The Flaw In Fair Trade
The new July 2015 issue of the Review of Economics and Statistics contains the most rigorous academic study to date on the impact of fair trade coffee. Not only does the article demonstrate that fair trade coffee is unlikely to yield long-term benefits to coffee growers, it explains exactly why. The paper by my colleagues Alain de Janvry, Craig McIntosh, and Elizabeth Sadoulet, “Fair Trade and Free Entry: Can a Disequilibrium Market Serve as a Development Tool?” shows how the designers of the current fair trade model overlooked basic laws of economics in the creation of the fair trade mechanism. The conclusion from the paper states that the mechanism “causes almost complete dissipation of producer rents, and that producer benefits are negative when the floor price does not bind.” Despite their best intentions, the fair trade mechanism as it has been implemented to this point, is incapable of yielding long-term benefits to the very coffee growers it intends to help.
The intuition of the flaw can be understood by anyone who has taken a principles of economics class (and probably received a grade of at least a B- or so). A basic law of economics says that wherever there are surplus rents (profits) in the economy, free entry into these markets will allow firms to enter these markets and capture the surplus rents. But as more firms seek out the surplus rents, the rents begin to dissipate. In the normal case of for-profit firms they dissipate due to downward price pressure from the added number of firms entering into the market. In the case of fair trade coffee, the process is a little more subtle, but the underlying result is the same: benefits go away in the long run.
Why this happens stems from the flawed design of the fair trade mechanism. Growers who want to sell their coffee in the fair trade market must pay a certification cost. The cost of certification entails not only a direct cost, but involves the cost of compliance with a number of requirements with which growers need to adhere in order to be certified. These requirements involve wages paid to laborers, environmental standards, and so forth. But the point is, they involve added costs to coffee growers. And because of the added costs of certification, it only pays to be fair-trade certified if the benefits from certification are greater than the costs. The benefits offered by fair trade are a $1.40 price floor on coffee sold through fair trade channels ($1.70 for more production-costly organic) plus a $0.20 premium to that supports investment in the fair trade cooperative structure and community investments.
When the price resides above the price floor, as it has for most of the last 10 years, the benefits to fair trade to the individual grower are essentially nil; they may even be negative once certification costs are taken into account. Once the price falls below the price floor, however, the benefits begin to kick in, but this is where the problems start as well. As the benefits to certification increase, de Janvry et al. show that more coffee growers choose to become fair-trade certified to gain access to the higher price. But since there is a finite market for fair-trade coffee, this means that a smaller percentage of the crop of these growers can actually be marketed under the fair trade price. The rest must be sold at the regular market price. This lowers the real return to fair-trade membership, as the fraction of a grower’s coffee sold at the fair trade price becomes increasingly smaller until…equilibrium happens. And in equilibrium the benefits of being fair trade certified dissipate and are no greater than from not being certified. In other words, in the long run, individual growers are no better in fair trade than outside of fair trade.
This is the essential argument made by de Janvry et al. and with 14 years of returns to coffee growers in the fair trade network they empirically demonstrate that the rents generated by fair trade indeed do dissipate in the long run. It is a brilliant paper, so brilliant I decided to write a novel that incorporates the findings as part of the story. And the moral (to quote Dean Karlan) is that impoverished coffee growers need more than good intentions. Interventions have to be smart and well-designed–otherwise their biggest impact simply may be to allow people in rich countries feel better.
Follow Bruce Wydick on Twitter @BruceWydick and at AcrossTwoWorlds.net.