telephone market information can be passed on to the producers and retailers; and
even to the consumers. By means of this the information advantage of the wholesalers
can be countered and thus their market power can be challenged. However, for this to
happen the IT knowledge of the farming community should be further increased and
proper information sharing mechanisms among markets should be established and that
will have some costs. But in the long run there will be more benefits as rent seeing
can also be minimized with this.
Depreciation of Rupee and negative balance of payments can be addressed several
ways. On method is by limiting imports and increasing exports. However this has its
own merits and demerits. When the imports are restricted there can be scarcity of
goods in the markets and the people will have to suffer and it could lead to the
creation of displeasure towards the government among the people. On the other hand
in order to increase the exports earnings the exports competitiveness of products will
have to be increased. It is a known fact that countrys main exports are facing fierce
competition in the international markets and experiencing price drops. Under such
circumstances the country will have to find exports where the country has as
comparative advantage and therefore can guarantee sustainable earnings.

Based on these individual solutions to specific problems two solution packages can be
presented as follows;

Solution 1

Importing vegetables from a country which has a comparative advantage in production of

vegetables (at a lower cost) and thereby supplying to the market at an affordable price to
consumers while shifting the land and labor currently employed in agricultural production in
to some other sector where Sri Lanka has a comparative advantage; this will lead to an
economic as well as social restructuring process.

Advantages This way of addressing the issue will guarantee the best prices for the
consumers and higher earnings for the producers (-once they are shifted to
another sector). The country will be able to optimally utilize its resources
and this will lead to higher earnings and higher wealth creation for the

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country. This will help in reducing the debt burden of the country and
improving the balance of payments. If the rupee appreciates and the
balance of payment turns in favor of the country, and most importantly if
the demand for Sri Lankan products (goods as well as services) in the
global markets is high, servicing the existing debt will not be a problem.

Disadvantages High dependency on international trade and international relations is the

main disadvantage in this method. Also the economy will be more
vulnerable to the fluctuations in the world markets. As the new industry
structure will be based on the comparative advantage there will be only a
few home industries and that involves a considerable risk. Another side of
the problem is the extinction of indigenous products, methods and
processes and culture. There is also a risk of losing food security that could
adversely affect the national security. Higher proficiency of risk
management and handling international relations will be required if this
approach is followed. Also it will take a considerable time in transitioning
the economy.

Solution 2

Preserving the agricultural production (and therefore, as a part of it, the vegetable
production) in Sri Lanka by offering subsidies and incentives to the industry and altering the
distribution of income within the supply chain while taking necessary steps to redistribute
wealth within the entire economy of the country; this will also lead to an economic as well as
social restructuring process.

Advantages The main advantages of this approach are the restoration of the subsistence
economy and the food security gained through that. Also the economy will
be less vulnerable to the fluctuations in the foreign markets.
Through the changes in income distribution the producers will get better
prices. This will be good for the rural populations based on the agriculture
and are the majority.
This approach will take relatively less time in transition and will require
less expertise than the solution 1.

Disadvantages The local prices will be higher than the average prices in the global markets
and therefore the consumers will not get the best prices. However this will
only affect the urban populations who are still not a majority. This is an
issue to be addressed.

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4. Recommendations

Considering the available two approaches in finding a solution to the problem solution
package 2 is preferred as it is less costly, less changes are associated and provides results in a
comparatively shorter period of time. In order to implement this solution the following need
to be done:

A value chain analysis vegetable trading should be done.

The profit margins of each party involved in the value addition process should be
identified.
New profit margins should be set based on the costs and risk associated with the
functions of each party providing allowances for competition.
A statutory body should be established to monitor the prices in various markets in
order to ensure that the prices fluctuate within the preset profit margins of each party.
This can be done through the Consumers Affairs Authority too, but the act will have
to be amended.
An interim allowance should be paid to the various segments in the society such as
the adversely affected urban population. This should not be viewed as a heavy burden
on the economy as they are a minority; the solutions to the problems of the majority
rural community will also result in price reductions in the long run.
The above procedure should be extended to cover all the industries and the entire
economy of the country thereby redistributing the income of factors of production
depending on their relative scarcity and utility. This should be made part of countrys
economic development initiative.

5. References

1. Burkett J. P. (2006), Microeconomics: Optimization, Experiment and Behavior,

Oxford University Press, United Kingdom (188-190)
2. Consumer Affairs Authority Sri Lanka Act 9 of 2003
3. Khan, M.H. and Jomo K.S. ed.(2000), Rents, Rent-Seeking and Economic
Development: Theory and Evidence in Asia, Cambridge University Press, United
Kingdom
4. Pasour E. C. Jr. (1983), Rent Seeking: Some Conceptual Problems and Implications,
The Review of Austrian Economics
5. Pindyck R. S. and Rubinfeld D. L. (2003), Microeconomics, 5th Ed. Pearson
Education, India
6. Varian H. R. (2010), Microeconomic Analysis, 3rd Ed., Viva Books, India

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