Parastatals and Constrained Reform: The Food Corporation of India

Steve McCorriston (University of Exeter, UK)

Donald MacLaren (University of Melbourne, Australia)

29th July, 2011

This research has been sponsored by the Australian Centre for International Agricultural Research (ACIAR). We are grateful to participants at the conference on “Facilitating Efficient Agricultural Markets in India: An Assessment of Competition and Regulatory Reform” New Delhi, India, February 2011, and specifically to Rajesh Chadha, Sisira Jayasuriya and Scott Davenport for discussions on the issues covered in this paper.

Parastatals and Constrained Reform: The Food Corporation of India

Abstract In this paper, we consider the role that the Food Corporation of India currently plays in meeting the objectives of government policy through the procurement and distribution of wheat. These issues are addressed in the context of a methodology that can be applied to compare changes in market structure. We apply this framework to provide a quantitative analysis of the current arrangements regarding the FCI and consider alternatives in which the roles of the Food Corporation are reduced and the procurement and management of wheat is increasingly accounted for by the private sector. These alternatives are evaluated according to the degree of competitiveness in the private sector in conjunction with the government's use of alternative policy instruments to meet its twin objectives of maintaining farm-level prices and the provision of low-cost food to the most vulnerable. The results show that when the role of the Food Corporation is limited to only procurement for the buffer stock, there are considerable welfare improvements. JEL Classification: 013; 038; Q13; Q18 Keywords: Parastatals; Policy Reforms; Food Corporation of India

1

Parastatals and Constrained Reform: The Food Corporation of India 1. Introduction The economic benefits of state marketing boards, and of state trading more generally,

when compared with the economic benefits of the private sector has long been a

contentious issue across many developing countries. Rashid et al. (2007) and Ganesh-

Kumar et al. (2010) provide recent surveys of the issues involved. In this paper, we

focus on the Food Corporation of India (FCI), there being several reasons why this is

an important case to investigate. First, the FCI currently plays a dominant role in the

procurement and distribution of staples such as wheat and rice but it is now under

increasing scrutiny as the Government of India looks to the reform of agricultural

policy. Second, while de-regulation is on the policy agenda, there is considerable

opposition to it where opponents of reform, often reflecting special interests, make

reference to food security and the welfare impact on certain groups as reasons for not

undertaking reforms,. Third, the reform of the FCI raises concerns that often

characterise the debate on parastatal reform more generally, i.e., the role of the private

sector and the potential harmful consequences of market power (Ganesh-Kumar et al.,

2010). In reality, the most likely outcome regarding the role of the FCI is that reform

will be partial in nature. The current debate reflects how some of the objectives of the

Government of India’s agricultural policy can be met by other means with the role of

the FCI being limited, and it co-existing with the private sector. Thus it illustrates the

more general point that, in practice, reforms of parastatals are partial rather than

complete.

2

In addressing the issue of parastatal reform in India, we develop and apply a formal

theoretical framework which can be employed to illustrate the issues highlighted

above. While much of the debate on parastatal/state trading reform has centred round

case study evidence, the contribution of the methodology presented here is to supply a

framework that can be applied to provide an ex ante assessment of parastatal reform,

highlighting in particular the role of the private sector1.

In detail, we follow two strategies to identify the effect of the FCI2. The first is to take

a more abstract perspective that highlights the pros and cons of a dominant parastatal

when compared with solely a private sector alternative. We focus on the welfare

impacts of the relative inefficiency of the FCI and compare the outcome with the

private sector outcome, where the latter is characterised by various degrees of

competitiveness. This approach enables us to highlight one of the main concerns of

parastatal reform, namely, that in the absence of a dominant government institution,

farmers and consumers may be exposed to exploitation by market intermediaries that

exercise buying and selling market power (Ganesh-Kumar et al., 2010). We address

these issues using a number of metrics that are relevant to the policy debate, in

particular the welfare and food security impacts of reform. This set-up will provide

some expectations about the direction and scope for changes in welfare and food

security that may occur through reducing the role of the FCI.

1 Since the reform debate centres around comparisons across different market structures, there are essentially two ways to proceed: either develop theoretical propositions that can provide analytical insights; or to calibrate the theoretical framework such that the direction and the potential magnitude of the changes can be readily identified. While the former underpins the analysis that is presented here, in order to consider the role of the FCI, we take the latter approach, highlighting the mechanisms involved and, inter alia, the potential for the framework to be applied to other examples of parastatal reform. 2 A recent study that parallels the approach here focuses on export supply chains and the role of market structure. See Porto et al. (2011).

3

The second part of the exercise is to focus on the more detailed functions of the FCI

through the process of systemically constraining them from the current focus on farm

price support, on stock accumulation, and on distributing subsidised food to the poor,

through to the case where the FCI procures only to achieve a given level of buffer

stocks. We show that the welfare effects of these constrained reforms will depend on

the degree to which private traders also play a role in the wheat marketing chain. The

key insight here is that the FCI essentially creates a residual market in which private

traders can operate. As its functions are reduced, the size of this residual market

increases, thus affecting procurement prices, sale prices and quantities and, in turn,

welfare. The extent to which welfare changes arise as a consequence will depend on

the overall competitiveness of the market as the functions of the FCI are constrained.

The paper is organised as follows. In Section 2, we provide some background to the

recent pressures for reform in the Indian wheat sector and comment on the role

currently played by the FCI. In Section 3, we outline the theoretical framework that

we use to analyse the effects of parastatals. We consider three different scenarios.

