INCENTIVES- DISINCENTIVES IN TRANSNATIONAL VALUE CHAINS
Lorenzo Giovanni Bellù (FAO-TCSP)
Piera Tortora (FAO consultant)
April 2010
1.
1.
2.
3.
4.
5.
Introduction ........................................................................................................................ 1
Value chain structures ........................................................................................................ 1
The case of the Cotton Value Chain in Burkina Faso ........................................................ 5
Accounting for incentives or disincentives to producers in global value chains ............... 9
Conclusions ...................................................................................................................... 10
References ........................................................................................................................ 11
1. Introduction
This note is the zero draft, to be further discussed and validated, of the chapter in the MAFAP
methodology addressing the issue of transnational value chains, i.e. value chains covering
different countries from the origin to the final destination of a commodity and/or related
processed products, in which selected agents operate, directly or indirectly, in more than one
country and dispose of market power at one or more stages of the chain. The section 1
presents a general discussion of concentration issues in value chains. In section 2, the cotton
value chain in Burkina Faso is presented as a possible paradigmatic case of a global value
chain where regulated local monopsonies at the processing stage exist, with the same agents
acting to a good extent both at national and international level. Section 3 presents a simplified
accounting framework highlighting relevant variables for policy monitoring and policy
making in global value chain. Section 4 provides some concluding remarks for the issues
addressed in the note.
1. Value chain structures
The form of vertical structure of a value chain impacts on both the price formation at every
stage of the chain and on results of policies. On the one hand, concentration at one stage of
the value chain alters the relative upstream-downstream bargaining power and the related
terms of trade in ways that could either benefit or affect adversely the final consumers and/or
the primary producers. On the other hand, depending on the vertical structure, policies that
benefit firms at a certain stage of the vertical chain may either operate at the expense of firms
at another (linked) stage of the same chain or benefit the entire chain. Moreover, alternative
market structures entail very different net welfare and distributional effects of trade policy
measures (see Messerlin 2001, Larsen 2002).
In monitoring policies we are interested, among other things, to the spread between a
commodity price and some efficiency benchmark, as the result of market and/or policy
failures. Such spread can be seen as an approximation of the incentive or disincentive
relative to the efficiency benchmark.
The relevance of the incidence of market structure on price formation can be illustrated by a
simplified example (we follow Gilbert, 2006). Let us focus on two stages of a given value
1
chain: production and processing, and assume that the first operates in competitive markets,
while the latter in monopoly. The fact that processing firms operate in monopoly implies that
the processed commodity price is higher than it would be if firms operated in competitive
markets ( Ppo  Ppc ) and that the processed commodity supplied quantity is less ( Qpo  Q pc ).
In order to see what is the impact of this on the price and quantity supplied of the primary
commodity, we assume linear demand and supply functions, and denote supply function of
the primary commodity with Sr, while the supply function of the processed commodity with
Sp. Processing costs and margins sum-up to a constant “c” and quantity losses in processing
are zero. Figure 1 shows that the monopoly in the processing stage of the chain reflects
negatively also on the upstream agent, i.e. the producer of the primary commodity, with a
reduced raw commodity price compared with the one which would prevail under competitive
markets( Pro  Prc ) as well as reduced quantity traded ( Qro  Qrc ). This is due to the fact that
the monopolist find its equilibrium not where the supply meets the demand schedule, as in
point a, but where the supply meets the Marginal Revenue (MR), in point b.
Figure 1: Market structure and prices in a simplified value chain
P
D: Demand curve faced by the monopolist
MR: Marginal Revenue of the monopolist
Sp
Sp: Supply of the monopolist
Sr: Supply of the primary producer
Pp,c
Pp,o
b
a
Sr
Pr,c
Pr,o
MR
0
Qo
Qc
D
Q
Along agricultural value chains, imperfect competition is thought to be widespread in food
processing and retailing, while more competitive markets usually characterize the upstream
(primary commodities production) stages of the chain.
