A item in the Times of India reports on “Retail loot: Mandi prices are a fraction of retail prices. What explains the wedge in prices?

The report reads:

The potatoes you bought yesterday for anything between Rs 8 and Rs 12 per kg depending on which part of the city you live in, cost your retailer just Rs 3 per kg at the mandi. And the cauliflower he is selling for Rs 12 to Rs 16 per kg costs him only Rs 2 per kg.

It is natural to feel that prices should reflect costs. But in reality, prices often diverge very drastically from costs. Imagine a hypothetical situation where it costs Rs 2 to produce a kilo of potatoes. What’s the proper price of potatoes? That depends. It can be anything from zero to a very large positive number. It is not even guaranteed that the price cannot be a negative number also.

Let’s for the moment forget that the price can be a negative. What positive non-zero price can it be? Assuming that the supply of potatoes for a given period is fixed (which means that it takes time to increase the supply of potatoes by planting and harvesting them), then the market-clearing price is strictly determined by demand. If the demand for potatoes is high, the price goes up. A medical journal report says, “A few potatoes a day keeps cancer away,” and suddenly everyone is eating potatoes. The price goes up.

The next week a report clearly indicates that potatoes are the chief cause of dementia. Down goes the demand and you cannot even give those potatoes away. People refuse to eat potatoes. Prices crash. The potatoes rot in the heaps and someone has to be paid to haul the stuff away for disposal.

Bottom line: in the short run, the supply is fixed. Short run is actually defined as the period in which you cannot change the supply. In the long run, the supply of everything is flexible — you can produce more or less of something. In the short run, the price is determined by the demand.

Now back to the specific case of vegetable prices. The wedge between farm gate prices (the price that the farmer receives for the produce) and the price that the consumer pays at the retail store is a reality. The intermediary buys at mandi or farm gate prices and sells it at the retail price.

The price of Rs 20 a kilo is justified given the fixed supply and the prevalent demand. There is no link between the cost to the buyer at the farm gate (Rs 2 per kilo) and the price that customers pay at retail. Can the retailer charge Rs 100 per kilo? Not realistically. At Rs 100 per kilo, he will have lots of unsold potatoes. For profit maximizing, the price has to be set so that the quantity at hand is bought by the customers.

Should the government intervene and force the sellers to sell the potatoes at Rs 3? At Rs 3, the quantity demanded will be more than what is at hand to be sold. Early shoppers will buy a lot and the later shoppers will find the market devoid of potatoes.

Will this be good for you? Depends on whether you are among the lucky few who got to the market early. Overall, the government mandating a below market-clearing price is not a good idea. It is in fact a very bad idea.

Here’s how. Imagine that the intermediary between the farmer and the consumer is a good guy and does not rip off neither the farmer nor the consumer. The farmer produces stuff and the intermediary brings it to the market. The price is determined by the interaction of the fixed supply and the market demand. Suppose the price is Rs 20. Given that price, suppose the farmer receives Rs 18, and the intermediary keeps Rs 2. Assume that the cost of production was Rs 4. The farmer therefore makes a profit of Rs 14 per kilo. Other farmers notice that. Onion farmers who were making only Rs 5 per kilo decide to plant potatoes. So in a short time (the time it takes to grow potatoes), the supply of potatoes goes up. The retail price drops as a result and with it the profits of potato farmers. In a while, the profits drop sufficiently that farmers don’t find it profitable to switch to potato farming.

Imagine if the government has mandated that while the market-clearing price was Rs 20, that retailers must sell potatoes at Rs 7. Now if that intermediary kept his Rs 2, the farmer receives Rs 5. His cost of production is Rs 4. His profit is Rs 1. No great profit. The production of potatoes does not increase. At Rs 7 a kilo, there is a perpetual shortage of potatoes. People who have connections, actually get to eat potatoes and pay a black market rate. The poor don’t get any potatoes at all.

That’s what happens when price ceilings are mandated by the government. The producer does not have the incentive to increase production. The poor consumers get rationed out of the market.

What’s going on in the vegetable market in India? The demand is high and the supply is limited. That explains the high prices. If the intermediary pays the producer Rs 2 and is able to sell the production at Rs 20, then the farmer is not getting the signal to increase production and the consumer suffers high prices. The only winner is the intermediary. So what is the answer? The answer is to get other intermediaries. Suppose another intermediary B enters the market and offers the farmer Rs 5 for his potatoes, thus outbidding intermediary A. The farmer will sell it to B. Healthy competition among intermediaries will ensure that the intermediary will make a fair profit and that the bulk of the gains will reach the farmer. Seeing that some farmers are making a lot of profit, other farmers will enter into production. And so on.

The fact that there is a huge wedge between farm gate prices and retail prices has to do with an inefficient supply chain. The intermediation has to be looked at. But to maximize loot, the government can limit the number of intermediaries. The intermediaries make a killing and they pay the government for the license to operate their killing machines.

Isn’t socialism wonderful?

{Thanks to Barbarindian for the question.}