The first is the case where the parastatal exists on its own and is solely responsible for

domestic procurement, trade and distribution. The second is the case where there is no

parastatal and only private traders. As an example of the cases that exist across many

developing countries (including India), we also consider the case where the parastatal

co-exists with private sector firms. In Section 4, we consider a range of additional

issues that relate directly to two functions of the Food Corporation. We successively

remove these functions to allow the FCI ultimately to procure only for the buffer

stock, while meeting the two objectives of government policy by other means. These

are food stamps, rather than subsidised distribution that the FCI undertakes at present,

4

and a guaranteed producer price in place of procurement and stock-holding. In

Section 5, we summarise the main insights from this research and the implications for

the future path for reform in the Indian wheat sector. The headline conclusion is that

the current functions of the FCI are unnecessarily costly and that there exist

substantive welfare gains and budgetary savings if its functions were to be limited to

procuring only enough to achieve a 'normal' level for the buffer stock with the other

two current objectives of the Government of India attained through two other

instruments. As the role of the FCI becomes more limited, there is more scope for the

private sector to be involved in procurement and distribution, the potential costs and

benefits of the constrained reforms being dependent on how competitive the private

sector is. More generally, the framework outlined here can be used to analyse a

number of issues that are relevant when considering market structure reforms.

2. Pressures for Reform in the Indian Wheat Sector

The key feature of agricultural policy in India is the need to provide access to low-

price staples (such as wheat and rice) especially to the poorest sections of society

while, at the same time, supporting agricultural prices and promoting price

stabilisation through the procurement and management of stocks of key commodities.

These objectives are potentially incompatible especially when there is a single

intermediary charged with implementing these policies, i.e., the Food Corporation of

India. Specifically, the stated objectives of the FCI are: (1) effective price support

operations for safeguarding the interests of the farmers; (2) distribution of food-grains

throughout the country through the public distribution system; and (3) maintaining a

satisfactory level of operational and buffer stocks of food-grains to ensure National

Food Security (FCI, 2011a).

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Effective farm price support is met through the use of a Minimum Support Price

(MSP) which is an announced price paid by the FCI in the procurement of wheat and

rice. Procurement of grains at this MSP forms the basis for the stocks held and

subsequently disbursed by the FCI. Farmers are obliged to deliver a share of their

output to the FCI, with the FCI typically accounting for around 50 per cent of all

marketed surplus (Persaud and Rosen, 2003). In principle, the MSP is set in relation

to costs of production as determined by the Commission on Agricultural Costs and

Prices (CACP). In recent years, these prices have risen “reasonably” (in nominal

terms) to maintain incentives for farmers (Government of India, 2011).

The FCI procures grain of “fair-to-medium” quality in surplus areas during harvest,

with the support price being paid directly to farmers in the local markets in which

they sell their grain3. Though the MSP for wheat has declined in real terms since the

1970s (see Jha et al. (2007) and, for more recent coverage, the Government of India

(2011)), the MSP is the main mechanism by which the Government of India can

influence specific agricultural prices. Procurement by the FCI to accumulate the

stocks which provide the necessary supplies for the Targeted Public Distribution

System (TPDS) as well as procurement for the buffer stock are the principal costs of

the FCI. While procurement has increased (almost doubling between 2005 and 2009),

the increase in off-take for the TPDS has risen by a lesser amount. As a consequence,

stocks held by the FCI have increased significantly and are well in excess of both

operational needs and buffer stock norms (Government of India, 2011).4

3 Clearly, the extent of the FCI’s procurement activities will be greater in the wheat-surplus states of the Punjab, Andhra Pradesh, Haryani and Uttar Pradesh. 4 Given the role of the FCI in procurement and distribution, some commentators equate the FCI’s role as the “de facto nationalisation” of grain markets (Persaud and Rosen, 2003).

6

Ensuring access to low-priced food for the most vulnerable was the function of the

Public Distribution System (PDS) which was the system for distributing subsidised

staple foods through approximately 500,000 “fair price” outlets. This system was

reformed as the Targeted Public Distribution System (TPDS) in 1998/99 which

increased the subsidy component of low-price food to consumers that were below the

poverty line and with a higher price paid by those consumers above the poverty line.

Ramaswami and Murughar (2005) report that 10 per cent of the rural poor and 14 per

cent of the urban poor purchase grain from this source. The cost of distributing

subsidised food is considerable; Jha et al. (2007) note that prices for below-the-

poverty-line consumers were 33-38 per cent below the previous PDS prices and

covered approximately one-third of the costs of the FCI subsidised distribution, while

prices to consumers above the poverty line covered around 60 per cent of the FCI’s

costs of distributing wheat.5

The economic burden that arises from the use of these policy instruments is

exacerbated because the FCI is also inefficient. Ganesh-Kumar et al. (2010) note that

the marketing costs of private traders are around 70 per cent of those of the FCI. The

targeting of the TPDS system has also received criticism. Despite the widespread

coverage of the TPDS, most of the poor still rely on the commercial market for

purchasing staples (Jha et al., 2007). Moreover, operating the TPDS is costly. These

authors report that, to transfer Rs.1.00 to the poor costs Rs3.14 in the State of Andhra

Pradesh and Rs4.00 to transfer the same amount in the State of Maharashtra. Breaking

down the costs of transferring subsidised food, 16-26 per cent was due to the high

5 Other mechanisms by which the poor are targeted include food-for-work programmes and school lunches (see FCI (2011b) for a list of other welfare programmes involving subsidised food grains).

7

costs of grain transport, handling and storage, 26-31 per cent was accounted for by

transfers to non-poor households, and 15-28 per cent due to so-called ‘leakages’

where subsidised food finds its way back onto the commercial market. Ramaswami

(2002) reports that only 32 per cent of subsidy expenditure reached the targeted

groups in the State of Maharashtra. Persaud and Rosen (2003) also report comparable

levels of costly distribution in the functioning of the PDS. More recently, Khera

(2010) reports that 67 per cent of wheat aimed at the poor missed its target group.

