EEP 131: Fair Trade

1. EEP 131: Fair Trade November 23, 2007

2. Topics in this series of lectures • Basic issues and definition of “Fair trade” • Discussion of market failure and fair trade. • Falling prices for agricultural commodities and past attempts to provide price support. • Objectives of Fair Trade (FT) movement. • Mechanics of obtaining FT certification. • Criticisms of FT and response to criticism. • FT as a remedy to market power. • FT’s effect on consumers. • FT “bundles” reforms, e.g. those involving credit and length of contract.

3. Basic issues • The fair trade movement attempts to increase the prices that producers in developing countries receive for the goods they sell (principally handicrafts and some commodities). Other goals include better credit, increased stability of earning, and promotion of institutional “capacity building”. The movement also wants to increase awareness, amongst consumers in richer countries, of development issues. • Skeptics of the movement think that it will have little practical result. It might even be counterproductive if it leads to increased supply and lower prices for producers who do not have fair trade certification, or if it encourages producers to remain in “dying sectors” rather than looking for jobs in sectors with more growth potential.

4. What is Fair Trade? According to FINE, the umbrella organization that comprises the four largest Fair Trade organizations (FLO, International Federation for Alternative Trade, Network of European World Shops, and the European Fair Trade Association): • “Fair Trade is a trading partnership, based on dialogue, transparency and respect, that seeks greater equity in international trade. It contributes to sustainable development by offering better trading conditions to, and securing the rights of, marginalized producers and workers—especially in the South [FINE 2001]”. • Fair Trade is an approach to treat the relationship between international trade and poverty alleviation in the global South based on a strategy of “trade not aid.” • Markets for Fair Trade coffee and other items link ethically minded Northern consumers with democratically organized groups of poor Southern producers. The goal of this alliance is to provide disadvantaged producers a chance to “increase their control over their own future, have a fair and just return for their work, continuity of income and decent working and living conditions through sustainable development” (Fair trade Foundation, 2002).

5. Common justifications for fair trade (http://en.wikipedia.org/wiki/Fair_trade) • Implicit and often explicit in fair trade is a criticism of the current organization of international trade as being "unfair". Fair trade advocates argue in favor of the need for fair trade by mentioning the purported microeconomicmarket failures of the current system and an alleged commodity crisis and its impact on developing country producers.

6. Market Failures (the Fair trade version) The Fair trade movement claims to support free trade, but states that the assumptions underlying trade theory do not hold in rural agricultural societies, including lack of perfect market information, perfect access to markets and credit, and the ability to switch production techniques and outputs in response to market information). Therefore, the absence of these microeconomic conditions can nullify or even reverse the potential gains to producers from trade. Fair trade is seen as an attempt to address these purported market failures by providing producers a stable price for their crop, business support, access to premium Northern markets and better general trading conditions.

7. Be alert when people advance “market failure” as a rationale for policy intervention • Some of the “market failures” listed in the previous slide (e.g. lack of perfect market information, perfect access to markets and credit, and the ability to switch production techniques and outputs in response to market information) may not actually be “failures”. For example if “perfect market information” is expensive to obtain, it is rational (efficient) for information to be “imperfect”. (We would not regard the fact that, when facing a positive price of widgets we do not consume as many as we would under a 0 price, as a “market failure”.) • Even where there are genuine market failures, some forms of intervention make things worse.

8. Effect of fall in commodity prices • Prices of sugar, cotton, cocoa and coffee fell by 30 to 60 percent during 1970 – 2000. FAO estimated that these lower prices caused a loss of $250 billion for developing countries during 1980 – 2002. • Lower prices do not always lead to a decrease in supply. Farmers sometimes increase sales in order to maintain minimal income levels. Majority of people in poor countries are the rural poor, and these are the most vulnerable to fall in commodity prices. Agriculture employs over 50% of the people in developing countries, and accounts for 33% of their GDP. • Fair trade supporters believe current market prices do not properly reflect the true costs associated with production; they believe only a well-managed stable minimum price system can cover environmental and social production costs. There is a long history of attempts to create such a system, mostly ending in failure.

