Markets and Economic Development for Poverty Reduction in Developing Countries
Faculty Fellow, RIETI / Associate Professor, Graduate School of Economics, The University of Tokyo
Importance of understanding "market failure"
Market economy refers to a world comprised of and based upon transactions. However, as evident from a series of business scandals such as the fabrication and use of earthquake-resistance data and the Snow Brand Milk Products Co. poisoning incident, only a fine line separates legitimate business transactions from fraudulence and cheating. Even in developed countries, government authorities find it difficult to crack down on these types of unlawful acts. Their counterparts in developing countries can find the situation beyond their control. Nevertheless, the market economy is somehow functioning in developing countries. In our research (Yasuyuki Sawada and Tetsushi Sonobe, eds., Shijo to keizai-hatten: Tojokoku ni okeru hinkon-sakugen ni mukete [Markets and economic development for poverty reduction in developing countries], Toyo Keizai, 2006), we have sought to identify institutional factors which allow the market to function effectively.
Actors in the market economy - companies, merchants, farmers, and so forth - constantly make efforts and devise ways to fulfill transactions, of which the effective and efficient ones become customary and evolve into grassroots institutions. Supported by such efforts and the ingenuity of private-sector actors and the institutions, the market economy has been managing to function in developing countries even where government authorities are less reliable. If we lose sight of this picture, we will never be able to realize successful economic structural reform or create a truly effective social safety net.
When we look back on the stream of ideas on international development to date, we can see a lack of understanding of markets throughout the course of history - from the era of structural adjustment and liberalization in the 1980s, through the 1990s when emphasis was placed on a non-market-oriented safety net, and to the current approach of prioritizing poverty reduction as seen in the United Nations Millennium Development Goals (MDGs) adopted in 2000. Without a sound understanding of markets, no policies will be designed.
In economics, a situation in which the market is not functioning properly is referred to as "market failure." Economic policies are meant to correct market failure so as to improve economic welfare. The first step toward that end is to accurately understand where problems come from and how private-sector actors are responding to them. However, it appears economists at various international institutions such as the International Monetary Fund (IMF) and the World Bank as well as those working at Japanese aid agencies are rather oblivious to the importance of understanding the actual state of market failure.
Cases of successful overcoming of market failure in developing countries
What is a market? What are the characteristics of a market that is destined to fail? And what institutional policies are needed to overcome the failure? To find answers to these questions, we have collected, for the purpose of this research, a series of case studies accumulated by researchers of development economics and those specializing in economic history of Japan.
In this research, it is assumed that merchants play an important role because they are the driving force of market formation and possess some characteristics of the Schumpeterian entrepreneur. In the early stage of development, communities also play an important role. A community, a group that is bound by trusting relationships based on very close and intense personal interactions, has a remarkable ability to reduce transaction costs. Apart from traditional communities such as farm villages, subcontracting arrangements between major manufacturers and their parts suppliers and personal relationships in a company can be defined as a quasi-community while industrial agglomeration is also an important concept.
Stating the conclusion first, although the market does not function properly in transactions involving laborers, goods, and money, a wide variety of transaction participants such as farmers, merchants, and entrepreneurs in developing countries, including pre-war Japan, have been contributing to the smooth processing of transactions by utilizing implicit contracts based on family ties, kinship, territorial connections, camaraderie, ethnic ties, and community rules, thereby helping overcome any existent market failure. Specific cases of this are introduced in the following.
(1) Goods market failure
A major challenge for the agricultural products market in a developing country is, by nature, the question of matching. That is, how efficiently small farmers' production and supply can be linked to demand in urban areas within the country or overseas. In the case of the Philippines' rice farming industry, independent rice-collecting agents are playing an important role. Many of these agents have a discerning eye. Rice millers, by extending credit, facilitate financing for such agents, thereby giving them an incentive to engage in fair and honest dealing. From the viewpoint of the rice-collecting agents, a loss of confidence of rice millers would mean the loss of their means of livelihood. Thus they strive to provide a steady delivery of high-quality rice to rice millers. Rice millers, for their part, need to maintain stable relationships with retailers and thus they sell to them on credit, without interest. Here again mutually beneficial trading relationships work out. The presence of such communal, interdependent relationships among various players in the rice industry has made possible the steady distribution of high-quality rice to consumers in the Philippines.
