Download 1 SUPPLY RESPONSE WITHIN THE FARMING SYSTEM CONTEXT

SUPPLY RESPONSE WITHIN THE FARMING SYSTEM CONTEXT
WEEK 2: DAY 3
INPUT SUPPLY AND PRODUCT MARKETS
by Eric Tollens, Catholic University of Leuven
CONTENTS
1. INTRODUCTION
2. INPUT MARKETS
2.1. The essential nature of input supply
2.2. Structural adjustment and input markets
2.3. Input market failure and the need for government intervention.
3. PRODUCT MARKETS
3.1. The essential nature of product markets
3.2. The nature of market competition
3.3. Instability in agricultural markets
3.4. Marketing efficiency and performance of product markets
3.5. Market failure and government intervention in agricultural markets
4. SUMMARY AND CONCLUSIONS
REFERENCES
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1. INTRODUCTION
Input supply and product markets constrain agricultural supply response, particularly in
developing countries. Traditional farmers or subsistence farmers - Ellis (1988) calls them
peasants - are usually partially integrated in markets that tend to function with a high degree of
imperfection. The degree of subsistence is one of the reasons why the integration of peasants
into the market economy is only partial. But peasant production is always exposed to some
extent to the market forces. The inputs and outputs of peasant farms are subject to valuation by
the wider market, at prevailing prices, even if a small proportion of the households' requirements
are satisfied through interactions in the markets.
Markets provide both opportunities and pressures. Engagement in them may lead to higher
living standards or more diverse consumption, but at the same time it may also expose the
participants to the possibility of ruin either from adverse price trends or from the exercise of
unequal market power. Thus the relationship between the traditional farmers and the market is
characterised by a continuous tension between the risky advantages of market participation and
the preservation of a non-market basis for survival. This plays a major role in determining the
supply response. Markets work in different ways depending upon the number and size of
participants on each side of the market, the adequacy of information flows between buyers and
sellers, and the physical infrastructure (roads, railways, wholesale and retail facilities, etc.)
necessary for commodity transaction.
Traditional or peasant farmers are characterised by their varying rather than total commitment to
the market. This implies also a variable capacity to withdraw from the market and still survive.
The markets themselves are incomplete and often function poorly. Such market imperfections
are defined in comparison to a hypothetical ideal, the perfectly competitive market. In the
perfect competition model, no coercion, domination, or exercise of economic power, by some
economic agents over others, can exist. In contrast, traditional or peasant society features nonmarket, or reciprocal, transactions between farm households. Reciprocity refers to exchanges
which are culturally defined, non-replicable between one event and the next, and involves unlike
goods and services. Such transactions are not valued by market price. Reciprocity may also
involve social norms of sharing and redistribution which are designed to ensure that all members
of the community survive, irrespective of the year to year productive performance of individual
households (Ellis, 1988, p.10). Thus, competition does not exclusively or even principally define
the relations of peasants to each other or to outsiders.
The markets confronting peasants may be imperfect for reasons of low and uneven development
of the economic infrastructure. This may be because of spatial fragmentation due to poor
transport and communications. Market information may also be poor or non-existent.
Ellis (1988, p. 11-12) compares the economic situation of a typical farm family in an industrial
market economy with that of a peasant farm family:
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Industrial market economy
- credit is abundantly available from developed
financial markets (banks, credit agencies etc.)
at competitive market rates of interest;
Peasant farm family
- credit and rates of interest may be tied to
other factor prices like land and labour within a
dependent economic relationship, thus factor
markets may be locked together contractually
rather than being independent;
- variable production inputs may be erratically
available or unavailable, their quality may
vary, access to them may involve formal or
informal systems of rationing;
- variable production inputs (fertiliser, seed,
fuel, chemicals) are available up to any
quantity that an individual farmer might wish
to purchase from reasonably competitive
suppliers;
- knowledge of the latest available
technologies is widespread and discussed at
length in all farming magazines;
- market information is poor, erratic,
fragmentary and incomplete, and there is a
high cost for the farm household in acquiring
information beyond the immediate confines of
village or community;
- a freehold market for land does no always
exist, and where it does non-market rights of
access or non-price forms of tenancy are likely
to predominate over open market transactions
in land;
- markets and communications in general are
not well integrated, and depending on place
and infrastructure there are varying degrees of
isolation between local communities, regions,
and the more developed segments of the
national economy.