In figure 2, four theoretical cases of value chain structures are presented. The four cases are
distinguished on the basis of market concentration and value added shares at each stage of
the value chain. Case I illustrates market concentration in the processing and wholesale/retail
stages and competitive markets at the production stage. Higher value added associated with
downstream stages is assumed. Case II depicts the case of a monopoly at the processing
stage which buys all the production available on the market from small scale producers and
sells to wholesalers/retailers which operate with some degree of market power. The
assumption of higher value added levels associated with downstream stages is retained. In
Case III, the value chain is characterized by some degree of vertical integration between the
production and processing stages, where agents operate in less then perfectly competitive
markets. Higher concentration and higher value added are associated with the downstream
2
stage. In Case IV, a key role in the value chain is played by middlemen, who exert
monopsonistic power over small scale producers and avoid been squeezed by agents
operating in downstream stages of the chain.
Figure 2: Typologies of value chain structures
CASE I
0%
Market share
100%
Wholesale/Retail
Processing
Value
added
Production
CASE II
0%
Market share
100%
Wholesale/Retail
Processing
Value
added
Production
CASE III
0%
Market share
100%
Wholesale/Retail
Processing
Value
added
Production
3
CASE IV
0%
Market share
100%
Wholesale/Retail
Processing
Value
added
Trade
Production
Many value chains, including export-oriented ones, are also characterized by some forms of
monopsonies on the output side and/or monopolies on the input side for primary producers.
These are often organized on a geographical basis, in such a way that a single producer in a
given zone cannot access alternative sources of inputs or sell its output through alternative
channels. Unregulated monopolies increase the price of inputs paid by producers with respect
to prevailing prices under competitive markets. On the other side, monopsonies reduce the
price of the output as well as its optimal quantity. Figure 3 illustrates the latter case.
Assuming “well-behaved” supply and production functions, the monopsonist (e.g. a sugar
refinery) maximizes his profits when the marginal cost of the input (MC) (e.g. the sugarcane)
equals the Marginal Revenue Product (MRP). Note however that, due to the fact that the
monopsonist is the only-one who buys that input, he faces the whole supply curve of the
sugarcane producers. This implies that the marginal cost curve (MC) for him is steeper than
the supply curve S1. He will purchase the quantity Qe which is lower than the competitive
equilibrium quantity Qe’. For that quantity he pays the Price Pe, which is lower than the
competitive equilibrium price Pe’.
1
For the canonical explanation of the behaviour of a monopsonist, see e.g.: Gravelle and Rees (2004): Gravelle
H & Rees R. Microeconomics, 3rd Ed. Prentice Hall.
4
Figure 3. Monopsony on the output side of primary producers.
P
MRP”
MC
MR: Marginal Revenue
Product of the monopsonist
MRP
MC: Marginal cost curve of the
monopsonist
S
S: Supply curve of the input
producer
Pe: Equilibrium price under
monopsony
MCe”
MCe
Pe’
Pe”
Pe
0
a
Qe: Equilibrium quantity
under monopsony
b
c
Qe Qe” Qe’
Pe’: Equilibrium price under
competition
Q input
Qe’: Equilibrium quantity
under competition
2. The case of the Cotton Value Chain in Burkina Faso
Cotton is the main export crop of Burkina Faso, covering between 50 to 60% of the export
revenues, depending on the years.
.
The cotton Value Chain in Burkina Faso is characterized, a much as the cotton value chains in
other countries, by three main stages: Primary production, (seed cotton), ginning (cotton
fibre), bailing and trading. Primary production is essentially a relatively small-scale farm
activity (350,000 producers with 8 hectares on average).
The seed cotton (primary commodity), is non-tradable internationally. It needs to be
processed (ginned, cleaned and bailed) before selling it to foreign buyers.
Collection and ginning activities are organized as local monopsonies (figure 4). Since 2004, a
national law attributed to the former national monopsonist SOFITEX, a joint venture of the
government Burkinabè with the state-owned French company DAGRIS2, the local
monopsonies in the west provinces of the country. Two additional ginning companies were
created and were attributed two local monopolies: the FASOCOTON and the SOCOMA,
covering the central and eastern provinces respectively.
2
Dagris is a semi-public French integrated agro-industrial group with operations spanning the entire cotton value
chain. Dagris’ central base of operations is in Africa and Central Asia where it concentrates its resources and
know-how in four core business activities: cotton fiber and seed production, cotton fiber sales and quality
control, production and sale of oil crops and supply of logistical services.