9. Fairness and Efficiency “Fairness” does not play any role in standard economic theory. However, economic theory does recognize that market failures may cause prices to be inefficient – but see earlier slide on the use of “market failure” argument. Proponents of the fair trade movement base their support on the ground that it increases “fairness” (as commonly understood) and “efficiency” (by correcting market failures). Critics of fair trade (FT) claim that it does neither of these things.

10. Some background • Worsening “terms of trade” for commodity producers means that the ratio of the price of their exports to the price of their imports falls. (Producers’ welfare depends on relative, not absolute prices.) • This fall leads to a fall in primary commodity producers’ “real wage”, defined as the number of “baskets of consumption goods” a producer can obtain by selling a unit of labor. The fall in the price of coffee lowers the wage (and the income) of coffee producers. • Factors that cause the deterioration in commodity producers’ terms of trade (i.e. lower prices) include: i) increased productivity shifts out the supply; ii) the demand for these commodities is price-inelastic; iii) increased income in consuming nations does not lead to proportional increases in demand (demand is income-inelastic) • Throughout the 60s- 90s there were attempts to introduce policies and institutions that would mitigate the effects of worsening terms of trade for commodity producers.

11. Previous Efforts to mitigate effects of worsening terms of trade for commodity exporters • Generalized System of Preferences (GSP) permitted developed countries to charge lower tariffs on imports originating in developing countries. GSP was contrary to GATT non-discrimination requirement but was given an exemption from GATT rules. GSP was an implicit subsidy for developing countries. • EC negotiated Lome Convention(s) (the STABEX system) with previous colonies, as a means of stabilizing their export prices. STABEX system guaranteed producers minimum prices, but in many years the price floors could not be defended: market price was too far below the floor, and the volume was too high, relative to program funding. In 1997 WTO ruled that the Lome system violated the WTO non-discrimination requirement.

12. International commodity agreements of 60s – 80s • International Coffee Agreement (ICA) – various generations. An agreement between coffee importers and exporters, to maintain “price stability” – really a price floor. • Importing countries (e.g. US) supported ICA in effort to reduce threat of revolution. • Distributors in importing countries supported ICA (perhaps) as a means of “raising rivals’ costs” (even though it also raised their own costs). • The higher-than-market price stimulated increased supply, eventually making the price floor too expensive to defend. ICA dissolved in 1989

13. Comparison of previous efforts and Fair trade • Both FT and previous efforts seek to increase commodity producers’ income. • Previous efforts involve governments, and had broad coverage of producers. • Fair trade is voluntary, consumer-financed. It has narrow coverage of producers – only those who have Fair trade status, and only provided that they have buyers. Fair trade status gives producer the right to market the good under Fairtrade label, but does not guarantee a buyer.

14. Fair trade Objectives: • Creating opportunities for economically disadvantaged producers: Fair trade is a strategy for poverty alleviation and sustainable development. Its purpose is to create opportunities for producers who have been economically disadvantaged or marginalized by the conventional trading system. • Transparency and accountability: Fair trade promotes transparent management and commercial relations to deal fairly and respectfully with trading partners. • Capacity building: Fair trade is a means to develop producers’ independence. Fair trade relationships provide continuity, during which producers and their marketing organizations can improve their management skills and their access to new markets. • Payment of a fair price: A fair price is defined as one that has been agreed through dialogue and participation. It covers not only the costs of production but enables production which is socially just and environmentally sound. It provides fair pay to the producers and takes into account the principle of equal pay for equal work by women and men. Fair traders ensure prompt payment to their partners and, whenever possible, help producers with access to pre-harvest or pre-production financing. (The concept of “fair price” has essentially no role in modern economic theory.)

