Textbooks economics and support prices

It has been repeatedly highlighted that support price mechanism create distortions in commodity markets by de-coupling producer’s cost from international prices. Since indicative prices are meant to act as price-floors, they increase miller’s procurement cost, who in turn pass it to on to end consumer, creating a deadweight loss.

Forming a cogent argument in either direction, however, requires analysing the mechanism by which such price floors are determined. In this respect, Punjab’s Directorate of Agriculture (AMIS) routinely publishes estimates of various on-farm services, which in turn are used to recommend minimum price levels to policymakers. Following analysis uses estimated cost of production for sugarcane as base case to understand the appropriateness of these policy recommendations.

A superficial review of past calculations by AMIS reveals that given the prevailing costs of farming inputs such as fertilizer, pesticides, and services such as seedbed preparation, sowing, and harvesting - cost of production to farmer exceeds the current support price level of Rs180per 40kg (or maunds).

However, it is necessary to point out few caveats. One, AMIS estimates are obviously theoretical, and use optimal level of inputs which result in maximum cost of production. For example, use of DAP is estimated at 1.5 bags per acre, against use of two bags of urea per acre. As any reader with passing understand of farming practices would appreciate that the urea to DAP application ratio suggested as per AMIS is very high and may not be a true reflection of on-ground realities.

A counter point to this observation is that support prices are recommended in order to encourage farmers to use optimal level of inputs in order to maximize yield. Except, in order to tease out per ton production cost, AMIS used average yield per acre of 25 tons, instead of target or champion yield, which should result from deploying recommended levels of input. Table 1b seeks to highlights this discrepancy. If recommended use of inputs were to result in target yield of 30 tons per acre (or 75T/ha), cost of production at mill-gate (incl. of transportation) would decline to Rs160 per 40kg.

Interestingly, even achieving the target yield level would offer growers only a 12 percent return on investment (effectively annualized given sugarcane cycle is of a full 12-month crop). For any entrepreneur, this level of return is flat-out mediocre, considering various business risks associated with farming such as crop losses, liquidity challenges due to payment delays, inflation risk, and opportunity cost of substitute crop plantation due to delay in sugarcane harvest.

Which brings us to second caveat. AMIS estimation of producer’s cost is rooted in the principles of economic cost/profitability, and not accounting principles. For example, the greatest weightage among all inputs is of land rent at nearly two-thirds of total input cost per acre. However, as has been previously pointed out, sugarcane farming has the greatest concentration of large-scale farms among all major crops in Pakistan, indicating large-scale zamindar’s preference for the crop. (For more, read: Zamindar’s fixation with cane published on July 05, 2019). This, in turn, may indicate that majority of cane is grown on owner’s land, and not by tenant farmers.

Nevertheless, land has an economic value, and by growing cane themselves zamindars forgo the opportunity of earning rental income from the same. But exactly how often does product pricing in Pakistan, manufacturing or service- oriented, reflect the opportunity cost of assets deployed in production? Most products, even personnel, value their services based on accounting principles of cost-plus pricing. Net of land rent, cost per maund comes out at just under Rs140 per 40 kg, resulting in a decent profit of thirty percent for the grower.

It is commendable that policymakers have an appreciation of textbook economic concepts such as opportunity cost. Except, if only governments were to leave commodity pricing to market forces of supply and demand – another cardinal textbook economic principle - they would not have to deal with the headache of creating distinctions between economic and accounting profit.