In many developing countries, contract farming, a system under which foreign retailers enter an agreement with local farmers to buy agricultural products at low prices, is drawing increasing attention. However, there has been a series of unsuccessful cases, which are generally attributable to the unreasonableness of foreign companies and farmers entering into direct contracts. In this light, the efficacy of a community that binds a number of farmers together is quite understandable.
The raw milk market in Kenya used to be fully controlled by the government. However, following market liberalization in the first half of the 1990s, merchants and milk processors have entered the market, triggering competition for distribution. This is a successful example of government withdrawal of direct control resulting in a properly functioning market.
(2) Labor market failure
In small businesses in the Philippines, those who have been employed through a family connection tend to earn higher wages and work more years as compared to their colleagues with no family connection. This indicates that these enterprises secure a stable supply of high-quality workers through strong personal networks. The presence of a communal information network seems to be significantly reducing the transaction costs of effectively matching workers and employers, which would otherwise be too expensive for small businesses. On the other hand, large companies, which need to secure a stable supply of a large number of employees, end up paying higher transaction costs if they resort to recruitment through this type of personal connection. Thus, in terms of policy with large companies, it is important to establish job placement service agencies or other mechanisms for sharing labor information to solve the problem of uneven distribution of information about employment opportunities and workers.
(3) Capital market failure
In Kenya, banks and other financial institutions require borrowers to be in business for a certain number of years and/or to provide appropriate collateral as a condition for lending. Therefore, micro and small enterprises, even promising ones, can face credit constraints. In such cases, an informal mutual financing association called a "rotating savings and credit association" (ROSCA), along with borrowing from relatives, has been serving as an important financial source. This is another example in which a market failure has been overcome by the presence of a grassroots system based on intra-community personal relationships.
Likewise, a community formed by waste collectors in Delhi, India has been serving a similar function. A waste collector (locally called a kabadi) typically borrows a cart and funds from a dealer and in return sells the collected waste to that dealer. In some cases, a network of waste collectors working for the same dealer provides a basis for forming a ROSCA for mutual financing. Then, using funds borrowed from the ROSCA, some waste collectors purchase their own carts and expand their business, eventually becoming a dealer or wholesaler. Here again, a community mechanism is what provides the ground for the possibility of waste collectors moving to a higher class of work. It is also noteworthy that this mechanism plays a part in promoting recycling. Transactions that have self-evolved in the process of internalization of external diseconomy are facilitating further internalization.
(4) Lack of insurance market
The Pacific coastal region in Iwate prefecture has periodically suffered crop damage due to cold summer weather caused by northeasterly winds called yamase. As a way to mitigate these weather risks, people living in this region developed a unique form of tenancy contract under the prewar tenant farming system. Traditionally, there were two basic types of tenancy contract; namely, the sharecropping contract and the fixed-rent contract. Under the sharecropping contract whereby the landowner and the tenant farmer agree on their respective shares in the crop harvested from the land leased, the parties also split the risks involved. Thus, this form of contract is suitable for high-risk areas. On the other hand, under the fixed-rent contract whereby the tenant farmer pays a fixed amount of rent after harvest, any residual profits and crop yields on the farmland are kept by the tenant, thereby providing incentive for hard work to realize higher productivity. On the negative side of this arrangement, the tenant had to bear all the risks associated with crop failure, for instance, if the harvest was not enough to cover the rent. To address this problem a new type of fixed-rent contract emerged that provides for ex post rent reductions in years of worse-than-average harvest, a mechanism serving as a sort of insurance. Historical documents show that the sharecropping contract was predominantly chosen in high-risk areas, with the fixed-rate contract with the state-contingent rent reduction clause preferred in low-risk areas. This can be cited as an example in which a type of contract based on a communal mechanism compensated for the lack of an insurance market.