15. Fair trade objectives, continued • Gender equity: Fair trade requires the work of men and women is “properly valued and rewarded”. Each person is always paid for their contribution to the production process and are empowered in their organizations, regardless of gender. (Economic theory says that the “proper reward” is an agent’s value of marginal product, not something determined by committee – unless you’re a CEO.) • Working conditions: Fair trade means a safe and healthy working environment for producers. The participation of children (if any) does not adversely affect their well-being, security, educational requirements and need for play and conforms to the UN Convention on the Rights of the Child as well as the law and norms in the local context. • Environmental protection: Fair trade actively encourages better environmental practices and the application of responsible methods of production.

16. The Fair Trade movement has many objectives. Summary of these objectives: • Higher prices • Less price variability • Greater security of sales • Environmental and labor protection • Promotion of cooperative efforts to benefit the community.

17. Fair trade price = max(price floor, market price + Fair trade premium) Here is a comparison of market and Fair trade price for cocoa

18. Obtaining fair trade certification • Buyers (Fair trade NGOs and private firms) who use the trademark must (i) purchase their primary commodity input under fair trade conditions from the FLO register of approved smallholder farmer organizations and (ii) pay a license for the trademark. • Sellers: Only small producers and cooperative farms are eligible. The cooperatives receive capacity building support from NGO ‘Fair trade organizations’ operating in the South. These Fair trade NGOs also often have a ‘trading arm’ through which they behave as buyers. Fair trade organizations, their producer partners and private firms participating in the trademark system together constitute ‘Fair trade’. • Fair trade importers – not the producers – are charged the cost of certification (mechanism is unclear to me). Even if this is true, we expect that this cost is actually born by both groups – as with the producer and consumer incidence of a tax.

19. A criticism of Fair trade’s use of producer price increases as a means of helping producers • (Economic “fact”) Commodity prices are low because supply is high relative to demand. Higher prices will (likely) stimulate increased supply. • (Empirical observation) Not all of this increased supply will be sold under the Fair trade label. (Raynolds says that on average certified producer groups sell only 20% of eligible coffee in FT market; the rest is sold as regular coffee. Weber says that in 1995 only 13% of FT-eligible coffee was sold under the FT brand.) • (1) The increased supply will lower the price of regular coffee, leaving producers who do not have Fair trade certification (and possibly even those who do) worse off. • (2)The producers who are harmed by lower prices may be the most vulnerable poor, e.g. landless ag workers on plantations; for most crops, plantations who hire workers cannot obtain FT certification. • (3) Even producers who benefit may be harmed in the long run, if FT certification encourages them to stay in a sector rather than pursue opportunities in other sectors.

20. A response to this criticism of fair trade (FT) • The claim that higher prices stimulate increased supply need not be true in cases where FT coffee producers sell part of their harvest as non-FT coffee; they receive the non-FT price for these sales. Rational producers base their production decision on marginal, not on average price. • FT certification increases their average price, but unless it effects their marginal price (= the price of non-FT coffee) it (typically) has little or no effect on their production decision. Higher prices resulting from FT certification are “like” an income transfer, and do not create a distortion. For this reason, the fact that FT-certified producers sell only a portion of their product on the FT market enhances, not diminishes, the effectiveness of FT. • There are exceptions to this claim. If production has decreasing marginal costs (increasing returns to scale), a price-taking producer wants to produce at capacity or not at all. The ability to sell some product at the higher FT price may change the producer’s decision from “0 production” to “production at capacity”. In this case, the FT does increase production. However, decreasing marginal costs is unlikely to hold for ag production, so this caveat is not very important.

21. What is the effect of FT on price of non-FT coffee? • FT certification creates a market niche, but is unlikely to alter over-all demand for coffee (absent changes in price). The amount of consumption and production that shifts from non-FT to the FT market must be equal (supply = demand). As long as FT producers sell some product in the non-FT market (so that their marginal price equals the price of regular coffee), the original (pre-FT) market price remains an equilibrium. In other words, there is no presumption – using economic logic -- that FT should increase supply and depress prices (when FT producers also sell in non-FT market). • Empirical question: has FT certification increased supply of producers with the certification (controlling for price changes)? Wikipedia claims that empirical evidence suggests that producers use their additional income from Fair trade to improve their homes, send their children to school and improve the quality of their existing crop, rather than to increase production. (Is this true?) http://en.wikipedia.org/wiki/Fair_trade • Fair trade organizations encourage producers to invest in diversification and specialty crop development programs. Examples include coffee growers moving into other premium tropical produce (citrus, nuts, bananas) or investment in alternative income-generation projects such as eco-tourism, or in community health and education programs.