- there is a freehold market in land, so that the
potential exists for new entrants to begin
farming and unsuccessful farmers to exit from
agriculture;
- information on prices of both inputs and
outputs is available typically on a nation-wide
basis, reflecting the high degree of integration
of markets and communications.
This comparison illustrates why supply response may be quite different between these situations,
and how input and product markets in developing countries may constrain supply response more
than in industrialised countries.
2. INPUT MARKET1
2.1. The essential nature of input supply
Input supply is an essential condition for agricultural production and supply response. Inputs are
either produced on the farm, such as farm produced seeds, manure and compost, farm tools, or
are purchased, such as fertilisers, pesticides, new seeds, irrigation water, mechanical power,
animal feeds, breeding stock and veterinary services. The process of agricultural development, in
every part of the world, had been associated with increasing dependence on such purchased
inputs. Today the scope for expanding the area under cultivation of pasture is limited and
growth of agricultural output must come from increases in intensity, which necessitate utilisation
of more purchased inputs The large increases in crop production during the “Green Revolution”
1
This section draws on “Input markets” prepared by Martin Upton of the University of Reading for the module
“Structural Adjustment and Agricultural Policies” of the thematic field "Agricultural Economics and Agricultural
Policies".
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in Asia resulted from the introduction and delivery of a complete package of complementary
inputs including new seeds, fertiliser, irrigation and pesticides.
Governments of developing countries have therefore seen the provision of agricultural inputs as
an important method of promoting supply response and agricultural growth. Public institutions,
such as the extension advisory service, crop parastatals, credit agencies or Agricultural
Development Corporations have been charged with input delivery, very often at subsidised
prices or even free of charge.
The delivery chain for a farm input may have many stages between production or manufacture
and distribution to the farmer; and vertical integration is rare. The manufacture of some inputs,
such as agro-chemicals, vaccines or machinery, involves large-scale and sophisticated
technology. In the early stages of development they were generally imported, but subsequently
many governments have adopted import-substitution strategies and encouraged domestic
production. A secondary aim of agricultural input policy may be to promote the supply industry
by means of import controls and subsidies on the domestic product. Farmers are “consumers” of
an input, their derived demand reflecting the marginal value productivity of the input.
In developing countries, markets confronting peasants are often incomplete and imperfect.
Markets for some factors of production may not exist, for others it may be fragmented or
distorted, and market information may be highly imperfect. When this is the case, supply
response will be greatly constrained by the poor performance of input supply markets.
2.2. Structural adjustment and input markets
The four main components of most structural adjustment regimes are:
−
exchange rate policy to correct over-valued exchange rates;
−
reform of the trade regime, to reduce tariff protection for industry and remove other
controls;
−
price reforms to improve export incentives particularly for primary products;
−
market and institutional reforms to reduce the role of the public sector and encourage
privatisation, in the belief that this will result in greater efficiency.
All of these changes are likely to affect agricultural input markets.
Trade and price reforms normally leads to a rise in the domestic prices of tradable commodities,
including both export crops and imported food. These changes provide incentives for increased
domestic production and greater use of purchased inputs. The relaxation of trade restrictions
may have the opposite effect, by allowing the entry of cheap imports. Currency devaluation also
raises the price of imported tradable inputs which increases the farmer’s costs of production and
acts as a disincentive.
It is assumed by those implementing structural adjustment measures that the benefits to farmers
from increased product prices will exceed the increased costs of imported inputs. However, in
some countries where structural adjustment regimes have been introduced, input prices have
risen faster than output prices, with consequent adverse effects on supply response and farm
incomes. The effect is exacerbated by market and institutional reforms involving cuts in
government spending on the provision of inputs, and moves towards privatisation.
Where inputs such as planting material or pesticides are provided to the farmers free of charge,
or at a price below the full cost of supply, the government must make up for the difference by
means of a subsidy from public funds. This is generally the case regardless of whether the input
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delivery is in the public or the private sector. There are some serious disadvantages associated
with the payment of input subsidies from public funds. It is argued that private funding through
full cost recovery from farmers is preferable in terms of efficiency, sustainability and equity
(see James & Upton, 1993).