The combination of high support prices, the cost of subsidised food and the build up

of excess stocks, has increased the budgetary costs of government intervention in the

wheat market. As a consequence, the 'food subsidy' (the combined cost of the

agricultural price support, the cost of distributing food to the poor and the costs of

stockholding) has increased substantially in recent years (Government of India, 2011).

The high and growing costs of the food subsidy, together with the annual loss of

millions of tonnes of food-grains through inadequate storage, are the most evident

signs of the need to reform policy.

Traditionally, India has been a net importer of wheat but, with the increase in

domestic production, it has become an occasional exporter to world markets. In more

recent years, India has again faced a moderate wheat deficit and again has relied on

imports from the world market. The principal mechanism for managing international

trade is the FCI, which traditionally has maintained exclusive rights over exports and

imports, thus maintaining a dominant role over all traded staple commodities. Despite

the control over imports, government imports of wheat in the recent past have been

8

approximately zero.6 With respect to private trade, the tariffs on wheat imports have

been high (the bound tariff being 100%), though, in recent years, the applied tariff has

been reduced to zero.

This brief overview of the Government of India’s policy in the wheat sector clearly

shows that current policy arrangements are both costly and ineffective.7 A key feature

in any reform package must be the assessment of alternatives to the functions

currently undertaken by the FCI. However, with the overall concern of food security

paramount, the FCI will not disappear but its role would be limited to maintaining a

'necessary' level of stocks, while targeting the poor could be met by alternative policy

means such as food coupons. This latter issue has been discussed by a number of

commentators and politicians, and it has featured in a recent Economic Survey

(Government of India, 2011) and in Basu (2010).

Commensurate with limiting the role of the FCI is increased participation of private

traders in the wheat marketing chain. However, this change raises the issue of the

potential exercising of market power in procurement and distribution. Abuse of

market power has long been a concern associated with the de-regulation of parastatals

in developing countries in general (Ganesh-Kumar et al., 2010), with Banerji and

Meenakshi (2004) providing some evidence for market power in procurement in

wheat markets in Northern India. The competitive effect however interacts with the

6 The potential trade distorting effect of state trading enterprises such as the FCI in wheat and rice trade has been explored by McCorriston and MacLaren (2006) where they highlighted that managing trade in this way would be equivalent to an import tariff/export subsidy beyond the bound tariff rates typically reported in publicly available documents. In other words, managing trade through the FCI acted as another distortion to trade beyond more standard trade policy instruments. 7 One further characteristic of the Indian wheat sector is the barriers to inter-state trading that exist. In the model presented below, we treat the Indian market as integrated in order to focus on the effects of competition and the specific functions of the FCI.

9

size of the commercial market. One outcome of the current functions of the FCI is that

the state procurement for the TPDS, for the buffer stock and to maintain the MSP

creates a ‘residual’ commercial market. Ganesh-Kumar et al. (2010) note that public

intervention is particularly significant in wheat-surplus states and that the private

traders’ share of the market has been less than 10 per cent. It is the combination of

competition and the change in market size that are the principal sources of the welfare

changes that arise from changing the functions of the FCI.

3. State Procurement and Distribution versus the Private Sector

(i) Outline

We begin by abstracting from the realities of the Indian wheat market in order to

establish some results that will provide insights into the economic effects of the FCI.

We do so by comparing and contrasting the effects of a parastatal that may have

exclusive rights in procurement (both in the domestic and import markets) and in

distribution with those of a private sector alternative using a formal theoretical

framework. As noted above, rather than provide the underlying theoretical

propositions, we highlight the applicability of the framework by calibrating the model

with data for the Indian wheat sector.8 The calibration data are reported in the

Appendix. This model forms the basis for the more direct analysis in section 4 of the

functions of the FCI with the insights gained here giving some indication of the

direction and size of the effects associated with the increasing role of the private

sector in the Indian wheat market. The quantitative results are interpreted as the

relative impact that arises from different configurations of reform.9

8 Formal presentations of the underlying propositions are available upon request. 9 In comparing results, we benchmark the base scenarios in each case at 100 to focus on the relative changes that may arise, rather the exact quantitative impact that may be expected.

10

The alternative market structures will be assessed using various metrics which reflect

different perspectives on the role and purpose of government policy. These metrics

are: (i) net social welfare; (ii) the distributional aspects of policy as measured through

producer and consumer surplus, the latter being associated with purchases on the

commercial market only; (iii) food availability, as measured by the level of self-

sufficiency (domestic production/domestic production plus imports) and total

availability (domestic production plus imports); and (iv) the impact of any reforms

with reference to changes in farm-gate and consumer prices.10

(ii) Model Details

We assume that there are two sources of supply, imports (subscript m) and output

from the domestic agricultural sector (subscript d) which are differentiated in

consumption. Procurement may be undertaken by the parastatal, subscript S, or by the

private firms, subscript P or by both. The inverse supply functions are denoted pA

representing prices in the domestic agricultural sector and pw representing world

market prices. Note that these inverse supply functions are upward sloping, which

captures the effect of monopsony/oligopsony power in domestic procurement and the

large country, terms of trade effect for imports.11 These inverse supply functions are

given by:

A d

w m

p f kQ

p F KQ

(1)

10 As noted above, much of the concern in many countries regarding food security in the context of exogenous shocks has related to the 2007-2008 price spike. In the analysis conducted here, we could focus on shocks emanating from the domestic agricultural sector. The reason for this is that, with the data used for the model calibration, the level of trade in wheat was minimal and therefore it would be more appropriate to gauge the price transmission effects associated with shocks in the domestic sector. However, we do not evaluate the effect of production shocks on prices because we are not directly modelling the effects of variability, except to the extent that we incorporate a guaranteed price as a way of moderating down-side producer price risk. 11 We use a linear functional form which eases the analysis and permits the calibration.

