Tuesday, February 8, 2011

Econ 101 about India's food inflation

Monetary policy failings, hoarders, black marketers etc are all straw men in India's inflation story. A cursory reading of Econ 101 teaches us that there is nothing surprising about the high food prices in India. It is the inevitable result of an interaction of supply constraints and an inelastic demand profile.

The result of all this is obvious. For very small supply volatility, prices fluctuate sharply. As can be visualized from the graphic, small supply squeezes translate into disproportionately high price increases.

Further, there are other forces at work that may be amplifying problems at both supply and demand ends. At the supply-end, the growing importance of big retailers, without proportionate increase in production, is squeezing supply elsewhere. Since the big retailers keep enough supply channels open to hedge against any supply shocks, the impact of the resultant scarcity is felt with much greater intensity in the remaining market.

And worryingly, the demand curve, atleast for vegetables, fruits, meat, and pulses, is getting more vertical. Not only are people consuming more, they are also willing to pay even more to access these hitherto luxury foods. Or, as Paul Krugman has written, "it takes big price rises to induce people to consume less, yet collectively that’s what they must do given the shortfall in production". The increased demand for processed foods too is putting pressure on food. As people shift from consuming chicken to sausages, the amount of chicken required to generate the same meal multiplies.

So, why are producers not responding to these price signals? The simple answer is that they are not getting those signals. The hopelessly inefficient agriculture distribution chain ensures that producers get only a small portion of the increased prices. The major share is captured along the chain by various intermediaries and traders.

There are no simple solutions for this conundrum. We need to increase production. This requires incentivizing farmers to expand their acreage and improve productivity. This requires both investments in agriculture and ensuring that farmers get remunerative prices for their produce. And this lies at the heart of any lasting solution to India's food inflation problem.

Update 1 (12/2/2011)

An NYT report indicates that while demand for lentils and beans are growing at 6.5% a year, supply is increasing less than 1%. See also this report on agriculture supply constraints in India.

Update 2 (16/2/2011)

See this Room for Debate on global food price inflation. See this article that explains how diversion of land for biofuel production has increased the pressure on foodgrain prices. Wheat and soy prices increase when corn prices are high, since their acreage allotment is replaced by corn. In addition, wheat and soy get substituted for corn as animal feed. High corn prices cause higher meat, dairy, wheat and soy prices for consumers.

See this FAO monitor on global food prices.


vijay said...

Hi, Gulzar. "growing importance of big retailers" that is an insight. lefties shout that futures trading in food commodities also causes high inflation! how far could that be true. I could not grasp that. can you throw some light.


KP said...

Dear Gulzar,

Supply shocks are ( should be ) short term. But the ability of the system to respond is not instantaneous in the case of agriculture.

The larger chains have effectively smoothened the shocks - as you imply by keeping supply channels open. Which is a good thing - for their clientele - your earlier post that the chains sold upto 40% cheaper during the height of the supply crisis.

The increase in prices is in some sense contributing to the overall well being of the farmer - though only a trickle could be reaching the farmer.

So, in any case smoothing these effects will not benefit the farmer.

Smoothing through better supply chains has positive consequences for the consumer - in terms of predictable spending patterns – and is the big retail format.

I was wondering – what will constitute incentives to the farmer - if the small marginal farmer is who you have in mind.

Or is large corporate farms the format under consideration?

The daily wage urban labourer is possibly the hardest hit - and the middle class the most vociferous - in response to the crisis.

Many of them are frugal consumers -not falling within the band of any kind of excessive consumption that is referred here.


gulzar said...

sorry vijay, the link on "growing importance of big retailers" was wrong. see this


KP, the incentives for the farmers can come only when they start getting higher prices. period! and that requires minimizing the intermediate rents. how can we do that? more and widely accessible storage capacity, better price information, access to credit, access to more formal marketing channels, etc are all part of this process.

the price signals are more likely to reach the corporate farms - they are more certain of receiving higher prices.

i agree that the daily labor are the worst hit - they have access only to the most volatile part of the market.

Sridhar said...

Gulzar, what is your take on Loksatta JP's argument that removing export quotas on food grains could help farmers get renumerative prices? Governments obviously seem to be more interested in consumers than producers by imposing restrictions on food grains and cotton.

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