(5) Multiple market failures
As part of a resettlement program for farmers displaced by the construction of a dam in Java, Indonesia, a freshwater aquaculture project was launched to help them rebuild their lives as fish farmers using the reservoir water created by the dam. Aquaculture, however, was a technology unknown to the farmers and there existed no insurance market to mitigate the risk of fish mortality. Data indicates that people willing to make investments under such circumstances have a low risk aversion level. As other key factors in promoting the shift to fish farming, displaced farmers must have knowledge of the types of technologies needed for success and profit in fish farming and a network through which they can obtain this knowledge, and they need sufficient education to properly mobilize the knowledge. Credit availability is also important because substantial funds are required to start up a fish farming business.
As such, development can be constrained by several, intertwining factors including: 1) lack of a mechanism for internalizing externalities such as technical knowledge and management know-how, 2) lack of a mechanism for insuring uncertainty and risks, 3) an underdeveloped capital market, and 4) costs of analyzing supply and demand in goods and labor. This kind of situation is referred to as "multiple market failures."
Efficacy of a community and policy designing
Some people argue that multiple market failures can be overcome by dealing directly with companies from developed countries in the forms of foreign direct investments (FDIs) and global value chains. However, not many developing countries have the capacity to attract FDIs and thus it would be difficult to overcome all market failures by these means. In this regard, a community - be it a village or a city - is considered an effective means for overcoming problems in terms of helping with matching as well as punishing cheating, including the supply of defective products, thus serving as a contract enforcement mechanism.
Others argue that we should therefore promote community capacity building by implementing various community-participatory projects and programs. However, promoting decentralization through community-participated programs may lead to the further locking-in of the existing power structure and local capture of the program benefits, thereby inducing greater rent-seeking by power holders and resulting in amplification of the community's weakness, not the empowerment of the community. Therefore, in order to design an effective program for community-participatory assistance, there needs to be an accurate contextual understanding. In pursuing this end, studies based on extensive field surveys, such as our research, are quite important.
In terms of policy, it would be effective to provide public goods that assist farmers, merchants, and companies in their activities. Specific measures would include investment in transport and communication infrastructures, enhancing public information services, establishing quality certification systems, creating an insurance market, providing loan programs, supporting industrial agglomeration, and offering intellectual assistance programs such as technical training and management seminars. In each of these areas, governments should play an important role because both individuals and companies have their limitations in making improvement.
In the area of recent development economics, there is an emerging tendency to give high marks to micro-level experimental program evaluations. Often lacking in such evaluations are "structural" viewpoints concerning the role of communities and the complementary relationships between communities and markets. It is important to incorporate these viewpoints in evaluating development programs in the future. As part of efforts to achieve that, interaction (or organic dialogue) needs to be enhanced between researchers undertaking empirical studies on market failures and government officials in charge of development and assistance polices.
Question and Answer Session
Q: Haven't there been cases where communal traditions and conventions hinder the establishment of an effective market?
A: There have been cases in which certain conventional values prevent a shift to a desirable situation. However, in discussing such problems, we need to know in what aspects and in what context a certain community is functioning properly or hindering development. And for this, extensive filed surveys are indispensable. Generally speaking, when a country goes through economic development, employment and production shift from the agricultural, to the industrial, and then to the service sector, with the rural-urban migration. The government should assist the process in which communities adjust to such drastic structural changes. For instance, industrialization calls for higher levels of educational attainment and the government's role is critical in terms of establishing a public education system so as to help local communities increase the rate of return on education.
Q: When traditional communities based on conventional values and ideas begin to change, what specific changes can we expect?
A: People begin to properly respond to economic incentives. What I mean to say is that people begin to think and find ways to make money properly and not by fraudulent or deceptive means. That is, people in a community begin to see values in creating goods and properly conducting economic transactions, by which the community will be empowered by itself. The government needs to facilitate communities' adjustments to such drastic structural changes in society by providing a wide variety of infrastructure.
* The original Japanese text, published in the December 2006 edition of METI Journal, was compiled by RIETI editorial staff from a lecture delivered by RIETI Faculty Fellow Yasuyuki Sawada at a seminar on September 12 and the Q&A session that followed.
December 25, 2006
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