Efficiency is reduced by paying a subsidy, since it encourages excessive use of the concerned
input thus diverting expenditure from other lower-cost but unsubsidised inputs. Similarly,
suppliers are encouraged to produce more of the subsidised input than that would be justified
under competitive market conditions and divert resources from the supply of more productive
inputs.
Continuous subsidisation of inputs may be unsustainable because of the drain on limited
government funds. The intended effect of the subsidy is to increase sales and usage of the input,
but this means that the cost of a fixed rate subsidy is likely to increase over time. Governments
facing increasing debt burdens from this and from other causes, may be unable to maintain
adequate supplies of the subsidised input to meet the market demand. This may lead to shortages
necessitating some form of rationing, and/or an eventual development of illegal high-priced
parallel markets. The results are losses of efficiency in resource allocation and in distributional
equity. These problems could be avoided if the full costs are recovered from the farmers using
the inputs.
The equity problem relates to the regressive effect of input subsidies on income distribution.
The wealthier, larger-scale farmers and herders who use more of the input than those less-well
endowed, will necessarily benefit more from the subsidy. In case of shortages caused by the
subsidy, the rich and powerful again are better able to gain access to the limited supplies. In
contrast, full cost recovery is equitable in the sense that the user pays directly for the benefits
derived from the productive input.
These arguments have considerable force and may explain the pressures for full cost recovery
from farmers as a condition of World Bank and other international loans. However, there are
equally strong arguments emphasising cases of market failure (see further) and the continuing
need for government funding for the provision of certain essential agricultural inputs. Attempts
at cost recovery for the entire spectrum in input services may have disastrous effects on
agricultural supply response. It may explain in part why supply response in the framework of
structural adjustment policies, at least in the short- and medium-term, has been very limited
(reference is made to the section on agricultural supply response assessment - week 3 - day 4).
2.3. Input market failure and the need for government intervention
Imperfect market or market failure implies that some conditions necessary for the competitive
situation are not fulfilled. Three main causes of market failure can be identified, namely; (i)
public goods, (ii) imperfect information and high transactions costs, and (iii) market
imperfections.
(i) Some agricultural inputs, such as measures to prevent the spread of livestock diseases, or the
erosion of topsoil, have the characteristics of public goods. A public good is one which meets
the criteria of non-exclusivity and non-rivalry. The first of these criteria means that it is
impossible to exclude people from enjoying the benefits of a campaign to eradicate rinderpest, or
to prevent soil erosion, even if they are “free riders” who do not pay. Furthermore, non-rivalry
means that if one more livestock keeper or soil cultivator benefits from the programme, no
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additional costs are incurred; the marginal cost is zero. In contrast a private good, such as a bag
of fertiliser used by farmer A cannot be used by anyone else and has a positive marginal cost.
Direct cost recovery from users of a public good is very difficult, if not impossible. Although
some public-spirited individuals may be willing to pay some of the cost there will inevitably be
underspending on the input. Public funding, or indirect cost recovery through taxes, is essential
for efficient allocation of resources to such inputs.
(ii) Imperfect information among producers, regarding the states of supply and demand and
prevailing prices, can cause inefficient allocation of resources. This applies to most agricultural
input markets since the population of farmers is widely dispersed and communications are
difficult. Thus the costs of acquiring information and organising trade, known as “transactions
costs”, are high. Indeed, in some circumstances these transactions costs are so high in relation to
the overall economic surplus that may be gained through trade, that no private market develops.
Another cause of high transactions costs is the problem of enforcing contracts. Thus, collection
of fees for vaccinating or dipping cattle, or credit repayment, may sometimes necessitate
repeated visits or even legal action.
The provision and improvement of rural infrastructure, feeder roads, communications, a legal
system for the enforcement of contracts and market information, are the responsibility of the
Government. Such public goods must be funded from the national budget. In addition, provision
should be made for the regulation and quality control for agricultural inputs. Producers may
suffer from imperfect information relating to the quality of purchased inputs, such as improved
seeds, fertilisers, other chemicals and veterinary drugs and vaccines. Unregulated private
enterprise, it is suggested, might sell inappropriate, untested or adulterated materials or items
which had passed their “sell-by” date (and may have lost their potency).
