Various episodes of inflation point to the need for active management of supplies and demand for some critical commodities by the government to assure their availability at reasonable prices. Supply-side shocks in such commodities often revive the debate on the thin margins of security available to poor developing economies. More than just the overall inflation rate, it is the rise in prices of ?essential commodities? that makes inflation such a sensitive matter. An ability to rein in prices of food and energy will provide considerable space for policy in battling inflation. Even slight improvements in output or supply can ease prices in primary commodity markets, but it is the ability to fill the gap quickly enough that makes all the difference.
Building excessive production capacity appears to be a good strategy in a fast-growing economy at the macroeconomic level, especially if the economy is sensitive to inflation. In other words, building production capacity, or more generally supply capacities, for some of the critical inputs and commodities is an important strategy for sustaining high levels of overall growth. There appears to be a greater appreciation of this in the case of energy, perhaps because of obvious limitations of available sources within the country?s borders.
Yet, instruments such as tax breaks and subsidies for sustained periods of time for achieving such excess production capacity may not be very efficient. There are many reasons why such excess is a costly proposition. Creating capacities ahead of demand may, for example, mean getting stuck with old technology. Large unutilised capacities can also become an eyesore. However, the high level of concern over speculative pricing, hoarding and suchlike in times of inflation suggests that a balance of costs will have to be struck.
If price shocks occur when production capacity utilisation is at its peak, then clearly the impact on prices by the rationing of available supplies would be large. The risks of market imperfections multiply. Hoarding and speculation kick in, and failures of the rationing mechanism make both the consumer and producer feel deprived of welfare. The difficulty in cranking up additional capacity to deliver extra production quickly makes it that much harder to rein in inflation sparked by supply shocks.
At least in the case of agriculture, an excess capacity strategy would seem to have a higher payoff. It may not be quite as attractive in the case of cement and steel, sectors where producers are informed well enough to assess future demand conditions and plan accordingly. However, in the case of agriculture, planning at the aggregate level is important. The thin margins of maneuverability are obvious. There is not much in terms of additional land that can be brought under cultivation. In fact, there may be less and less available for cultivation, as non-farm usage expands. It is also not easy to bring more water for irrigation. It is, therefore, more intensive applications of technology that hold the key to expanding agricultural production capacity. Unutilised organisational inefficiency, in terms of small and fragmented holdings, and inadequate credit markets also offer scope for gains, but it is technology that will increase capacity in a sustained manner.
What appears to be reducing the ability to build excess production capacity is the need to balance the interests of both consumers and producers: the agricultural sector trilemma of keeping input prices low, farm level prices high, and consumer prices low, has always been a challenge to farm policymakers.
The choice between subsidising current consumption versus subsidising capacity creation has often been resolved in favour of low consumer prices. This has implied that there are not enough profits in agriculture that can finance technology production and dissemination. In fact, short-term fluctuations in prices and output also reduce the ability of farmers to invest in raising productivity using even the existing technologies.
In a large and fast-growing economy, ensuring quick supply responses for critical inputs is necessary. Globalisation clearly expands available supplies immensely. However, global supply shocks are also not uncommon. While the scope for expansion of capacity at the global level, which may well prove more cost-effective than the expansion of domestic capacity, cannot be discounted, periodic episodes of inflation point to the need for strategies that provide more reliable supply responses in the case of critical commodities.
In the case of agriculture, the need for continuing improvements in productivity is obvious. Investments in technology production and dissemination will remain a public policy imperative in building production capacity that exceeds what is required just to meet current consumption needs.
The existence of food stocks and a widely spread distribution system have granted some breathing space to policymakers, but it is incumbent upon them to create conditions for faster supply responses than what we currently have.
Shashanka Bhide is senior research counsellor, NCAER. These are his personal views