About a month back, I’d written that farmers in Karnataka, when faced with a glut in the tomato crop, elect to throw sack loads of tomatoes on the highways, rather than selling them. During the great depression in America, sack loads of wheat were burnt in order to prevent wheat prices from falling. During the India-Pakistan test match in Bangalore 2 months back, an entire stand (south east i think) was left completely unsold. All these have a common thread of logic – artificially restrict supply so that prices don’t crash, and you make more money.
Yes, I understand this is counterintuitive. How can you expect to make more by selling less rather than selling more? How can you expect to make more money by destroying what you’ve produced after investing thousands of rupees? Here is my take on the same. I’ll start with the necessary conditions for this kind of a situation, and then proceed to try and explain why this works.
1. Monopoly: A monopoly is essential for implementation of this kind of a situation. It is easy to understand why. Suppose there are multiple independent suppliers. Who is going to dump their stock? What is the incentive for you to dump your stock? You would rather that your neighbor dump his stock which is going to increase your profits. The only way out of this is in collusion. All producers get together and decide to dump stocks. Which effectively creates a cartel, and thus a monopoly.
2. Inelastic demand: For dumping to work, the additional revenue we make out of the un-dumped stocks should be more than the revenue we would’ve made from the dumped stock if we hadn’t dumped it. So basically the demand needs to be inelastic – around the region where we are going to dump. What i’m saying is that for a small change in quantity supplied, the price should increase by a large amount. As long as this keeps happening we can dump.
Going back to textbook monopoly economics, what we do to price is to maximize quantity * price. In other words, we supply the quantity where the total revenues are maximized. And it usually happens that this particular level is below the total amount we have produced. So we introduce into the market only as much produce that will maximize our revenues.
But what about the effort that has gone into production of this excess? Just look at the examples that I’ve mentioned. In all of them, you have already spent whatever amount that you had to spend. The costs have already been sunk. Apart from a couple of minor expenses (transportation, facilities, etc.) all expenses have been incurred before we made this decision. In other words Revenues are almost equal to profits. So we maximize revenues, not profits.
The other thing with tomatoes is that farmers don’t cooperate when they are making the decision regarding what to plant. If they did back then, some land that would’ve otherwise been used to sow tomatoes would be diverted to some other crop, which on the margin would yield more. Interestingly, the farmers seem to come together in a cartel only after the tomatoes have been produced!
Second, the farmer needs to be able to easily estimate the revenues he will get by storing his goods. More importantly, he should be able to have a good idea about the revenues he will get from each crop even before he sows. And should be able to lock in the revenues before sowing.
We need to extend futures markets into all agricultural commodities. And keep the lot size reasonable so that it is accessible to small farmers. It is not as if the farmers won’t be able to use technology. Make it accessible to them, and they’ll easily take to it. The cell phone revolution is proof of that. Yes, small lot size could be a problem when it comes to settlement. Cash settled futures need to be explored.
Throwing tomatoes on the highway may be economically efficient when looked at in isolation. Looking at the larger picture, it only points to certain amounts of land and water and other inputs that have been wasted. That have been wasted growing tomatoes which no one needs, when they could’ve been used to grow something else. Agricultural commodity prices have been going up all over the world. Agricultural land and water are precious inputs, and need to be utilized judiciously if we have to continue feeding everyone. Futures markets help us allocating these resources efficiently.
Cross posted at the Indian Economy Blog