(iii) The argument that a market equilibrium is efficient, breaks down if there are market
imperfections, for instance, if the number of suppliers is small which is quite commonly the case
for agricultural input delivery. Indeed, input delivery systems are generally subject to technical
economies of scale, which create “barriers to entry” and establish a “natural monopoly”. The
economies of scale derive largely from the high costs of distribution and delivery to large
numbers of widely dispersed farmers. These costs do not vary directly with the number of users
or the amount of input used; they are, in part, fixed. Thus the average cost per unit of input
delivered is likely to fall as the quantity delivered is increased. It would be inefficient for
competing suppliers to duplicate the delivery system and share the market, especially where the
input is bulky or perishable and therefore costly to deliver.
Imperfect information and high transaction costs may create barriers to potential market entrants,
and consolidate the monopoly of an existing supplier. Furthermore, governments often grant
licences or franchises to private companies for the distribution of farm inputs, whilst maintaining
managerial control and supervision of the process. The issue of a licence or franchise
establishes a “legal monopoly” for the firm concerned. Thus, local monopolies are far more
likely to result from privatisation than are perfectly competitive markets.
As is well known, a private monopoly is inefficient. The supply of the product -in this case a
farm input is restricted in order to raise the price received. This results in a dead-weight loss of
welfare to the whole economy as well as a transfer of welfare from agricultural input consumers
to the monopolist input supplier.
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Given the fact that the consumers often are resource-poor farmers, and the monopoly supplier is
more likely to be a relatively well endowed commercial firm, or even a transnational, this
income transfer may be considered particularly undesirable. There is, thus, a debate over
whether government control of private monopoly power is feasible or indeed whether
privatisation which substitutes a private monopoly for a public one has any merit.
In a developing economy, most agricultural input delivery systems are natural monopolies with
increasing returns to scale, and decreasing average costs. Thus government price and quality
regulation are some times necessary to protect consumers of inputs, although some of the
efficiency benefits of privatisation may be lost as a result. Such regulations may prove difficult
in practice. Group activity by farmers to procure and distribute inputs has some obvious
advantages, but its promotion and development may prove intractable.
Unfortunately, the record of government-sponsored farmer co-operatives is not encouraging on
the whole. Where they have survived, they have often remained as effective organs of
government or they have been dominated by a few wealthy members. It is not easy for the
government to promote and support non-government organisations without compromising their
integrity. At the same time evidence suggests that true co-operative activity is only found in
relatively small groups. Thus, despite the desirability of farmer participation in input supply, it
may be difficult to promote.
The above explains why input supply remains an important constraint in supply response, even if
(output) price incentives are present. Non-price factors such as input supply, and in particular
the agricultural input supply delivery system, play a critical role in determining agricultural
supply response.
3. PRODUCT MARKETS2
3.1. The essential nature of product markets
Buyers and sellers of goods interact in markets and exchange goods for money or in-kind
(barter). Money facilitates the exchange process. Even in very primitive societies, simple
markets will develop as individuals exchange goods with each other, and gain because of the
advantages of the division of labour and specialisation. The basic economic forces which operate
in markets are, demand and supply.
In a free competitive market, there is an equilibrium price at which buyers take all that sellers
can offer and the market is cleared. The balancing of supply and demand is arrived at
automatically, through a sort of "invisible hand". This is because goods are moved from places
where prices are low to places where prices are high such that eventually prices are so close that
further movement is unprofitable. This process of moving goods to reach an equilibrium price is
called arbitrage. It is vital in any free market that arbitrage takes place.
In a command economy or state directed economy, the same basic economic forces operate but
the state fixes the prices and thus commands how much needs to be produced and how much can
be consumed. Rationing is often part of a command economy as it is nearly impossible for the
2
This section draws on “Market theory: the state and the private sector“ prepared by Eric Tollens of the Catholic
University of Leuven for the module “Structural Adjustment and Agricultural Policies” of the thematic field
"Agricultural Economics and Agricultural Policies".
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state to set an equilibrium price which exactly equates demand and supply. Thus, it is no surprise
that in command economies, free or black markets spring up, although they are often illegal.