5
FASOCOTON is controlled by the Swiss multinational company REINHART, one of the
major cotton traders world-wide, while SOCOMA is controlled by DAGRIS. The partial
privatization of DAGRIS by the French government in 2008 shifted the control of DAGRIS,
as well as SOCOMA, to the French holding GÉOCOTON. This company is controlled by
ADVENS (51%), a French multi-national corporation which owns interests in agro-industrial,
logistics and transport activities in Senegal and Mali, and participated by CMA-CGM (49%),
the world’s third-largest container shipping French company (APE 2008)3. These local
monopsonies export their cotton mostly through REINHART, and DUNAVANT4, the
American largest private-owned cotton merchandiser in the world.
Figure 4: Monopsony zones in Burkina Faso.
REINHART, DUNAVANT as well as GEOCOTON are, directly or indirectly (via controlled
companies), both cotton processors in various African countries and cotton traders.
At the beginning of the season, the monopsonists announce a floor price for the seed cotton
(the same for all the three monopsonists), which is the 95% of the “Pivot price”, a reference
price based on the average international price of the cotton fibre of a given quality in the last
five years (Cotlook A index), taking into account a technical conversion factor between seed
The remainder of the State’s shareholding (13.7%) of DAGRIS was transferred to the Agence française de
développement (French Development Agency), which “will seek to promote the Association of Collective
African Investments (association d’intérêts collectifs africains) pertaining to Dagris’ sphere of operations, with
a view to the acquisition by these investments of a shareholding in the capital of this enterprise”. APE (2008):
Agence des Participations de l’Etat: French State as a Shareholder. Ministère de l’Économie, de l’Industrie et de
l’Emploi. Report 2008.
4
Dunavant owns various real estate development companies, a truck brokerage company, cotton warehouses in
the United States and Australia, ginning operations in Zambia, Uganda, Mozambique, and Australia, as well as a
commodities trading company with locations in New York, New York and Memphis, Tennessee.
3
6
cotton and cotton fibre (around 3:1) and some standard processing costs. During the
campaign, farmers are paid the floor price at the delivery of the seed cotton, net of the cost of
the inputs they received at the beginning of the campaign and related interest. At the end of
the campaign, the “ex-post” price of seed cotton is calculated using the same criteria applied
for the pivot price but this time, the past five-year average Cotlook A index is replaced by the
average “Cotlook A index” of the campaign. If the “Ex-post” price is lower than the floor
price, the monopsonists receive a compensating payment from a stabilization fund (“fond de
lissage”). If the “ex-post” price of the seed cotton is comprised between the “floor price” and
101% of the “pivot” price, the monopsonists pay to the farmers the difference between the
“Ex-post” price and the “floor” price. If the “Ex-post price exceeds 101% of the “pivot” price,
the part up to the 101% goes to farmers, while the part exceeding the 101% goes partly to the
“stabilization” fund, partly to the monopsonists and partly to the farmers, according to an
algorithm which considers the level of the surplus and the needs of the fund.
Note that at the beginning of the season, the cotton companies act under uncertainty. They
assume that, on average, a given output price (cotton fibre) will prevail in the markets where
they operate. With reference to figure 5, the marginal revenue product curve MRP will be an
expected-one. They will therefore announce a floor price for seed cotton close to Pe, in order
to stimulate farmers to produce the quantity Qe.
Figure 5. Structure of cotton value chain in Burkina and ownership of cotton companies
Seed Cotton
Producers
WEST
Seed Cotton
Producers
CENTRE
SOFITEX
FASO
COTON
Gov. BF 35%
Reinhart 31%
35%
Others 69%
Seed Cotton
Producers
EAST
SOCOMA
DAGRIS 51%
DAGRIS 30%
Others
UNPCB 20%
35%
Others 29%
National
International
traders
Border
International
traders
International
traders
Consumers of cotton fibre
Three issues related to pricing mechanisms in the Burkina Faso cotton value chain must be
noted:
7
1) the cotton company do not pay the producers on the basis of the price they actually
receive by the international traders, but on the basis of an index that is, by
construction, a systematic underestimate of the actual market prices5; This could
configure a systematic “disincentive” to cotton seed producers, not captured by the
gap between the “official” international price (the Cotlook index) and the price
received by the producers.
