REGIONAL RESEARCH CONFERENCE

AGRICULTURAL TRANSFORMATION AND FOOD SECURITY IN CENTRAL ASIA

Food safety, SPS regulations and dairy value chains in Kyrgyzstan: private or government inspections?

Alexander Saak(collaborator Nurbek Omuraliev, Center of the Methodology of

Science and Social Research, Kyrgyzstan)

International Food Policy Research Institute

Introduction

Provision of food safety is subject to moral hazard - consumers learn quality after purchasing This problem is compounded in developing countries - unstable supply chains - limited private liability for health losses - limited public funding for oversight Policy question: private or government monitoring of compliance with food safety regulations?

Food safety policy in Central Asia

• important for consumers and producers

• 50% of food exports was SPS-sensitive: meat and preparations, dairy, eggs, fish, fruits and vegetables (Kyrgyzstan, 2005)

• access to international markets requires compliance with SPS and veterinary regulations

• reforms of inspections and food safety standards

Government monitoring of agricultural producers in Kyrgyzstan

Investment Climate as seen by Small and Medium Enterprises in the Kyrgyz Republic (World Bank)- survey of 623 farmers (owners of private agricultural firms, total 321856) in 2009 - farms are small: annual profit $1200 on sales $3100- government oversight: farmers were least subject to inspections 29% were subject to investigation by at least one inspectorate in 2008- informal payments: 24-44% gave bribes to government officials- cost of government inspections relative to profit is 2.5% - current standards for processing firms are particularly burdensome Quote from the report:“It is therefore recommended that the Kyrgyz Republic moves away from the [mandatory government standards and certification] for food products, and ensures instead (i) that all food business operators implement and adhere to HACCP, GMP and GHP and (ii) the traceability of all food products, starting with meat and milk. These approaches are in line with Codex Alimentarius food safety practices.”

What determines the choice between private and government inspections?

- intrinsic motivation (public health vs profits)- monitoring technology (obsolete test for nitrates vs innovation)- size and scope (69% of permits to farmers were issued by local governments) Some monitoring is technologically necessary - testing and grading by fruit size or milk fat content

Some monitoring is technologically unnecessary - inspections of compliance with food safety regulations

Our focus is compare which inspection system is better: downstream party inspects upstream party (second party monitoring) orgovernment or private auditor inspects upstream party (third party monitoring)

Model of value chain

Second-party monitoring Third-party monitoring

supplier

seller + monitor

buyers

supplier

seller

buyers

monitor vs

Stage game 1. Seller is matched with a random supplier with limited liability 2. Seller privately proposes contracts ),,( lh www

and ),,( lh fff

to supplier and monitor 3. Supplier and monitor publicly decide whether to accept contracts 4. Supplier and monitor play a simultaneous move game: supplier privately chooses high or low effort (e=h or e=l) at cost c(e) monitor privately chooses to monitor at cost k or not 5. Monitor publicly reports },,{ lhr and contractual transfers are made 6. Seller sets the final good price p 7. Buyers get pev )( if they purchase 8. Quality },{ lhq is publicly observed if buyers purchased Trade repeatedly with discount factor )1,0(

Institutional choice Compare performance (social surplus) in two regimes: - second-party monitoring (seller inspects) - third-party monitoring (independent party inspects) Incentive compatibility conditions suppliers are willing to - randomize between compliance and non-compliance - participate monitor is willing to - inspect - report truthfully the outcome of inspection seller is willing to offer contracts to supplier and monitor buyers are willing to buy

Endogenous variablescontracts between the playersz(r,q) – probability that the game continues (reputation is good)x – probability of compliance with food safety standardsy – probability of inspection

Two types of inefficiency - costly inspections - no trade or trade in low qualityhappen in equilibrium 

Second-party monitoring Inspections are frequent Compliance frequency is determined by

payoffdeviation

sseller

hh

effortlowofyprobabilitthebydivided

costmonitoring

valuereputationdiscounted

sseller

hh cvx

kkcvx

'

'

1 1))((

- no information rent for suppliers maximizes sustainable compliance rate - social surplus is wasted on monitoring => third-party monitoring may improve welfare - if supplier’s liability is large, infrequent monitoring is optimal and social surplus is not dissipated

Third-party monitoring For small discount factor

rentreputation

smonitorpayoffdeviation

sseller

h

valuereputation

chainsupply

hh

xx

kv

kcvx

'

'

)1(1

)(

(contracts deviation constraint)

- low compliance - frequent inspections - buyers never forgive low quality For large discount factor

rentreputation

smonitor

payoffdeviation

sseller

lh

valuereputation

chainsupply

hh

xx

k

z

vxxv

zxx

cvx

''

)1(1

)1(

))1((1

)(

(contracts deviation constraint)

- high compliance - infrequent inspections - buyers sometimes forgive low quality

Intuition

effortlowofyprobabilitthebydivided

costmonitoringrevenuecurrent

sseller

valuereputationdiscounted

sseller

gainldeviationa

sseller

valuereputation

sseller

x

kcvkcvx

vkcvx

'

'

1

''

11

1))((

))((

monitoringparty -second

third-party monitoring with frequent monitoring

rentreputation

smonitorgaindeviation

sseller

valuereputation

chainsupplyxx

kvkcvx

'

' )1(

))((1

1

third-party monitoring with infrequent monitoring

rentreputation

smonitor

gaindeviation

sseller

valuereputation

chainsupply

xx

k

z

vx

zxx

cvx

''

)1(1))1((1

)(

Empirically testable hypotheses - compliance is greater under infrequent inspections than under frequent inspections

Compliance cost\Reputation concern

small large

small frequent, third-party infrequent, third-party (low-risk products) frequent, second-party (high-risk products)

large no trade or low quality

frequent, second-party

SPS-sensitive products private inspections: big downstream party (national or international brand, export, large market share) high cost/price ratio, competitive markets government inspections small downstream party (sells in local market, small market share) small cost/price ratio

Evidence from survey (coming soon) Dependent variables

Frequency of inspections Frequency of compliance Who inspects Bribe extortion?

Explanatory variables Frequency of sales and size (to measure reputation capital or discount factor) Premium for high quality products and compliance costs (to measure returns to quality) Upstream penalties for non-compliance (to measure whether liability is limited) Cost of monitoring How are public and private food safety inspectors incentivized?