11

where: Qd (Qm) is the total quantity procured from the domestic market (from

imports) by either the parastatal or the private firms or both.

The inverse demand functions are given by:

1 1 1

2 2 2

d m

m d

p a b Q Q

p a b Q Q

(2)

where 0221 bb represents the extent to which the supplies from imports and the

domestic market are substitutes.

The parastatal differs from the private firms in two respects. First, the parastatal may

be less efficient. We denote this by a coefficient . The second main difference

between private firms and the parastatal is their pay-off functions. As is standard, we

assume that private firms maximise profits. The representative private firm maximises

profits from two sources of procurement (domestic, qd, and imports, qm) and from

sales as given by:

1 2( ) ( )priv A d m mp p q p p q (3)

For the parastatal, we assume that its pay-off function reflects the potential bias of

government policy towards consumers or producers. This specification captures a

range of alternatives regarding agricultural policy bias; for example, reflecting a bias

towards consumer welfare ( c p ) or a bias towards producer welfare ( p c ).

Note that when 1c p , we have a welfare maximising parastatal. Also

embedded in this characterisation is a profit maximising parastatal where

( 0c p ). Then, the only difference between the parastatal case and the private

12

firm case is the number of market participants (n = 1 in the monopsony/monopoly

case and in the profit-maximising parastatal case).

The pay-off function of the parastatal comprises producer surplus, consumer surplus

and profits from procuring from domestic and imported sources, and is given by:

, ,c p d S m SW CS PS (4)

, ,

,

, ,0

, 0

1 , 2 ,

where

( )d .( )

( )d

( ) ( )

d S m S

d S

Q Q

d S m S

Q

d d S d

S d d S m m S

CS p z z p Q Q

PS p Q p z z

p p Q p p Q

Unlike the characterisation of FCI in section 4 below, the parastatal here is assisting

poor consumers and farmers through the choice of values for and c p , respectively,

rather than through additional policy instruments.

The process of comparing the two cases involves taking the first-order conditions

from (4) for the parastatal and those from equation (3) for the representative private

firm. The representative firm chooses quantities assuming Cournot behaviour, which,

when aggregated over n firms, gives the resulting total quantities. The corresponding

first-order conditions for the parastatal case and the n-private firm case, are given by

equations (5) and (6) respectively:

,1 1 1

,2 2

(2 ) (2 ) (2 )

(2 ) (2 ) 2d Sc p c TPDSoff BS

m Sc c

Qb k a b Q f kQ

Qb K a F

(5)

and

13

1 1

,

2 2

,

( )( 1) 0 ( 1) 0

1 0 0 0

( 1) 0 ( )( 1) 0

0 0 1 0

d

d P

m

m P

qb k n n a f

Qn

qn b K n a F

Qn

(6)

Note the obvious differences between the two cases. In the case of the parastatal, the

first-order conditions reflect the distributional bias of government policy towards

producers and consumers (as reflected in c and p ). It also reflects the relative

inefficiency of the parastatal as reflected in the size of )1( . Finally, the size of the

residual commercial market is determined by the quantities removed by the parastatal

for the purposes of the buffer stock ( BSQ ) and the distribution of food to the poor

through the TPDS ( TPDSoffQ ). In the case of the private firm outcome (equation (6)),

the number of firms competing in the market matters. If we choose n to be low (or in

the limit, n = 1), we have the oligopsony/oligopoly (monopsony/monopoly) case

while, if n is large, we have the more competitive case. Therefore, choosing different

values for n allows the role of the competitiveness of the private sector to be

expressed.

With the optimal quantities given from the respective first-order conditions, we can

now proceed to derive the effects on prices, on food security, and on the

corresponding welfare effects. Given the range of market structure combinations we

are considering both here and below, as well as the number of parameters, deriving

formal comparison across the various scenarios provides few, if any, insights.

Therefore, and as noted above, to provide insights into those scenarios, equations (1)

and (2) are calibrated with data for the Indian wheat market.

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(iii) Results and Insights

We start by measuring the effect of inefficiency of a welfare maximising parastatal

( 1c p ) on the distributional and net welfare effects. The inefficiency of a

parastatal is associated with its costs being higher than those of a private firm

benchmark. We consider two levels of inefficiency; one where the parastatal’s costs

are 25 per cent higher and the other where the costs are 50 per cent higher than the

private firm's costs. The effects of this difference are reported in Figure 1, where the

comparisons are made with respect to an efficient parastatal.

As can be clearly seen, inefficiency in the procurement and distribution of wheat

reduces net welfare significantly. With the degree of relative inefficiency being 25 per

cent, social welfare is reduced by 10 per cent and if relative inefficiency is 50 per cent

it reduces social welfare by around 17 per cent. The inefficiency of the parastatal also

reduces welfare for both farmers and consumers. With relative inefficiency at 25 (50)

per cent, producer surplus is reduced by 28 (45) per cent while consumer surplus is

reduced by 24 (38) per cent respectively. The implications for food security and

livelihood security are also reported in the Figure. Inefficiency has a substantial

impact on the total availability of wheat, while there is little noticeable effect on self-

sufficiency (not shown) largely because inefficiency reduces both domestic

procurement and imports. The total wheat available decreases by as much as 21 per

cent at 50 per cent relative inefficiency. Consumer prices rise by as much as 29 (53)

per cent when the parastatal is 25 (50) per cent inefficient and farm-gate prices fall by

22 (37) per cent under the same scenarios. Thus, the inefficiency of the parastatal is