A free market is the basic model of a market used by economists -the perfectly competitive
market- although real markets often deviate from this ideal model of a market. In general, free
agricultural markets approximate more closely the perfectly competitive model than do markets
for industrial or other goods. A lot of economic theory is founded in the perfectly competitive
market model. The manner and extent to which a particular market departs from the perfectly
competitive model, is important for marketing policy and government intervention.
Product markets provide an outlet at a certain price for agricultural producers. This price can be
a real incentive to produce, or can be disincentive, inducing the farmer to reduce the amount of
product which he or she brings to the market. If the incentive is insufficient, the farmer may aim
to become self-sufficient only, selling in the market only occasional surpluses. If enough
production incentives are present, the farmer may decide to specialise in a particular product and
produce wholly for the market. The cash income thus derived will be used to meet his/her other
needs, which will also be procured mainly through the market.
According to Ellis (1988), peasants cease to be peasants when they become wholly committed to
production in fully formed markets. They become instead family farm enterprises, producing for
the market and deriving their income and livelihood through the market. Their supply response
is then fully dependent on the performance of markets.
3.2. The nature of market competition
In a fully competitive market, a supplier can sell all its goods at the market price but it cannot
affect the price. The demand curve faced by each supplier is infinitely elastic. Under such
competition, all a supplier or a firm can do is to try to lower its costs to a minimum and increase
volume produced.
One way to escape from such competition is to produce a non-homogeneous product, such as a
new product or a product with a special taste or appearance or with an attractive brand name.
Such attempts are moves into the direction of monopolistic competition or oligopoly, meaning
competition by a few.
In principle, competition encourages efficiency. In the long run, only the most efficient will
survive. This is often labelled by proponents of state intervention as the law of the jungle or the
law of the most powerful or even chaos. In a fully competitive market, the pressure is high to
increase productivity and thus to lower costs, for instance through adoption of new technologies.
Also, changes in market preferences and market conditions must be followed closely in order to
survive. The prices established in competitive markets really act as signals to producers to
produce more or less, to consumers to consume more or less. They are thus co-ordinating
mechanisms which equate supply with demand. Fully competitive markets do require good
marketing information and clear rules of marketing conduct. This is called marketing software,
and in most developing countries deliberate government intervention is necessary to provide
such public marketing information and proper rules of marketing conduct. This is not to say that
market participants by themselves also cannot operate a public market information system and
establish marketing regulations and even conflict settlement in disputes, as is often the case in
many industrialised countries. Moreover, efficient agricultural marketing also requires a
minimum of marketing infrastructure, the hardware, such as roads, communications and physical
marketing infrastructure such as wholesale and retail markets, warehouses etc. This is also a role
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for governments or public authorities (e.g. municipalities or local government) since the private
sector is usually not interested in providing these services or when they provide it, they do it as
monopolists. Thus, although competitive markets may spring up by themselves, they are not
necessarily efficient nor performing because of lack of marketing software and hardware
resulting in high transactions costs and market failures. If this is the case, supply response is
bound to be less than what it would be in the case of well performing competitive markets.
3.3. Instability in agricultural markets
Demand and supply schedules are always considered for a particular time period or per unit of
time. Over time, demand and supply can vary considerably. For agricultural products, supply
varies because of seasonal variations induced by climate and growing season, and cyclical
variations because of the time lag involved in the reaction of supply to changed market
conditions. The biological nature of agricultural production implies considerable time lags in
supply response, resulting in sometimes very unstable markets. Demand can also vary with the
seasons and according to business cycles (expansion and contraction or recession in the
economy). The inherent instability in agricultural markets, including world markets for
agricultural exports, and domestic food markets, is one of the main arguments in favour of
government intervention in the market. Such intervention can take many forms.
Direct government intervention along established private sector traders to influence market
prices is invariably very costly on the government treasury. Total control of the market via a
monopoly granted or a state or parastatal marketing board usually brings with it many
inefficiencies, including rent seeking. Structural adjustment programs usually require
governments to liberalise markets and to reduce government intervention. This usually brings
with it more instability in agricultural markets. More instability means higher price risk for
farmers and when risk is higher, supply response will be lower compared to the situation with no
or less risk.
3.4. Marketing efficiency and performance of product markets
It is important to be able to evaluate marketing efficiency and performance of a particular market
to guide government intervention. In general, marketing performance can be judged by
following three criteria:
− efficiency:
• allocative efficiency or resource use efficiency: Indicates that marketing functions are
performed at the lowest possible cost.