2) This “disincentive”, as long as the producers’ supply curve is rigid, might translate
almost exclusively in a reduction of their income, rather than also in a reduction of
output, which would affect also the cotton companies. This rigidity could be the result
of institutional factors, such as the influence of cotton companies on farmers via
agricultural input availability, “informal” social pressure etc.
3) The price actually received by the cotton company might not be the same price
received by the international traders (net of a “normal” trade commission) due to the
fact that the sellers are directly or indirectly controlled by the traders6. They are indeed
to a good extent two sides of the same economic subject, due to the substantial (if not
formal) vertical integration between them. This vertical integration may constitute a
constraint regarding the choice of the international trader7.
The latter point, on conceptual grounds, presents some analogies with the classical “PrincipalAgent theory” (Spence, A.M and Zeckhauser R. (1991) 8. Here the principal (the cotton
company) relies on the services of the agent (the international trader). Clearly, the cotton
company has limited instruments to verify the performances of the international trader.
However, if the cotton company and the trader were completely different economic subjects,
the first should be free to choose among traders, the one(s) which maximises the company’s
revenue, i.e. who pays the highest price for cotton. On the contrary, in situations where the
trader itself has a say on the choice of the trader by means of its control on the company itself,
the company may not be free to maximize its revenue. This collusion between part of the
cotton companies and the international traders is represented in figure 5 by the dashed
rectangle surrounding both the cotton companies and the international traders.
By lowering the prices paid to domestic companies below those actually received on
international markets, foreign investors (i.e. the international traders) generate profits
downstream, by shifting losses upstream. This is a well known mechanism to inflate and
5
The A index a virtual price calculated as the simple average of the five cheapest daily CIF quotations of cotton
of the same quality (MIDDLING 1-3/32) out of nineteen “growth” (zones of origin) traded on selected Far East
markets. http://www.cotlook.com/index.php?action=explain_cot_indices
6
The case of the cotton value chain in Burkina Faso requires further in depth analysis before coming to
conclusive considerations. However, signals of possible collusion are quite apparent.
7
To this regard, the case of the FASOCOTON, controlled by REINHART, whose fibre is almost totally traded
by REINHART is the most striking.
8
Spence A.M and Zeckhauser R. (1991) Insurance, information and individual action; American Economic
Review, 61 pp 380-387. Agency theory regards two subjects”, one of which i.e. the “Principal” assign to the
other, i.e. the “Agent” a task to accomplish, (the classical case being the employer-employee relationship), but:
1) the desires and goals of the principal and the agent conflict; and 2) it is difficult or expensive for the principal
to verify what the agent is actually doing. For an early review of the agency theory see e.g. Eisenhardt, M.K
1989: Agency Theory: an Assessment and Review. The Academy of Management Review. Vol 14 n.1 (Jan 1989
pp.57-74).
8
expatriate profits used by transnational companies (see Brealey and Myers, 2007) 9. By the
point of view of the producers, with reference to figure 3, the collusion between cotton
companies and international traders results in lower seed cotton prices, as, in absence of
collusion, the marginal revenue product curve would be MRP”, generating the equilibrium
price Pe” > Pe.
All this translates in a further disincentive to producers which is not captured by the gap
between the “official” international price and the price actually received by the producers.
3. Accounting for incentives or disincentives to producers in global value chains
In general terms, accounting for rents in global value chains implies looking at both the
segment in the producing and exporting country as well as the segment in the importing one.
Assuming that the producing country is a small country characterized by some inefficiency
and market imperfections in processing and transport technologies, the producer price of the
exported commodity Pd f can be represented as:
Pf  PFOB ExDC / FC  S  Tbf0  Tbf1  Rbf
(1)
where PFOB is the FOB price in foreign currency, Ex is the exchange rate (units of Domestic
Currency- DC for one unit of Foreign Currency), S, is the “unit” export subsidy (negative if
it represents a tax) , Tbf0 is the “efficient” component of costs incurred to process the
commodity and take it from the producer to the border (somehow assessed according to a
“standard” efficiency benchmark) and Tbf1 represents “excessive” costs (technical
inefficiencies and /or infrastructural gaps incurred for the same operations); Rbf .represents
the rent claimed by the downstream agent in the domestic market at the expense of the
domestic producer.
