Why do agricultural value chains fail? Part (IV): Misaligned incentives

While the beginning of the fertiliser subsidy provides incentives for farmers to apply fertiliser to increase the yield, the latter part of the subsidy prompted them to overuse

Introduction

The prime objective of the policies towards agriculture is to ensure sustainable agricultural production and food security. Sustainable agriculture deals with economical, environmental and social sustainability of the agricultural efforts while food security is focused on accessibility, affordability and nutrition. 

Governments have used many economic instruments to achieve food security and sustainable agricultural production. Input and output subsidies, technology transfer, access to technology, access to finance, protection against local produce and price controls can be identified as some of these major economic instruments. These economic instruments have shown positive as well as negative outcomes. 

The probability of success in any economic instrument towards the agriculture sector largely depends on the “incentives”. As long as the economic instrument generate enough incentives for farmers to be engaged the probability of it been successful increases. The objective of this article is to highlight several examples where incentives have played a significant role in the outcome objectives of the economic instruments. 

Organic paddy farming: Are there enough incentives to adopt?

Until recently chemical based farming was the popular approach to paddy farming. Fertiliser subsidies were used as an economic instrument to promote the use of inorganic fertiliser where paddy sector being the main recipient. Fertiliser subsidy significantly contributed to the increase in agriculture production however it leads to many negative externalities. The subsidy was very significant where the fertiliser price was subsidised almost 90%. 

Any farmer who is registered with the agrarian services department and who was able to prove the ownership to land was eligible to the subsidy. Over the years farmers were able to develop very good relationships with the agrarian services officers and were able to enjoy the fertiliser subsidy without any significant hardship. 

The Department of Agriculture had published fertiliser and other chemical recommendations for paddy. However the easy access to the fertiliser subsidy and the level of the subsidy provide enough incentives for framers to obtain and apply more than the recommendations. Therefore over time the average fertiliser per acre went up. 

While the beginning of the fertiliser subsidy provides incentives for farmers to apply fertiliser to increase the yield, the latter part of the subsidy prompted them to overuse. The overuse of chemicals resulted in many negative environmental and health externalities and the burden on the budget was also high. Therefore the important question is “why wasn’t the fertiliser subsidy removed/reduced?” by the policymakers. 

The incentive for policymakers to continue with the fertiliser subsidy was obvious as it gave them the control over the electoral votes of agricultural farmers. Therefore governments kept on implementing the fertiliser subsidy despite they had enough evidences to show that the subsidy is being overused and creating economic, health and environmental negative externalities. 

Come to the present day, the fertiliser subsidy is being removed and a coupon system is in action. The coupon system allows farmers to buy the recommended levels of fertilisers and any additional requirement is supposed to be met with organic fertiliser. Therefore coupon system to a certain extent is meant to encourage farmers to adopt organic fertiliser. 

At the same time the current Government is geared towards sustainable agriculture and has the largest organic cultivation program in the recent history. Therefore it is possible to ask two questions at this point:

(1) What is the incentive for a chemical farmer who works with the coupon system to adopt organic fertiliser? 

(2) What is the incentive for a farmer to adopt fully organic agriculture?

As mentioned earlier the average fertiliser use per acre has increased drastically over time. The coupon system is not enough to buy the required fertiliser from the private market. Therefore farmers are left with three choices:

(1) Buy the rest of the required chemical fertiliser using own money 

(2) Reduce the cultivation area according to the fertiliser amount that is supported by the coupon system 

(3) Prepare or buy organic fertiliser for the rest of the fertiliser requirement. 

There is a fourth option where farmers can fully convert their lands to organic agriculture however that option has the least incentives since it will take at least five years for a chemical-based land to detoxify and stand as an organic cultivation. Let me first give my rankings on the options that farmers have. It will be done separately for commercial and subsistence paddy farmers. 

Among the three options I argue that the most attractive option for a commercial paddy farmer in terms of incentives is to buy the rest of fertiliser using own finances. Here the fertiliser cost will be reflected in the output price. This might increase the rice price in the short run but with proper management of paddy storages the price impact will be smoothened in the long run. 

The next best alternative for the farmer is to supply the rest of the fertiliser requirement through organic fertiliser. However the profitability in this case will be heavily determined on the scale of cultivation and the supply chain of organic fertiliser. This is because large amount of organic fertiliser is needed for an acre. 

Since the opportunity cost is high for an organic farmer to find organic fertiliser compared to an inorganic farmer (who can easily buy chemical fertiliser from the closest fertiliser outlet) they might demand a higher price. However their profitability might be low while competing with the inorganic paddy farmers (even though they use organic fertiliser partly it will not attract a willingness to pay similar to organic rice). 

The third option is to reduce the cultivation area where the hit on profitability is the hardest. Therefore yields least incentives for a farmer. For subsistence framers the best option is to reduce the cultivation area. Any other option will result in an additional cost. For a subsistence farmer it could be cheaper to buy rice from the market if needed rather than trying to produce by buying fertiliser. 

To answer the question on the incentives for a farmer to adopt organic fully (these cultivations will be on land that are marginalised, abandoned, willowed or with less chemical concentrations) we need to look at the opportunity cost of producing the organic paddy. 