• price efficiency: This is the efficiency with which prices are reflected back from consumers
to producers and vice-versa in the marketing chain. Good price efficiency indicates that price
signals are transmitted well in the marketing chain. There will be good vertical co-ordination
and good market integration. Arbitrage will take place and price differences between markets
will reflect transaction costs only. Thus, markets will be transparent and overall market coordination will be good.
− progressiveness: This is a measure for innovation and technological change in agricultural
marketing. In a performing marketing system, there is innovation in terms of products and
services and such innovation is rewarded by the consumers if it reflects customer wants and
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needs. It is maybe of more importance in developing countries than in industrialised
countries.
− equity: This has to do with the distribution of the benefits of agricultural marketing.
Everybody participating in the system should be rewarded according to his/her contribution
and nobody should get excess profits (e.g. monopoly profits). This excludes monopoly
operators or excessive market power by any one participant.
3.5. Market failure and government intervention in agricultural markets
According to Adam Smith's invisible hand theory, society is best served by an efficient market
in the sense that both individual and societal incomes are maximised when individuals react to
price signals in such a way as to earn the greatest possible profit or income. In such a concept,
private valuation equals social valuation. In some instances however, there may be a divergence
between the private profitability of certain activities and their social profitability. This provides
an argument for government intervention.
Private and social valuation of activities differs in the following cases:
1. When free market prices do not really reflect societal scarcities because of market failure;
2. When free market prices do not reflect societal scarcities consistent with society's or
government's development objectives or social goals.
Market failure is common for goods and services which normally escape market processes. Such
cases are called externalities or external effects that benefit or cost some people in society, e.g.
environmental pollution. Market failure also occurs when a firm cannot fully capture the
benefits of its productive activity. This is normally the case in the provision of public goods
such as defence, basic education, agricultural research and extension or emergency food storage.
In many of these cases, there is a free rider problem and it is impossible for the firm to control
the use of its product or service. If there is no government intervention in such a case, not
enough of these public goods will be provided. Another case of market failure occurs when
there is only one buyer or seller in a market, so that monopoly profits are earned. In the absence
of government intervention, production of the goods or services will be restricted and prices will
be set above competitive levels. Such a monopoly is often the case because natural conditions
allow only one firm (e.g. a mineral spring, an ore deposit), or very large economies of scale are
present in the production of the good or service resulting in only one firm allowed to operate.
This is often the case with public utilities, particularly in smaller countries. It is also possible
that through free market competition, an industry ends up with only one or a few firms through
mergers and acquisitions. This is then a case for antitrust measures by the government to restore
competition in the market.
Ellis (1992) lists market failures which call for state action to overcome them as follows:
1. Failures of competition: the existence of various types of monopoly power in the economy,
for example the existence of localised trading monopolies in the supply of consumer goods to
rural areas or in the purchase of crops from farmers;
2. Failures of provision: the existence of a class of goods and services that private operators are
not prepared to supply because once they are made available, it is impossible to exclude
individuals from making free use of them ("public goods" such as open pollinated varieties of
crops, street lighting, police force, national defence, and public roads);
3. Externalities: costs that are not incurred by the private operator but represent disbenefits to
other members of the community, such as the impact on downstream river users of pollution
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4.
5.
6.
7.
8.
by a private industrial plant (negative externality), or benefits that do not accrue to the private
operator but represent gains to society, such as the beneficial impact of higher education on
the level of skills in the country (positive externality);
Common property resources: resources of communal access (e.g. forests for firewood or
communal grazing lands) where the private cost of using more of the resource is lower than
the social cost incurred by the community as a whole, resulting in over-exploitation and
possible permanent damage to the resource;
Incomplete markets: where markets fail to produce commodities or services for which there
is a private demand at prices above production cost, due to transaction cost e.g. in fragmented
markets and moral hazard problems (the credit market, with high risk of default and high cost
of enforcing repayment, is a good example);
Failures of information: a tendency to under-produce the type of information to which
everyone should have access if markets are to work well (e.g. information on prices and
technologies);
Macroeconomic problems: problems that can only be handled by a central authority, for
example, money supply, inflation, exchange rate, taxation and so on;
Poverty and inequality : the market outcome may result in a degree of inequality or an
incidence of poverty that is regarded as socially unacceptable by the majority of people in
society.
