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.