Friday, January 7, 2011

Origins of food inflation - the role of big retailers?

The search for the causes of the stubbornly persistent food price inflation in India has taken us through several possible causes - lower growth in cultivation coupled with increased demand, bad weather and resultant reduction in crop yields and crop damages, trade controls, diversion to use as bio-fuels, hoarding by middlemen, and even the base effect of index changes. The real reason will surely be a combination of all or some of the aforementioned factors, depending on the crop.

Further, there is one possible reason that has, surprisingly enough, not received the level of attention it deserves. What is the contribution of the big-box retailers in the inflation story? Conventional wisdom argues that these big chains lower inflation rate by easing bottlenecks in the supply-chain and reducing waste.

However, it is also possible that these big retailers may be putting upward pressure on prices by their hoarding effect. Here are a few possible lines of reasoning in favor of this argument.

1. In recent years, there has been a proliferation of food retail chains, though their access remains restricted to a small section of the urban population. They exercise considerable market power, especially in the local markets where they procure. This in turn generates a ripple-effect. Local prices immediately shoot up, and the price signals invariably get transmitted across all surrounding markets and so on.

2. Fundamentally, big retailers exercise market power through the bulk nature of their procurements (in relation to local production), ownership of large go-downs and cold storages, and product purchase agreements with large numbers of farmers.

It is now well-established that even small marginal reductions or spikes in vegetable and fruit supplies arriving in the markets can influence prices in a dramatic manner. Even a handful of big retailers, with their bulk procurements and so on, therefore have the potential to exert a disproportionate effect on prices.

3. The retail chains service a small section of the urban population, albeit whose per-capita food consumption is amongst the highest. As indicated earlier, these retailers make bulk procurements, mostly contracted in advance directly from producers and middlemen. They generally have multiple supply sources that covers up for likely deficits from a few sources.

When the supply-side experiences market constraints due to some reason, the retailers amplify the impact on the market. They crowd-in a large supplies through multiple channels, thereby draining out an equivalent quantity from an already supply-constrained general market (which is experiencing scarcity). In other words, retailers make the general market bear the full burden of any supply squeeze, thereby putting upward pressure on prices in all markets.

4. Production of food - grains, vegetables, and fruits - has not increased dramatically since the big retailers made their entry in the last few years. Therefore, the big retailers and the general market are competing to source more or less the same supply. The big retailers have an obvious advantage in this race. This is borne out by the fact that big retail prices are upto 40% less than the general market prices. The general market ends up experiencing occasional bouts of shortages.

Econ 101 teaches us that such problems cannot exist in a free retail market. But that assumes an infinite number of retailers, catering to all potential buyers. As the aforementioned analysis shows, both these conditions are absent with the food market and big retailers in India.

Let me illustrate all this with the example of vegetables market exposed to some supply shock. Assume that the vegetable consuming population can be divided into two groups - the big retailers and the general market. A highly simplified graphic (for ease of representation) of the market, when exposed to a supply-shock, will be as follows.

Qe - total quantity supplied at equilibrium
Q1 - total quantity supplied after the shock
Qm - quantity supplied to the general market at equilibrium
Qm1 - quantity available in the general market after the shock
Qr - quantity supplied by the retailers

Qe = Qm + Qr, and
Q1 = Qm1 + Qr,

Subtracting we get
Qe-Q1 = Qm-Qm1

Reduction in total quantity available due to the supply shock = reduction in general market supplies.


KP said...

Dear Gulzar,

A quick comment before I study that graph again!

- Are you implying that the cost of fruits / vegetables outside of urban centres is now on par with the costs in urban areas? Your access to this kind of data I guess will be truly revealing of the crisis.

- In urban areas serviced by the big chains - what is the motivation to sell at lower than the "small retailer" prices - at 40%lower - if the buyer is capable of paying more.

- should'nt one of the outlets big/small retail be flooding the market to exploit the differential (or are they already?)

Is this a plain case of capacity shortfall - notwithstanding any big/small retail implications.


gulzar said...

KP, I am not very sure of drawing too many conclusions, because there is little conclusive evidence in any direction. i am only presenting this as a conjecture, corroborated by some empirical evidence (like retail chain prices being cheaper).

as i look at it, several factors are obviously playing a role in the food price inflation story. however, we cannot be sure about the relative contributions of each factor. and these contributions are likely to vary widely across areas.

no, i am not implying any equilization of prices across rural and urban centers.

i can only hazard guesses about the motivation of retailers to sell at lower prices. competition among the retailers (and there are a number of them in each big city) is one factor. there is also an attempt to capture markets.

these prices itself are a substantial mark-up on the original prices and coupled with their economies of scale and lower costs of procurement provide a large margin for the retailers. in contrast, the small vendors experience higher procurement and other costs and are forced into selling at much higher prices.

there are constraints (entry-barriers) to flooding the market to capture the market. however, the rapid growth rates in retail food business may be an effort to exploit the differential.