I had blogged earlier about why dispensing off with Fair Price Shops (FPS) for delivery of rations under the Public Distribution System (PDS) in India may not be appropriate. Subsequently there was a suggestion that private shops could operate alongside FPS. However, as this parable and graphic illustrates, this too may face a tough fight to succeed.
As part of its reform of PDS, Subsidyland gives permission to three private retailers - Messers Bulliah Private, Pulliah Private and Ramaiah Private - to sell PDS rations in addition to the existing FPS. The subsidized price of wheat is P(s) while the prevailing market price is P(mkt1). The government of Subsidyland announces a price ceiling of P(c) in order to limit the extent of subsidy. To the surprise of those who structured this market design, several incentive distortions immediately arise in the market.
The three private retailers decide to form a cartel and artificially boost the price of wheat to P(c) so as to capture the full permissible subsidy. The rising prices also incentivizes the three retailers to collude with the FPS dealer and divert sales from the FPS to the private shops and thereby extract a greater amount of subsidy. Further, the private vendors also work towards diluting the quality of wheat by mixing a larger share of brokens and other inerts. This market can be represented with the graphic below (the supply curve shifts leftward)
Now replace Subsidyland with any Indian town or village and M/s Bulliah Private, Pulliah Private and Ramaiah Private with the three or four retailers who dominate the market in such areas. In rural areas and small towns these vendors can act as oligopolies to prevent competition and sustain a cartel with the FPS dealer. Even without the simplifying assumption of a price (or subsidy) ceiling, there always remains a strong incentive to keep prices high so as to maximize on the subsidy payouts.
In a competitive market, where no single retailer can decisively influence the price, it is theoretically possible to efficiently allocate the subsidy payouts. But such markets may be the exception than the norm in most parts of India. Eliminating the dual-price market for certain subsidized commodities, while extremely desirable, may be difficult even with a UID-linked payment mechanism.