22. Market power: another response to the price-depressing criticism of FT • If FT-certified producers’ marginal price increases, they might increase supply, depressing the price of non-FT coffee. • However, the pre-FT price might have been inefficient, if it was the result of monopsony power -- i.e. market power of buyer/distributor (as distinct from final-consumer). • In that case, a higher producer price might increase efficiency, in addition to benefiting producers. • A monopsonist has an incentive to reduce her demand in order to reduce the price that she has to pay. If she is required to pay a minimum price, she has no incentive to reduce demand – since that reduction would have no effect on the price she pays. The next slide explains this.

23. What does a monopsonist do? price Monopsonist’s marginal cost of buying Supply curve facing monopsonist pc pm monopsonist’s demand curve Qm Qc quantity The competitive quantity and price are Qc and pc. The monopsonist reduces her demand to Qm in order to reduce the price to pm. A policy intervention that requires the monopsonist to pay pc eliminates monopsony power, and causes demand to increase to the competitive level, resulting in higher welfare for producers and an increase in efficiency.

24. Do coffee producers face monopsonistic middle-men? • By 1998 5 multinational companies controlled 70% of roasted and instant coffee market. 8 transnational export-import companies control 56% of coffee trade. From fall of ICA to 1997, producers’ share of final retail price has fallen from 20% to 13%. • Coffee producing nations’ share of the “coffee dollar” has fallen from 55% to 22% since from late 80s to late 90s. (See Bacon’s paper.) • This evidence is consistent with increased monopsony power, but it is also consistent with other explanations (e.g. changes in supply and demand).

25. How does fair trade attempt to reduce monopsony power? • Establishment of minimum price removes monopsony power (see a previous slide). • Fair trade movement attempts to make producers better informed about the market, and more active in marketing process. • But….. • Producers’ greater participation in marketing imposes real costs (e.g. administrative costs), which use some of the revenue from the price premium. Some producers object that they see little benefit from the premium. • In most cases, “middlemen” perform real services. Getting rid of them is not free. (If they did not perform real services, they would not exist in the market, absent coercion of some kind.) • The existing middlemen may be able to provide the marketing services more cheaply than the co-op, because of the middlemen’s greater experience and wider scope of action.

26. FT’s preference for a cooperatives over other forms of labor organization – and the monopsony argument again • The Economist magazine (December 7th 2006) objects to FT assumptions about the best way to organize labor. For coffee and some other commodities only small producer co-ops (not large family farms or plantations) can be certified. • (It would be interesting to review experience of co-ops in other countries, e.g. the US. My impression is that they are often not the best way – for producers – to organize production or sales.) • Three FT justifications: (i) Co-ops are more likely to give workers a fair deal when deciding how to spend the Fairtrade premium. (ii) Co-ops provide an alternative trading channels for smallholder farmers, thus diminishing monopsony power. Selling to cooperatives is meant to raise the returns to farmers by increasing their share of the prevailing world price. (iii) Higher producer returns encourage further capacity building, technical support and efficiency as co-ops work with Fairtrade NGOs.

27. Effect of fair trade on consumers • Since consumption of FT products is voluntary it (almost certainly) does not harm consumers – they still have the option of purchasing non-FT products. • FT brand creates a differentiated product, a “credence good” (one whose value depends in part on what the consumer believes about the product, rather than its intrinsic qualities). • If retailers pass on higher FT cost, consumers pay more. To the extent that their higher price reaches producer, the consumers make a (small) donation to producer (equal to the price premium). This could be an efficient way to transfer income from the rich to the poor. Many consumers are willing to make the small donation (a kind of implicit tax), so aggregate transfer might be large. Transactions costs might be quite small. • There is the fixed cost of obtaining certification and there may be some increase in cost of production (to conform to FT standards). But to the extent that those standards are socially useful (e.g. improved environmental practices, better labor conditions), the cost of achieving them is (more than?) offset by the increased benefits. So these should not be counted as costs. • Soliciting explicit donations is expensive; a large fraction of the donation goes to “administrative” costs, e.g. paying the solicitor. Also, those solicitations create (non-monetary) welfare costs – disturbing people at dinner, without obtaining a donation. These kinds of costs are not present with FT “donations”: FT consumers get the “warm glow”, and FT non-consumers are not irritated.