15

detrimental to both food security and livelihood security, as well as to overall social

welfare, which includes the parastatal's profits.12

Figure 1: Welfare Impact of an Inefficient, Welfare Maximising Parastatal a

-60

-40

-20

0

20

40

60

% Changein SocialWelfare

% Changein Producer

Surplus

% Changein

ConsumerSurplus

% Changein

ConsumerPrices

% Changein Farm

Gate Prices

% Changein Total

Availability

% Change25% less eff icient

50% less eff icient

Note: a the percentage changes are measured from the benchmark of an efficient firm

Consider now a marketing system characterised by competition between private firms

as the alternative to a welfare maximising but inefficient parastatal. In analysing the

role of competition, including the concern that a welfare-maximising parastatal may

be replaced by private firms exercising market power, we consider three scenarios

where we vary the number of firms competing in the market. The three are: first,

where the market is characterised by oligopoly/oligopsony – for this, we set the

number of firms equal to 4; second, where the market is reasonably competitive –

here the number of competing firms is set to 20; and third, where the market is more

competitive and the number of firms equals 100. For the sake of our evaluation, we

compare the private sector outcomes with the parastatal that is 50 per cent less

12 As we report below, the direction of the changes is not dependent on the parameter values chosen.

16

efficient than the private firms. Therefore, there are two principal differences between

these alternative market structures: first, the objective function of the parastatal differs

from that of private firms (welfare maximising versus profit maximising); and second,

the parastatal’s costs are 50 per cent higher than the private firms’ costs.

The results from comparing the alternative market structures with private firms with

the inefficient parastatal are reported in Figure 2. The effects on social welfare are

very similar. With a moderately competitive private firm environment (n=20), social

welfare is 21 per cent higher than for the inefficient parastatal; with a more

competitive environment (n=100), social welfare increases by approximately the same

percentage. With a small number of firms (n=4), social welfare increases by 20 per

cent.

Figure 2: Implications of Private Firm Scenarios Compared with a Welfare Maximising, Inefficient Parastatal a

-40

-20

0

20

40

60

80

100

% Change inSocial

Welfare

% Change inProducerSurplus

% Change inConsumerSurplus

% Change inTotal

Availability

% Change inFarm Gate

Prices

% Change inConsumer

Prices

% C

han

ge n=4

n=20

n=100

Note: a the percentage changes are measured from the benchmark of an inefficient parastatal

17

The biggest changes occur not in net welfare per se, but in the distribution of it. With

n=20, producer surplus is 63 per cent higher and consumer surplus is 47 per cent

higher. Consumer prices are lower in all cases with the biggest difference (-33 per

cent) arising (not surprisingly) in the more competitive (n=100) case. Total

availability of wheat also increases and substantially so as the market becomes more

competitive (an increase of 26 per cent where n=100). Finally, producers also benefit

(again, the greatest change arising in the more competitive case) from both an

increase in domestic procurement and an increase in the procurement price13.

(iv) Co-existence between private firms and the parastatal

In the final comparison of alternative market structures of the wheat marketing chain,

we consider the case where the parastatal co-exists with private firms. This example is

important since, across many countries (including India) where parastatals are

involved in procurement and distribution, this co-existence is likely to be the most

typical market structure. However, it is often the case that when the parastatal does

co-exist with private firms, the government bestows certain exclusive rights on the

parastatal, i.e., the government determines in which markets private firms can operate,

leaving the other segment of the market exclusively to the parastatal. A common

example of possible configurations would be where the parastatal has exclusive rights

over international trade. In this case then, we have three aspects of the potential

13 At this point, a word of caution in interpreting these results should be noted. We are comparing the private sector with a parastatal which, though relatively inefficient, is nevertheless maximising both consumer and producer welfare. If we were to amend the objective function of the parastatal, then the evaluations will change in percentage terms. Assuming the parastatal were to focus on profits only, the more competitive outcomes (n>1) would always dominate the parastatal case and more so than that shown in Figure 2. This outcome suggests, therefore, that there are factors which are potentially offsetting and others which are reinforcing, together suggesting that care has to be exercised in identifying the precise ingredients of the reform package before firm conclusions can be drawn. In the welfare-maximising case, the parastatal is already charged with the aim of re-distribution and it has the potential to dominate the private firm outcome. But, to do so, it would need to be much more efficient than has been assumed in Figure 2. For further discussion of this point, see McCorriston and MacLaren (2011).

18

asymmetry between the parastatal and private firms: the objective functions may or

may not differ; the parastatal may be relatively less efficient than the private sector

counterparts; and the parastatal may have sole rights over procurement/distribution in

specified segments of the market. Here we explore the more general case where the

parastatal co-exists with private firms in both segments of the market.

In dealing with this case, we have to re-define the inverse supply and demand

functions to reflect competition in procurement and distribution between private firms

and the parastatal. They are:

1 1 1 , ,

2 2 , 2 ,

,

,

( ) ( )

( ) ( )

( )

( )

d S d m S m

d S d m S m

A d S d

w m S m

p a b Q nq Q nq

p a Q nq b Q nq

p f k Q nq

p F K Q nq

(7)

The pay-off functions for the parastatal and the private firms remain unchanged.

Using equations (3), (4) and (7), the first-order conditions are:

1 1

2 2

1 1

2 2

,

,

,

( 1)( ) 0 ( 1) 0 ( )

1 0 0 0 0

( 1) 0 ( 1)( ) 0 ( )

0 0 1 0 0

[ (1 ) ( )] 0 (1 ) 0 (2 ) (2 ) (2 )

(1 ) 0 [ (1 ) ] 0 (2 ) (2 ) 2c p c c p c

c c c c

d

d P

m

m P

d S

m

n b k n b k

n

n n b K b K

n

n b k n b k

n n b K b K

q

Q

q

Q

Q

Q

1 1

2

1 1

, 2

0

0

TPDSoff BS

TPDSoff BS

S

a b Q f kQ

a F

a b Q f kQ

a F

(8)

Note that the optimal quantities obtained from solving equation (8) are a function of

the parameters , , and c pn .