The opportunity cost of supply mainly comes from sourcing organic fertiliser, seeds and labour. The conventional way of doing organic agriculture creates very little incentives for a farmer to adopt organic agriculture. Requirement of conventional organic fertiliser per acre is close to one ton. 

Farming practices in terms of land preparation, water management and pest and disease management creates many transaction costs. Organic farming is closely linked with traditional paddy varieties and these seeds are hard to find and costly. Therefore unless these opportunity costs are compensated the incentives to adopt organic paddy farming are very low. Recommendation here is to:

(1) Introduce an organic fertiliser that is more efficient and can be commercially produced and sold at an affordable price 

(2) Introduce less labour intensive farming practices and introduce more mechanisation (mechanisation may generate some disincentives and I will talk about that in the latter part of the article) 

(3) Introduce a seed program that will facilitate access to traditional paddy or introduce high improved varieties to organic paddy farming. 

Interestingly the National Program in Toxin Free Food has implemented these recommendations at pilot scale. Now the task is to learn from the field experiments and scale things up.

Use of banned chemicals in vegetable and fruit production: Are there incentives to reduce?

Use of banned chemicals in vegetable and fruit production has drastically increased recently. There are enough evidences to show that what we eat is not safe. Many awareness programs are there at farmer levels as well as the consumer level to show the health and environmental impacts of using banned chemicals. However farmers have not reduced the use of these chemicals and the consumers have not reduced the purchase. Therefore the questions are:

(1) Why farmers keep on using banned chemicals 

(2) Why consumers continue the consumption

The reason might be the misalignment in the incentives.

Fruit and vegetable cultivation is seasonal and there are storage issues. Therefore for a particular fruit or a vegetable the supply increases during the cultivation seasons and drops during the off-season. In order to avoid the price decreases in the cultivation season many farmers harvest late/early or try to store. Use of banned chemicals therefore is high during these activities. 

Overuse of chemical fertiliser is pretty much linked to the cultivation stage. Overuse of fertiliser and banned chemicals affects the healthy status of the produce and it is a quality parameter. The market does not have enough instruments or institutions to recognise the impact on the quality. Furthermore there isn’t a proper penalty system in place. 

From a consumer point of view there isn’t any recognised or recommended ways to detect the banned chemicals and over use of chemical fertiliser. Though there are popular norms in recognising these, they are not sufficient enough. Institutional structure is not strong enough to test and catch farmers who are applying these chemicals and neither are they penalised. Therefore a farmer does not have enough incentive to give up the use of chemicals. Rather he has enough incentives to use them so that he can avoid the price drops in the market. 

Market prices do not reflect the quality since it is not easily distinguishable. Hence all the farmers are better off using chemicals as they wish. The recommendation is to impose a system where quality can be easily detected. A penalty system must also be in place. Once the quality detection systems are in place the market will respond by allocating higher prices. This issue is very prominent in the local fruit and vegetable value chains.

Export value chains on the other hand are quality reflectively (for the most part). For example the Good Agricultural Practices (GAP) value chain has clear incentives to maintain quality. The value chain only allows the recommended levels of fertiliser and other chemicals. Farmers work very loosely with the agriculture extension officers where it is essential to get recommendations on any chemical applications. 

Record keeping is also mandatory. If everything is up to the standard a certificate is issued allowing the farmer to export his produce. In addition a final checking is also done at the quarantine centre to detect any banned chemicals. Therefore the quality detection system is strong. If a farmer is caught with banned chemicals his produce will not be allowed to export, hence the penalty is also very strong. Price clearly reflects the quality. For example one kg of bitter gourd will be demanded at Rs. 40-100 at the local value chain while it is demanded at Rs. 250-300 at the export value chain. 

While it could be easy to give recommendation to properly incentivise the farmers, it is hard to incentivise the consumers, especially the ones based on local value chains. In my view the average local consumer is left with only three options:

(1) Find informal signals (appearance, smell, colour and texture) that can detect the safe food

(2) Grow what you eat to the extent possible 

(3) Stop concerning about the quality but reduce the consumption. 

Each and every option above comes with a different incentive structure. For a consumer who has substantial knowledge on agriculture and connections with farmers it is possible to identify informal signals to detect quality. For an average consumer it is hard to trust the informal signals and the probability of getting deceived is high. Therefore incentives are low for an average consumer to look for informal quality signals. 

Grow what you can eat is about the opportunity cost. Sometimes the opportunity cost of growing in terms of time, space, and fixed and variable inputs might overweigh the willingness to pay for toxic produce. In such cases the incentives are towards consuming toxic produce rather than cultivating by yourself. 

For some consumers the third option might give the highest incentives. For example, there are consumers who have reduced the consumption of fruits and vegetables that are famous for using banned chemicals (e.g.: cabbage, capsicum, banana and mango). For them the foregone utility in terms of reduced consumption is lower than the opportunity cost of cultivation or searching informal quality signals. 

Machinery as a means of increasing efficiency and quality: Are incentives aligned?