28. Retailers might add large markups for FT products • Economist December 7, 2006 claims that retailers add large mark-ups to Fairtrade products, misleading consumers into thinking that the entire premium they are paying is passed on. The Economist estimated that producers receive only 10% of the premium paid for Fairtrade coffee. Fairtrade coffee, like the organic produce sold in supermarkets, is used by retailers as a means of identifying price-insensitive consumers who will pay more. It makes sense for retailers to charge large markups, to take advantage of the fact that FT consumers have less price-elastic demand. • When retailers increase the markup, some of the consumers’ “donation” goes to retailers, not to producers (a “waste” from some perspectives). • Fair trade proponents note that EU and US competition laws prohibit FT agency from participating in price-fixing discussions between retailers and importers. That is, even if retailers do use the FT label by increasing profits from price-insensitive consumers, there is nothing that the FT NGO can do about that.

29. Another possibility for retailer behavior • Retailers might not charge any price differential, in order to keep consumers’ search costs low. They might use product differentiation to increase their (the retailer’s) market share. • The Fairtrade Foundation cites 2005 studies showing that the majority of retailers do not increase their profit margins on fairtrade products, for fear of losing market share in the growing market. There is at least one instance of a retailer actually reducing its profit margins. In an effort to boost sales and improve its corporate image Sainsbury in December 2006 announced it would begin to offer only Fairtrade bananas at the same price that it had previously sold non-Fairtrade bananas. • Retailers might also pass on the increase in their costs, by increasing the price of both FT and non-FT products. If that occurs, then the non-FT coffee is implicitly subsidizing the FT coffee. Alternatively, retailers might reduce price paid to non-FT producers. Likely, some of the incidence of the premium falls on all agents (producers, retailers, and consumers) – just as would be the case with a tax. • Producers might increase their margins with FT coffee even without raising price. If FT consumers care less about quality, retailers might substitute lower quality coffee under the FT brand.

30. Is FT an efficient way to support poor producers? • Organization of FT involves real costs. A 2002 study finds that the Max Havelaar foundation (an early FT proponent) incurred organization and administrative costs equal to 34% of the “generated transfer volume”. By comparison, another (non-FT) German foundation incurred administrative costs of 22%. • We can’t make too much of this observation – it is only one data point, and we don’t know what else might explain the differences in costs. The point is that we should not ignore the admin and organizational costs of FT.

31. FT response to criticism that higher prices delay adjustment out of sector • It could be true. But poverty may make it more difficult to leave the sector, e.g. because of poorer educational opportunities associated with poverty. If FT price premiums are used to improve education (as claimed), then it might accelerate migration from sector. FT proponents also claim that the movement encourages diversification into other products. As a theoretical point, the criticism is not convincing. • Empirical question: what is the net effect on sectoral migration of higher commodity prices, and decreased poverty resulting from those prices?

32. FT requires that coffee importers establish long term relations with producers • A short term contract may create an obligation for a single season, whereas a long term contract might create the obligation of several seasons. Moving from short-term to long-term contracts leads to a reallocation of risk: sellers are protected against fall in price, and buyers are protected against increases in prices. If long-term contracts are efficient, why don’t market forces lead to these? Even if middlemen have monopsony power it is not clear that the exercise of this power would lead to inefficient length of contracts – so it is not clear that the requirement of long term contracts improves efficiency. • Suppose (as FT seems to assume) producers are better off with long term contracts, while retailers prefer short term contracts. It could still be true that long term contracts are inefficient (i.e. total surplus is lower with them than with short term contracts). In that case, both parties could be better off by sticking with short term contracts and compensating producers in some other way, e.g. with higher prices. FT “bundles” two reforms: higher prices and long term contracts. • The FT insistence on long term contracts seems motivated by “gut feeling”. It might be economically rational but I have not seen analysis of this point.