19

The welfare and security comparisons associated with this case are reported in Figure

3. Specifically, when private firms co-exist with the parastatal, net welfare is lower by

approximately 2 per cent compared with the inefficient parastatal alone, while net

welfare is 21 per cent higher if there are only private firms. Note, that in this

comparison, overall there are the same number of participants in the market (20) but

there remain asymmetries between the parastatal and private firms in terms of relative

efficiency and pay-off functions. When private firms co-exist in the market with the

parastatal, all metrics show an improvement with the exception of net welfare. The

explanation is that parastatal makes losses (negative profits) and this accounts for the

change in sign in net welfare despite the improvement in consumer and producer

surplus and overall availability of wheat.14

Figure 3: Welfare Implications of Private Firms Co-existing with a Welfare-

Maximising, Inefficient Parastatal

-40

-20

0

20

40

60

80

100

% Changein SocialWelfare

% Changein Producer

Surplus

% Changein

ConsumerSurplus

% Changein Total

Availability

% Changein FarmGate

Prices

% Changein

ConsumerPrices

% ChangeCombined Case

Private Firms only

Note: a the percentage changes are measured from the benchmark of an inefficient parastatal

14 If the parastatal were more efficient ( 1.25 instead of 1.5 ), net welfare with the parastatal alone would be greater than the case where it co-exists with private firms, but it still less than that with the private firm only case.

20

We can summarise the main insights from the above analysis as follows. First, the

inefficiency associated with the operations of the parastatal has a considerable impact

on social welfare and on the distribution of that social welfare, as well as on food

security measured as total availability. Notwithstanding other reforms to the wheat

marketing sector in India, improving the efficiency of the FCI could bring substantive

benefits. Second, comparing the more abstract case of a parastatal with a private firm

alternative depends on the objective function of the parastatal and the number of

private firms. Private sector outcomes dominate the inefficient parastatal case, but if

the relative efficiency of the parastatal improves, it can be that the competitive

outcome may not dominate the parastatal case even if the private sector case is

competitive. Third, when considering the nature of private sector outcomes, more

competitive environments do better across almost all metrics and bring the outcome

closer to the welfare maximising ideal outcome. The results above also indicate that

the effects on welfare and food security are potentially substantial. In other words,

changing market structure from the parastatal to a sufficiently competitive private

sector supply chain could bring benefits to food security, to producers and consumers,

and to overall social welfare.

4. Constrained Reforms of FCI Functions

In this section, we build on the analysis above to focus more directly on the

responsibilities of the FCI and the policy options that exist while, at the same time,

maintaining the overall objectives of government policy towards both farmers and

poor consumers. The insights above highlight the role that competition in the wheat

marketing chain could play in improving welfare for both consumers and producers

21

and the potential implications for food security and the circumstances under which

they are likely to prevail.

The contrast between the parastatal and the private sector alternatives in section 3 was

limited to the differences in the pay-off functions of the parastatal and private firms,

to the relative inefficiency of the former and to the number of firms. Across all the

comparisons above we allowed for buffer stock procurement, but in none of the

examples was the range of functions of the FCI fully captured in terms of

procurement to enable the distribution of subsidised food to the poor or, where

needed, additional procurement to support the MSP. This augmentation of the

functions of the parastatal is important. Not only will the existence of the parastatal

create differences from the private sector case due to differences in pay-off functions

and relative efficiency, but the procurement and distribution functions of the FCI will

determine the size of the market in which private firms compete. In other words, the

size of the residual commercial market changes with the functions of the FCI, thus

limiting the welfare impact of private firm competition. Moreover, the ‘food subsidy’

costs will not only be determined by the functions of the FCI (i.e., the levels of

procurement and distribution) but they will also be determined by the extent of

competition in the private residual market. Finally, in gauging the effectiveness of the

FCI in meeting the government's objectives, we should also assess alternative policy

instruments that could meet the aims of the government.

We therefore extend the analysis of the Indian wheat marketing chain and focus more

directly on the role of an inefficient FCI co-existing with private firms. The FCI’s

procurement is determined by the need to maintain stocks at the buffer stock ‘norm’

22

and the amount of wheat necessary for distribution through the TPDS. We highlight

the welfare and food security implications of this procurement by comparing the

FCI’s role in achieving the objectives sought when the commercial market is

relatively competitive and when it is less so. Specifically, the inefficient FCI retains

these roles in the procurement and distribution of wheat, but we vary the number of

private firms competing in that context. Consistent with the almost zero level of

imports by the FCI in recent years, private firms can procure from domestic and

import sources. We then proceed to assess alternative policy instruments that could

achieve the government's objectives. These are a deficiency payments mechanism for

producers in place of the MSP and the targeting of poor consumers through the use of

a food stamp programme in place of the 'fair-price shops'. The role of the FCI is now

limited to procuring wheat for the sole purpose of maintaining the buffer stock.