On the foreign market, assuming that the Foreign Currency FC is used, the price paid by the
final consumer, Pc can be described as:
Pc  PFOB  CIF  T  Tbc0  Rbc
(2)
where CIF refers to the “international “Cost, Insurance, Freight” to take the commodity from
the origin to the destination country, T represents a “unit” import tariff applied to the
commodity in the destination country, Tbc represents transport, processing and handling
costs from the border to the final consumers and Rbc represents rents on the same operations
in the destination country10. For simplicity, inefficiencies in transport, handling and
processing in the destination country are omitted.
From (2) the FOB price can be easily worked out:
9
For a review of tools to expatriate profits of foreign transnational companies, see e.g. Brealey R.A., Myers S.C
et al.(2007): Principles of Corporate Finance. 10 th ed. Mc Graw Hill ed.
10
9
PFOB  Pc  CIF  T  Tbc0  Rbc
(3)
and replaced in (1), to get:


Pf  Pc  CIF  T  Tbc0  Rbc ExDC / FC  S  Tbf0  Tbf1  Rbf
(4)
Note that in the (4) the price received by the producer is expressed as function of the price
paid by the final consumer Pc net some processing, handling, transport costs, converted by
an appropriate exchange rate whenever required and some fiscal charges, minus extra-profits
(rents) of the up-stream (domestic) and down-stream (foreign) agents.
In this framework, incentives-disincentives to producers (nominal, in this simplified case) are
determined, other things equal, by:
1) fiscal policies in both origin and destination countries, determining T and S;
2) the macro-economic set-up of the origin country, influencing Ex;
3) the willingness to pay for the product of final consumers in the destination country,
determining the price Pc ;
4) the institutional context and/or the market settings, allowing for the generation of extraprofits (rents) in the origin and/or destination country.
5) The extent to which transport, processing, handling costs approach (or depart from) a
somehow selected “efficiency” benchmark.
Note that, in this framework, on the one hand, the international price, (and the related FOB CIF derived prices) becomes irrelevant for the calculation of incentives and disincentives to
producers, provided that the abovementioned variables have been determined. The
international price becomes a simple device to transfer profits from upstream to downstream
agents (or vice-versa) and/or an accounting element to calculate fiscal charges. On the other
hand, all the other variables look relevant for policy monitoring, as all them are affected by
existing policies, missing policies and/or policy changes in origin but also destination
countries.
It is apparent that in the context of global value chain, specific investigation and analysis is
required both for diagnosis and calculation performance-monitoring indicators.
Concentration indexes, such as the Herfindal index, and other indexes related to monopolymonopsony rents, such as Lerner index and others, are useful. However, information on
agents, including trans-national ones, has to be worked out looking at different information
sources, such as income statements, balance sheets, analysis of production processes,
investigations on final markets for consumer prices and quantities etc.
4. Conclusions
In a context where trans-national agents operate on both the origin and destination segments
of value chains, if an analysis of incentives-disincentives to producers have to be carried out,
it is necessary to look at the whole global chain. In such situations, the international price is
most likely becoming to a large extent an “intra-corporation” transfer price, i.e. a device to
shift profits (rents) from one country to another. Only the investigation, analysis and
monitoring of the whole value chain enables analysts to provide decision makers with
relevant information for policy monitoring. Omitting to consider whole global value chains
10
and the way normal and extra-profits are generated and distributed along them would result
in poor information to, producers and consumers decision makers in both producing and
consuming countries. This appears to be particularly relevant for commodities constituting
the backbone of whole economic systems, or, at least the backbone of their international
trade. In addition systematic information on the variables discussed in the previous section is
likely to fuel the national and international debate on existing policies, missing policies and
necessary policy changes required in both origin and destination countries to favour poverty
reduction and food security.
5. References
....
11