33. FT requires that importers provide credit for producers • What is the rationale for this requirement? Why should importers provide credit – a specialized service for which they might not be suited? If there is a market failure in the credit market, leading to the under-provision of credit, it is not obvious why the remedy is to “bundle” credit services with “marketing services”. • If it is not efficient to have importers provide credit services, total surplus increases by dropping this requirement, making it possible to make both producers and importers better off. For example, importers are better off because they are not required to provide credit, but they compensate producers by giving higher prices; producers prefer the higher prices, even with the loss of credit services. • Why does the FT movement “tack on” certain additional requirements but not others? Why not require importers to guarantee input prices, or provide crop insurance, or other kinds of services?

34. FT creates “insiders” and “outsiders • This criticism has force only if FT increases output, reducing the price of non-FT products, thus harming the “outsiders”. I have explained why FT may not increase output. In that case, outsiders are not harmed by FT. • FT certification requires some initial institutional capacity. The most impoverished small producers may not have the ability to become “insiders”. • FT does not cover seasonal workers, which may be a significant fraction of the rural poor. It does not cover landless workers on plantations, because (for most commodities) those plantations are not eligible for FT certification.

35. FT might benefit outsiders • A case study of Bolivian coffee Fair Trade producers in 2005 concluded that Fair trade certification in the Yungas had a positive impact on local coffee prices, thus economically benefiting all coffee producers (Fairtrade certified or not). This increase was attributed to the fact that many non-fair trade producers benefited from fair trade funded infrastructure and programs: processing, credit facilities, quality improvement, crop diversification, conversion to organic production etc. In the case of Bolivia, conventional producers also benefited from greater political influence as a result of reforms pushed through by stronger, NGO supported, fair trade producer organizations.

36. Criticisms of FT “from the left” • The trade justice argument, or The mainstreaming argument, criticizing fair trade for stopping short of actively advocating immediate trade policy changes that would have a larger impact on disadvantaged producers' lives. Also, they are critical that the movement works actively within the current system (i.e. partnerships with mass retailers), rather than establishing a fairer and fully autonomous trading system. • Segments of the “trade justice” movement claim that fair trade focuses too much on individual small producer groups while stopping short of advocating immediate trade policy changes that would have a larger impact on disadvantaged producers' lives.

37. Summary • The fact that FT-certified producers sell in both FT and non-FT markets undercuts the main criticism against FT: that it promotes production and depresses price. • The argument that FT delays producers’ exit from a dying industry is “coherent” but not convincing. • FT is plausibly an efficient means for rich consumers to make individually small donations, which become large in aggregate. It can raise consumers’ consciousness about development issues. Thus, FT might be an efficient means of redistribution. • Retailers’ behavior – whether they pass on to consumers all of, more than or less than the FT price premium, has an important effect on the efficiency of FT as a means of “making donations to the poor”. Retailers’ actual behavior is an empirical question – the evidence is mixed.

38. Summary, continued • The main efficiency argument for FT is that it corrects monopsony power by importers/middlemen. The existence of this monopsony power is plausible, but it has not been convincingly demonstrated. • It is a common mistake to assume that middlemen are socially wasteful. In the absence of monopsony power, the replacement of middlemen by co-ops is probably not efficient – and does not benefit producers. • For important commodities, FT allows certification only for co-ops, not for large family farms or plantations. This choice is based on an ideological preference, for which I have not seen economic justification. Perhaps more good would be done by allowing certification for larger farms and requiring better working conditions/wages (as is done with some products, such as tea). • FT requires that importers provide long term contracts and credit. These requirements seem to be based on instinct, not economic analysis.