(i) The FCI Current Regime and Competition in the Marketing Chain

In evaluating the current arrangements, we need to amend the characterisation of the

market. Specifically, procurement by the FCI for the buffer stock and for the TPDS is

exogenous and the FCI does not procure for commercial reasons. However,

depending on the realised domestic procurement price, the FCI may have to procure

to support the MSP. The inverse supply and demand functions are given by:

1 1 1

2 2 2

*( ), if

otherwise

d m

d m

d TPDSalloc BS AA

w m

p a b nq nq

p a nq b nq

f knq k Q Q p MSPp

MSP

p F Knq

(9)

where: the inverse demand functions are specified for the commercial consumers

only; TPDSallocQ is the quantity procured for the TPDS which exceeds the quantity sold

23

through it, TPDSoffQ ; BSQ is the quantity procured for the buffer stock; and *Ap is the

realised procurement price. The private firms procure along the inverse domestic

supply function adjusted leftwards by the amount removed by the FCI. This

adjustment results in the modified constant in the first row of the right-hand side

vector in the first-order conditions, which are given by:

1 1

,

2 2

,

( )( 1) 0 ( 1) 0 ( )

1 0 0 0

( 1) 0 ( )( 1) 0

0 0 1 0

d TPDSalloc BS

d P

m

m P

qb k n n a f k Q Q

Qn

qn b K n a F

Qn

(10)

We assume for present purposes that *Ap MSP . From this, we can derive prices at

both ends of the marketing chain and the relevant welfare effects. Equation (10)

represents the status quo in which the FCI fulfils its three functions15.

Assume now that the FCI does not procure to meet the needs of the TPDS which are

met by a food stamp programme. Then consumers that previously bought wheat

through the TPDS are now added to the commercial demand function (the term

1 TPDSoffb Q in equation (12)). We further consider the possibility that, to support farm

prices, the government may need to use deficiency payments to guarantee a

procurement price of gp . The distinction between the MSP and pg is fundamental.

The MSP is maintained, if required, through marginal procurement and storage of

wheat by the FCI. The guaranteed price is maintained through a monetary transfer of

( )g Ap p per unit of procurement – the deficiency payment. Therefore, there is no

build-up and spoilage of stocks as there is with the MSP.

15 To simplify the presentation of the algebra, we set aside the discussion on the relative inefficiency of the parastatal as captured by .

24

The market characterisation that accommodates these cases is given by:

1 1 1

2 2 2

*, if

otherwise

d m

d m

d BS A gA

g

w m

p a b nq nq

p a nq b nq

f knq kQ p pp

p

p F Knq

(11)

The corresponding first-order conditions are given by:

1 1 1

,

2 2

,

( )( 1) 0 ( 1) 0

1 0 0 0

( 1) 0 ( )( 1) 0

0 0 1 0

d TPDSoff BS

d P

m

m P

qb k n n a b Q f kQ

Qn

qn b K n a F

Qn

(12)

The results from changing the functions of the FCI are reported in Figure 4. These

results are presented to reflect the costs of the current regime relative to what could be

attained if the instruments were changed in the way specified. The left-hand side bar

for each metric represents the case where a food stamp programme has replaced the

TPDS and the MSP no longer exists. The right-hand side bar represents the case

where the food stamp programme has replaced the TPDS and a deficiency payments

policy is used to support farm-gate prices. With the assumed 20 private firms, the

deficiency payment is activated and this adds to the budgetary costs of intervention.

The simulations show that the current functions of the FCI result in welfare losses

compared with the two alternative instruments. With the government’s objectives still

being met by other means, these effects are arising solely through the choice of policy

instrument, and not the policy objective per se. The results indicate that the

procurement functions needed for the TPDS and the MSP have a significant effect on

welfare, reducing it by around 40 per cent compared with the levels of social welfare

25

achieved through the re-instrumentation. There are, of course, important distributional

effects. Producers gain from the current arrangements because the FCI creates a

smaller residual market which causes farm-gate prices to be relatively high. Note,

however, that the current arrangements are regressive, so it is the relatively larger

farmers who will benefit most from current arrangements. When the functions of the

Figure 4: Evaluating the FCI’s Current Functions Relative to Alternative Policy Instruments

-80

-60

-40

-20

0

20

40

60

80

% Changein SocialWelfare

% Changein Producer

Surplus

% Changein

ConsumerSurplus

% Changein Total

Availability

% Changein FoodSubsidy

Cost

% ChangeNo TPDS/Food Stamps

Food Stamps/DP

Note: the percentage changes are measured from the benchmark of each of the alternative policy instruments

FCI are reformed, the size of the residual commercial market increases, causing farm-

gate prices to fall. Consumers are the main losers from the current arrangements with

consumer surplus for those consumers who purchase in the commercial market being

considerably lower. Note that the poor and vulnerable consumers still have access to

low-cost food through a food stamp programme so the results arise here because the

size of the commercial market has increased, which benefits consumers.

26

Reflecting the change in size of the commercial market and the reduced functions of

the FCI, total availability would increase with reforms to the benefit of food security.

The use of a deficiency payment scheme in combination with the food stamp

programme would lead to slightly higher levels of total availability compared with the

food stamp measure alone. Finally, the current arrangements lead to a high ‘food

subsidy’ cost: introducing a food stamp programme to replace the TPDS and the use

of deficiency payments to support farm-gate prices if necessary, would bring

substantial savings to the public exchequer. These effects are magnified as the

commercial market becomes more competitive; conversely, as the market becomes

less competitive, the welfare changes are smaller with the exception of the change in

farm-gate prices and producer surplus. This is because, with a smaller number of

private firms, there is the potential for the exercise of oligopsony power and the

guaranteed price serves to ensure that the farm-gate price does not fall below a

minimal level.

The results therefore suggest that the current arrangements lead to high food subsidy

costs, lower welfare, less wheat being available, and lower consumer surplus. Farmers

alone benefit from the current regime. Therefore, changing the functions of the FCI in

the way specified will bring substantive benefits, notwithstanding the impact on

producers.