It goes without saying that all these cases of market failure bring with them inadequate supply
response. If the markets fail in their main mission, which is to co-ordinate supply and demand in
a socially acceptable way, then the usual result is inadequate production to meet the demand.
Governments are more likely to intervene in agricultural markets, not only because of market
failure, but also because of social goals which cannot be attained through free market processes.
Such goals can vary widely and they are usually clearly spelled-out in development plans. They
almost always impose a cost on the economy in terms of loss of efficiency or economic growth.
Such goals include:
• improving income distribution;
• achieving a government determined growth rate, rate of exports, rate of employment, rate of
self-sufficiency, etc.;
• achieving more regionally balanced growth;
• achieving a particular production strategy, e.g. achieving a certain supply response.
Sometimes, such goals can best be achieved with market solutions with the government intervening through income transfer or fiscal policy. In other cases, governments tend to change
the prices in markets or become a direct participant in markets in order to have more control
over prices. Many governments in developing countries believe that market forces would be too
weak to accomplish the changes required for accelerated development. Often they tend to
overestimate their own power to change things in the required direction and neglect the time
span required for an adequate structural transformation. Impatience with the state of affairs is
often an argument for governments to intervene. It is often very attractive to have a "visible"
hand at work when the “invisible” hand seems to have very invisible consequences. There is
often also a belief that socially desirable investment opportunities would not be taken up by the
private sector.
In the agricultural sector, instability of agricultural and food markets is often the main argument
for government intervention. As food purchases often make up more than 50% of the
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expenditures of workers, including civil servants, governments feel they have a social obligation
to stabilise market prices and to intervene directly in the marketing system.
The extent of government intervention varies widely between countries and also the form of
government involvement in an economy can take many forms. In reality, all economies have
some mixture of government intervention and market functions. Even strong market economies
have an important public sector, whose role is to assure that the private sector operates in an
orderly fashion and to provide public goods and services which would not be supplied
adequately by private firms.
The excesses and inefficiencies of poorly executed government involvement in African countries
became evident by the early 1980s through a mounting debt problem, government deficits,
sluggish or no economic growth, balance of payments problems, overvalued exchange rates,
runaway inflation and other macroeconomic imbalances. If the countries had grown at 5% or
more in real terms, the excesses and inefficiencies would probably have been tolerated.
Ellis (1992) presents the following list of "state failures" as a contrast to the list of "market
failures" set out above:
1. Information failure: it is almost always wrong to assume that state officials have any clearer
idea of the market in which they are intervening than private sector operators in that market;
2. Complex side effects : the state has no way of predicting accurately the secondary and
tributary effects of actions carried out on a particular economic problem;
3. Second-best theory: when several market failures are present, state action to correct any
single one of them may result in a worse outcome for society than no action at all;
4. Implementation failures : even if a policy is correctly designed to increase social welfare, the
predicted gains may be lost in poor and inept implementation;
5. Motivation failures: state officials are often paid very low wages, sometimes even below
their needs of subsistence, meaning that secondary sources of income may be essential for
their livelihood;
6. Rent-seeking: state action that involves artificially restricting the supply of a good or service,
or making its availability conditional on the issue of a licence, can lead to bribery and
malpractice by those seeking to capture the rents to be gained by being allocated a share of
the restricted commodity. The methods used by individuals in order to get access to state
licences, etc. have also been called directly unproductive profit-seeking activities.
Again, state failures result in inadequate market performance and insufficient production
incentives. Supply response below what could be normally expected is the inevitable result.
With the structural adjustment policies, there is a resurgence of the neo-classical vision which
stresses the advantages of relying on markets rather than on deep government intervention. It is
believed that broad-based strong economic growth can best be achieved through a redefinition of
the role of the government in the economy, through economic liberalisation and a greater
reliance on the private sector for investment and growth. Even in the presence of market
distortions, it is believed that government intervention may introduce greater distortions,
wastage of scarce resources and rent seeking activities by government officials and citizens. The
regulatory framework of governments is often inconsistent and confusing and a streamlining and
tidying up of rules and regulations is called for.
