Column: Supply constraints or market failure

Updated: May 2 2014, 02:44am hrs
Food inflation has been haunting India for nearly a decade now, averaging 12.2% in the last five years alone. It is concerning that even an 8.3 percentage point drop in nominal income (per capita) growth since FY11 helped sober overall food inflation to just 11% monthly over April 2010-March 2013. In FY14, it shot up to 13% each month, on average, notwithstanding that nominal income stagnated while agriculture grew an outstanding 4.6%!

Why do food prices refuse to come down Why do farmers not grow even more The dominant view is that supply-side constraints are inhibiting output response, to which other problems add. But the faster acceleration in prices of other foods, relative to cereals or staples, questions if the major faultline might be market failureif support-prices distort the market for cereals, a free-pricing mechanism operates for non-cereal foods. Why then is production not responding to this shift in relative prices Can supply-constraints be such a barrier in this age of information flows Or, must we examine if price signals are actually reaching the farmers

As a backdrop, consider the various hypotheses explaining food inflation. The recently articulated view by RBI (Fighting Inflation, Governors speech on February 26, 2014) identifies the primary driver of food inflation as growing prosperity accompanied by dietary shifts; the latter, in particular, applies to prices of protein-rich, high-value foods. Other identified drivers are: minimum support prices (MSP) for key cereals and pulses, but quite justified by input price increases, especially fertilisers, fodder, cattle feed and rural wage growth; floor and indexation effects of the MGNREGA, but which only account for a small proportion of wage growth and whose effects are on the decline now; rural liquidity and credit effects of higher bank lending and land sales; labour shifts from agriculture to non-agriculture sectors, especially construction; and possible effects of declining female labour participation rate.

How has production responded to these demand-side developments By all accounts, agriculture performance has been outstanding over this period. The sectors growth averaged 3.6% annually over 2007-2012 (Economic Survey, 2012-13), more than a percentage point above the preceding decades average growth rate. Private investment grew an average 12.5% each year in 2007-11; its share in the total capital formation in agriculture rose nearly 10 percentage points until FY09, stabilising at 82% since. Fruits and vegetables output grew 6% on average each year in the last decade, while per capita availability rose some 50%; likewise, milk production growth averaged 4.5% annually, and that of eggs and fish rose 44% and 33%, respectively, in the six years to FY12; pulses production increased 54% in a decade, while oilseeds output jumped 62%, its net per capita availability nearly doubling with help from imports; on the trade side, India moved up to the 10th rank globally in agriculture and food exports, becoming the worlds largest exporter of rice in FY13. Other signs are a shift in nearly 10% of the total cultivable area from traditional crops towards vegetables production, increased global competitiveness and so on.

Production trends do reflect a buoyant response, therefore. The question is if this is enough to meet effective demand. The unabated food price increases suggest not; demand continues to outstrip supply. So, how much faster must agriculture grow to correct the imbalance From a policy perspective, surely this invites an assessment about the equilibrium point Especially as even the stellar growth in agriculture last year was accompanied by phenomenal price jumps11-13% increase in overall food prices on average each month and more than 25% in the case of fruits and vegetables! That FY14 was the third consecutive year of falling nominal income, raises doubts if food inflation is underpinned by just supply constraints or the problem lies elsewhere.

It is surprising that a decade-long, sustained increase in food prices has not incentivised farmers to grow even more than they already have. Or respond to relative price shifts within food segments, i.e., grow more vegetables, fruits and protein-rich foods than cereals, given the higher returns from the former Consider that vegetable prices accelerated 16.5% on average in the last five years, while that of eggs, meat, and fish trended at 17.2%, while for cereals it was just 9.2%. The accompanying table shows the relative price changes by broad category. It is worth noting that food inflation rates at both wholesale and retail levels are almost of equal magnitude.

This leads us to question if price signals are actually passing through to farmers. Unlike industry, where farmgate and wholesale prices are equivalent, the gains realised by farmers at the farmgate diverge significantly from those at wholesale levels. In a well-functioning market mechanism, this gap would be insignificant; price signals would rightfully reach the producers, triggering a reallocation towards production of whatever is more profitable. Again, unlike industry, the response lags to price incentives in agriculture are very shortless than a year for many items.

RBI suggests that output response has been insufficient possibly because the MSP-incentive is distorting production, i.e., encouraging farmers to grow more rice and wheat than vegetables and poultry. However, the relative higher inflation in non-cereal foods, whose prices are freely determined, counters this, especially as the price shifts are sustained. If farmers actually gained more from growing vegetables, fruits etc., why would they not reallocate production away from rice and wheat Technology extension, mechanisation, scale-farming, etc, cannot be a constraint when price incentives alter in such magnitudes; and in an age of quick, well-dispersed access to information as was the case, say in the 1980s, when dependence on state-guided direction to production was considerable.

Examining whether market failure or imperfections are the key impediment to output response, rather than supply-constraints, is essential as it has a bearing for policy shift in solutions to address food inflation. Reforming markets so as to address price signals obstructing the pace of reallocation of production would then be the key policy priority. The imperfections in unregulated markets deserve far more policy attention than currently accorded, even as minimising or complete removal of government intervention can capably resolve issues in rice, wheat, pulses etc. Farmers would surely respond. And monetary policy, which has taken a stronger turn to break the vicious wages-expectations spiral entrenched in the economy, would be more effective in containing the second-round effects of food inflation.

Renu Kohli

The author is a New Delhi-based macroeconomist