Technology transfer is another important method used by policy makers to increase agricultural productivity, efficiency and quality. Introduction of new machinery therefore play a very important role in the agriculture sector. This can happen through Government research institutes, trade or any other form of cooperation between countries or through the private sector. However, the ultimate recipient of many such machinery is the agriculture small holder.

Quite often it is possible that these machineries are not affordable for them. In such cases governments are to a certain extent responsible in providing financial assistance. However it is quite possible to see cases where the adoption of machinery is low despite financial subsidies are offered. I will further explain this using two examples I have come across during my own research work.

Value chains that operates around export agriculture crops are highly quality conscious. In most cases prices reflect the quality parameters and straight forward mechanisms are established to measure these quality parameters. In most of these value chains quality parameters are achieved through the use of new machinery. 

The global pepper value chain is something that is highly quality conscious however the one that we face mainly focus on threshed pepper which is exported in bulk form. Therefore, it does not provide many places for introducing new machinery. Yet threshing is an operation that can be significantly improved by introducing new machinery. Understanding the importance of this a subsidy scheme was introduced to pepper small holders to purchase threshing machines. Yet the purchase of machinery did not go up. The reason is the misalignment of the incentives. 

The majority of pepper from these smallholders went to India. It was exported as a bulk product and there wasn’t a price premium based on whether the pepper was threshed using a machine or feet. Therefore the market prices were distorted and did not recognise the quality as a parameter. In such a case the opportunity cost of taking a loan (which is subsidised) was higher than using labour to thresh pepper. This would have been a total different story if pepper were to be exported to a place where a price premium exists for using machinery to thresh. 

Another example is the use of machinery in organic paddy farming. As mentioned before one of the main opportunity cost component of producing organic paddy was the higher labour cost associated with management practices. Organic paddy farming is closely associated with traditional paddy varieties which most of the time create limitation in introducing machinery for farming practices. 

As I mentioned earlier, the National Program on Toxin Free Food is keen on introducing many new machinery to organic paddy farming efforts. However this might not yield expected results since there aren’t enough incentives for a farmer to invest in machinery. Rather than reducing, the introduction of machinery might increase the cost of labour. Therefore the recommendation is to work with new improved varieties or to select traditional varieties that closely resembles them. 

Coordinated farming or working with crop plans: Are incentives aligned?

In many cases agriculture produce attracts lower prices simply because the market is flooded with over supply. This happens since the cultivation efforts are not coordinated and large number of farmers cultivates the same crop at the same time in different parts of the country. In one of my previous articles I argued for the community level crop development plans as a solution. The solution was already in existence for paddy and the recommendation was to extend it to vegetable cultivation as well. However I did not go in to detail in explaining how that could be affected when incentives are misaligned. Let me do that here. 

Paddy is a homogeneous crop, therefore it is easy to implement a coordinated effort. There are incentives in doing that such as price bargaining as farmer organisation, irrigation water management and sharing machinery and labour during planting and harvesting. However vegetable cultivation is not homogeneous since there are many different types. Fertiliser requirements, farm management practices and pest and disease management varies based on the vegetable type. 

Farmers most of the time respond to market signals, mainly the prices. However prices are distorted and largely being controlled/manipulated by the wholesalers. Yet farmers respond to that since they do not put much trust on the information and recommendations they receive through the government extension services. The advantage of participating in a crop plan is that farmers can reduce the oversupply of a produce and attract a higher price. 

However if prices are distorted and controlled then there is no guarantee that they would be able to attract a good price even after taking part in a crop plan. Therefore if information asymmetry becomes a major issues then the incentives for a farmer to be a part of a community crop plan would be less. The recommendation therefore is to equip farmer with as much information as possible on the market. That will reduce the transaction cost of information search and would allow farmers to look for competitive prices in different locations. 

Information asymmetry can be reduced through a strong ICT intervention such as online pricing and online trading floors. However the transaction costs of searching information through online sources must be lower than of him looking for that information through the usual intermediaries. 

I am tempted to recommend the use of agricultural extension services as a support mechanism for farmers to get accurate market information but I have my doubts. I will explain my personal experience here. 

The GAP value chain is heavily dependent on the agriculture extension services officer. One of the main tasks of this officer is to link the farmer with an exporter so that a competitive price can be obtained. The farmer can also reduce his transaction cost in looking for market prices and buyers. However there is a flipside to this. What happens if the extension officers becomes a middle man rather than a facilitator of information? This is clearly evident in the GAP value chain where some farmers do not know their exporter and price negotiation happens between the extension officer and the exporter. 

I will make one final point on this. To my knowledge there are no restrictions on an extension officer becoming a farmer and being in the same value chain (if there are restrictions then this is a serious issue). An extension officer who plays a facilitator role between the farmer and the exporter has significant access to price and demand data. When such an official becomes a farmer it is quite possible for him to sell his harvest before all the other farmers for a better price. 

This is also evident in the GAP value chain where farmers are facing difficulties in finding exporters while their extension officer has sold almost three times of what farmers have produced. Therefore allowing the extension officer to reduce the transaction costs might reduce the incentives for farmers to stay in the value chain. 

(Dr. Chatura Rodrigo is an agriculture economist. He can be reached at [email protected] and 94 77 986 7007.)