Finally, it is worth commenting on why the potential effects of changing the functions

of the FCI are so large. The reason for this is that with the FCI procuring for the

TPDS and the buffer stock, the commercial market is effectively a “residual” market

27

and commercial trading is much smaller than what it would otherwise be. In the

absence of the TPDS and the MSP, and procuring for the buffer stock ‘norm’ only,

the commercial market increases in size. This is the source of the welfare changes and

given the over-procurement by the FCI in recent years, this is the principal source of

change that comes about, the extent of these changes being dependent on the number

of private firms that fill this ‘market space’. The budgetary effects are of course more

limited as the aims of food security and farm-price support are met through other

means.

(ii) Sensitivity Analysis

The results presented above and throughout the paper rely on a calibrated model. Such

an approach is not unusual for this type of exercise but the reported results are

potentially sensitive to the underlying parameters. In the cases outlined above, the

ranking of the results always stays the same even if the exact numbers do change.

While in most applications of calibration models the precise results vary with the

underlying elasticities chosen, in the model presented above, changing the underlying

elasticities also has an economic effect. Specifically, since reforming the functions of

the FCI changes the size of the residual commercial market, the slopes of the inverse

supply and demand functions will determine the likely impact of the “market space”

in which private firms compete. This, in turn, can have an effect on the various

metrics outlined above.

To illustrate this discussion, the price elasticities of domestic demand and supply were

altered and the five metrics that are shown in Figure 4 were re-calculated. For the

base case, the price elastictity of demand is –1.0 and the supply elasticity 0.5. For the

28

case labelled "smaller demand elasticity", the value is –0.25; and for the case labelled

"smaller supply elasticity", it is 0.25. The results of re-calculation are shown in

Figure 5. The only metric for which the direction of the percentage change differs

across the three sets of elasticities is the percentage change in total availability. The

comparison shows that instead of the FCI (the status quo) reducing the total quantity

available compared with the situation labelled "No TPDS/Food Stamps", if the

domestic supply function becomes more price inelastic, the FCI would increase total

availability. This same result holds also for the other regime labelled "Food

Stamps/DP" (not shown).

Figure 5: Sensitivity Analysis

5. Conclusions

The continued growth of the ‘food subsidy’, low productivity growth in agricultural

production that is associated with inadequate investment in Indian agriculture, and the

-100

-50

0

50

100

150

200

250

% Change in SocialWelfare

% Change in ProducerSurplus

% Change in ConsumerSurplus

% Change in TotalAvailability

% Change in FoodSubsidy Cost

Per

cen

tag

e ch

ang

e

Base

Smaller D elas.

Smaller S elas.

29

inefficiency in the functioning of the Food Corporation of India, are the factors that

are creating the pressure for policy reform. Given its dominant status in the

procurement and distribution of wheat, the future role of the Food Corporation of

India will be central to the reforms that should take place. Clearly, as one considers its

future role, the question arises of what net benefits private sector competition in the

wheat marketing sector can bring. But, at the same time, the Government of India

faces the very real constraints of its stated objectives of maintaining farm incomes and

ensuring that low-cost food is available to the most vulnerable. Reform of the Food

Corporation, subject to the constraints of the provision of these safety nets, together

with the potential beneficial role of the private sector has been analysed in this paper.

To undertake this analysis, we have drawn on a theoretical framework calibrated with

data that characterises the Indian wheat market. We have analysed the issue of reform

from two directions. First, in characterising the wheat marketing sector, we compared

the outcomes achieved by a welfare maximising, potentially inefficient parastatal with

those of a set of private firms. We abstracted from the availability and use of other

policy instruments and manipulated the market structure through the extent of the

exclusive rights given to the parastatal. In all scenarios investigated, we made

allowance for the holding of stocks at the level given by the buffer stock norm. The

central message that arises from this analysis is that improving the efficiency of the

FCI on its own would improve considerably welfare and food security, while more

competition in the wheat marketing chain would lead to additional substantive

improvements in welfare.

30

Second, building on this framework, we then explored the options for the FCI as it

currently operates and its mandate in managing the TPDS and the MSP. The reforms

that were analysed retained the Government of India’s objectives but sought to

achieve them through other instruments: a food stamp programme to maintain access

to food by the poorest and most vulnerable and, if necessary, deficiency payments to

maintain the farm-gate procurement price. The overall message that arises from this

analysis is that constrained reforms of the FCI have the potential to bring substantive

improvements in welfare and in total food availability, as well as significant

reductions in the 'food subsidy'. Reform of the FCI does not require the government to

give up its objective of food security. That objective would continue to be pursued by

the FCI through procurement sufficient to achieve the buffer stock norm. More

generally, the paper has presented a methodology which can be employed to assess ex

ante reforms in market structure which is central to the issue of parastatal reforms in

developing countries.

31

References

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32

DATA APPENDIX

The behavioural equations are:

1 1 1 1 1p a b Q Q : inverse demand for domestic product

2 2 1 2 2p a Q b Q : inverse demand for imported product

1Ap f kQ : inverse domestic supply function

2wp F KQ : inverse import supply function

The data and elasticities that were used to calibrate these supply and demand are as

follows.

price elasticity of demand = –1

elasticity of substitution = 2.2

price elasticity of supply of domestic wheat =0.5

price elasticity of supply of imported wheat = 10

quantity of domestically procured wheat = 80,560,000 metric tonnes:

of which the quantity procured by the FCI for its various welfare

programmes is 31.38484 million tonnes;

and of this procurement, 22.384 million tonnes is allocated to these

programmes;

the difference is assumed to go into the buffer stock; and

the buffer stock norm is 8.2 million tonnes

quantity of imported wheat = 290,000 metric tonnes

consumer price domestically procured wheat = Rs15670/tonne

consumer price of imported wheat = Rs15008/tonne

supply price of domestic wheat = MSP = Rs10,800/tonne

supply price of imported wheat = Rs13,400/tonne

In addition, a number of accounting identities were used to calculate the budgetary

costs of the various policy instruments which are a component of social welfare.