It is now believed that the disadvantages, including the cost, of detailed government intervention
are often larger than the deficiencies of the markets. Improving and strengthening the marketing
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system, including the provision of adequate marketing hardware and software, is far more
productive than attempting to supplant markets with a system of detailed administrative policies
and controls. Creating a positive environment for private investment and risk taking could have
much more beneficial effects than direct government involvement with markets. Moreover, low
farm prices arising from government intervention have often been cited as a major factor in the
poor performance of agriculture in many less developed countries (Stevens and Jabara, 1988).
This assumes that price elasticities of supply are high, at least in the medium to long term, and
that non-price factors are of lesser importance. This is often wrong as the constraints imposed
by non-price factors such as physical, institutional and technical constraints to agricultural
supply response including poor performance of input and product markets, dampen supply
response considerably, even in the presence of adequate product price incentives. “Getting prices
right” in developing countries is usually a necessary albeit insufficient condition to elicit large
supply response.
4. SUMMARY AND CONCLUSIONS
Input supply and product markets in developing countries are a constraint on agricultural supply
response. This has to do with market imperfections or market failures as a result of low and
uneven development of the economic infrastructure (hardware), particularly poor transport,
communications, market fragmentation, and inadequate rules, regulations and institutions
governing the functioning of markets, particularly information failures, high risk and excessive
market power by certain participants. This results in high transactions costs which is a symptom
of poor marketing efficiency and performance.
For given retail- or end-user prices, high transaction costs result in large marketing margins and
low producer prices that are inadequate production incentives. Even when production incentives
are adequate, absence of non-price factors, particularly public goods and services which
facilitate the functioning of markets such as roads and communications, marketing
infrastructure, market information and input delivery systems, constrain supply response.
Structural adjustment policies address market imperfections and market failures regarding input
supply and product markets. Concerning input markets, the changes are intended to provide
incentives for increased domestic production and greater use of purchased inputs. But cuts in
government spending on the provision of inputs, and privatisation have often affected negatively
the input delivery system. Full input cost recovery from farmers is not always possible,
particularly for inputs with a public goods character (e.g. vaccines) or with free riders problems
(e.g. open pollinated seeds). In addition, private input supply has some of the characteristics of
natural monopolies, with increasing returns to scale , and decreasing average costs, requiring
regulation from government or public bodies. Indeed, privatisation of input delivery systems
often results in local monopolies whereby one type of state failure is then replaced by another
type of market failure.
Governments often feel obliged to intervene in product markets because of the inherent
instability of agricultural markets, in order to correct market failures and to pursue social goals
which cannot be attained through free market processes. But government involvement in
markets often results in “state failures”. With structural adjustment policies, improving and
strengthening marketing systems instead of direct government intervention is advocated. But the
government has to maintain a vital role in maintaining and extending marketing hardware and
software and in preserving competitive market conditions.
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Adequate supply response is very much dependent on the efficient functioning of markets
because production incentives in a market economy originate from markets. Only well
functioning markets with low transactions costs will be able to provide adequate price incentives
throughout the marketing chain and induce adequate supply response.
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REFERENCES
Chhibber, Ajay (1988). “Raising Agricultural Output: Price and Nonprice Factors”. Finance
and Development, June: 44-47.
Commander, Simon (1989). Structural Adjustment and Agriculture - Theory & Practice in
Africa and Latin America. Overseas Development Institute. London: James Currey
Ltd. and Heinemann..
Eicher, Carl K. and Staatz, John M. (1990). Agricultural Development in the Third World.
Baltimore: The Johns Hopkins University Press.
Ellis, Frank (1988). Peasant Economics: Farm Households and Agrarian Development.
Cambridge: Cambridge University Press.
Ellis, Frank (1992). Agricultural Policies in Developing Countries. Cambridge: Cambridge
University Press.
James, A.D. and Upton, Martin (1993). Cost recovery for Veterinary Services. International
Farm Management Journal.
Stevens R., and Jabara, C. (1988). Agricultural Development Principles : Economic Theory and
Empirical Evidence. Baltimore: The Johns Hopkins University Press.
by Eric Tollens
Department of Agricultural Economics
Catholic University of Leuven
Kardinal Mercierlaan 92
B-3001 Heverlee
Belgium
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