For India, one of the crucial talking points of the year 2011 has been the sharp rise in food prices. So it’s only fair that I do a piece on this topic as well. However, through this piece, I would like to go to the basics, (ignore political bias and pragmatic difficulties) and look at the demand-supply dynamics in the food economy. So without further ado, let’s look at the situation we have at hand.
Since the demand and supply of food (or any other good/service for that matter) is dependent on its Price (P) and quantity available (Q), we plot a graph using P & Q, and proceed from there. Let’s say that the national demand for food is represented by the Demand Curve (D) while the national supply of food is represented by the Supply Curve (S). As we can see, D & S meet at point O, which is called the Equilibrium Point, at which the demand for food is matched by supply, and hence at quantity Q, its price is P.
For those who are already confused, let me give you a simplistic example. Assume that the demand & supply curves for Apples meet at point O, where the quantity of apples produced is 100 dozens and the price per dozen is only Rs. 20. Therefore, we can say that in the market of apples, equilibrium is at :
Q = 100 dozen & P = Rs. 20 / dozen
Now using this framework, let us now see how different external events affect the prices that we as consumers have to pay for food.
1. Government implements a rural job guarantee scheme (NREGA) which promises 100 days of employment every year to adults in rural households at Rs. 120 per day.
Since agricultural labor prices were traditionally determined by market forces (i.e. supply and demand), they were lower than what they are now. Hence, schemes like the NREGA have artificially inflated the labor prices, which the farmers have to pay. Since the farmer only has limited funds, he has to lower other costs to accommodate the rise in labor costs, or scale down his output. Since most of the other costs cannot be lowered much further, the only alternative that remains is to lower output.
2. Poor infrastructure, & the government lacking willingness (or ability) to reform has led to severe wastage of farm output.
Shoddy logistics, inadequate supply-chain mechanisms and substandard storage facilities have resulted in more than 30% the fruits and vegetable produce to rot before they even reach the market. All the while, the government eagerly spending Rs. 40,000 Crore (US$ 8.1 billion) on the NREGA scheme alone, and another 80,000 crore (US$ 16.2 billion) on fertilizer subsidies, but has failed to develop agricultural infrastructure. Instead of "spending" in that space, it is asking private companies to "invest" in such infrastructure. Can anyone else also see the absurdity in this scenario? At the end of the day, the implication here is simple - Loss of Output.
Both the scenarios mentioned above have one common element. There is a fall in output because of either government action, or government inaction (don't you love such irony). Or in other words, there is a decline in the Supply of output. On the graph, this is represented by a shift of the supply curve to the left (inward shift). As you can see, with demand holing up, a fall in supply causes prices to rise.
You can see that as the supply curve S shifts to S2, a new equilibrium point (O2) is formed where the quantity of output declines to Q2, and prices rise to P2.
I have only mentioned two examples, but there are many more issues that cause the output to fall, and a decline in supply. For instance, the Food Security Act (FSA) mandates the government to procure most of the annual grain output (and then import some more), to sell at subsidized rates. The prices are set using what's come to known as the 3-2-1 Model, where each family will pay Rs. 3/Kg for Rice, Rs. 2/kg for Wheat & Re. 1/Kg for Coarse Grain. At an estimated cost of close to Rs. 1.2 Trillion, experts are warning that the program can impact prices not just in India but the whole world. But the most imperative question at this point however is that how is the program going to be paid for and what impact is this going to have on India's fiscal deficit?
However, what I have said so far is only a 1-dimensional view of the food market i.e. only Supply side issues. For a diligent view, it is crucial to look at the demand side of the equation too. So let's go back to the NREGA; one consequence of this scheme has been that the rural incomes have risen leaving them with more money, which they can use to buy, among other things, more food (or some more tobacco to chew) for the household. This would increase the overall demand for food. Bear in mind that the government's Food Security Act only covers rice, what & coarse grains, and not fruits, vegetables or any meat/poultry. Hence despite FSA's exhaustive efforts, rural households will still have to pay market prices for the other food items. On the graph, this situation would be illustrated by a shift of the demand curve to the right (outward shift).
And somewhat like the last graph, observe that as the demand curve D shifts to D2, the new equilibrium point (O2) is formed where the quantity of output rises to Q2, and prices rise to P2.
I don't like repeating myself, but I have no choice except stating the obvious conclusion - government actions yet again have caused food prices to rise. Rising rural incomes may undeniably be a positive outcome, but its consequences are not. While the average GDP growth over the last 5 years has been 8.6% & the average population growth has been 1.3% (read: demand growth), the average annual growth in the agricultural sector has been a measly 3.1% (read: inadequate supply growth). An economic survey shows that post liberalization in 1991, annual per-capita production of food grains has declined 11% from 208 kg in 1996-97 to 186 kg in 2009-10.
In my next post, I will take this discussion further and show you the solution to this predicament, and talk about measures that the government should take if it seriously wants to lower food prices in a sustainable manner.
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