Overcoming the smallholder ‘Quality Penalty’ in agriculture
The smallholder agriculture sector constitutes the largest segment of producers in Bangladesh, India, Sri Lanka and Thailand. Increased performance of agricultural smallholders is a precondition for inclusive development. Smallholders have to be better itegrated in agricultural value chains, export oriented or otherwise. However the sector is plagued with structural issues that inhibit the effective integration of smallholders. One particular issue identified in the course of a recent LIRNEasia study is the Smallholder Quality Penalty (SQP).
Smallholder Quality Penalty
The Smallholder Quality Penalty is the financial penalty on the market price imposed on the smallholder by the first-handler (mostly a collector) due to the uncertainty of produce quality. This allows the first-handler to offset potential losses due to the perception of lower quality when selling to the next handler downstream. Thus the SQP exists in most transactions in supply chains that involve smallholders.
SQP is based on perception and maybe partly justified. Smallholders are often resource-constrained and are unable to make the investments necessary to ensure quality. However, even if the smallholders are able to take the necessary steps to improve quality, the perceptions of inferior quality produce persists, reducing incentives to invest in the first place. This creates a vicious cycle that depresses investment by smallholders.
How can the SQP be overcome?
Standardization of produce would certainly help communicate the quality of the produce downstream, which would reduce the SQP. However, standardization is neither easy nor cheap. Who will certify the same and how? Will it be economically meaningful for smallholders to spend on standardization certificates? Another possibility is to build and maintain trust by frequent interaction between smallholders and first handlers on quality attributes. This too could reduce the SQP. But again, the question is how such communication can be sustained over time.
The research found that smallholder markets in these countries could take at least three distinct forms: (1) an oligopsonic structure where a limited number of first handlers purchase from a large number of smallholders; (2) an out-grower structure where the first handler, who in most cases is an authorized representative of the large wholesaler or processing company, enters into (often individual) agreements with multiple smallholders to purchase their produce at a price either determined previously or in the market; (3) a cooperative type structure where the smallholders form societies bound by internal rules on quality benchmarks and act as quasi-large-holders. An out-grower model and a cooperative type structure are both more conducive to building social capital. Social capital in turn has a bigger role to play in reducing SQP when certification and/or accurate scientific quality determination is costly.
Overcoming the SQP in Sri Lanka:
The Pandeniya story
In Sri Lanka, smallholders dominate the rubber supply chain. Some opt to process the raw latex further into Ribbed Smoke Sheets (RSS) while others prefer to sell the raw latex. The quality of RSS (grades 1 to 5 with 1 the highest and 5 the lowest) is assessed through a visual inspection based on characteristics such as colour, transparency, blemishes, etc. and there is sufficient room for subjectivity when assessing grades. Buyers find it costly to inspect each and every sheet and even then there is often disagreement between producer and first handler about the quality. Hence buyers often pay prices in two bands: one for RSS grades 1 to 2 and another for grades 3 to 5.
Within the band there is hardly any variation between the grades. Hence smallholders often just make RSS 5, which is the lowest grade.
To get around this, 34 entrepreneurial smallholders in Pandeniya formed themselves into a group and created shared infrastructure, whereby all members of the society used the same smokehouse and warehouse. Similarly the processing of the raw latex is done in one place. The group has been operating successfully for nearly 20 years, yet many others have failed to replicate this effort. One of the biggest reasons for such failures is the trust deficit among the society members. Coordination within the society is important to reduce any free-rider problems. By coordinating and ensuring internal standards, and with the greater bargaining power as a result of being a quasi-large-holder, the Pandeniya group only makes RSS 1 and is able to avoid the SQP.
Role of Information and Communication Technologies (ICTs)
With the mobile phone being ubiquitous even to smallholders in this part of the world it becomes possible to think of ICT-supported solutions to the SQP problem. Simple phone connectivity itself improves social capital and coordination, which can reduce the SQP. A two-way ICT enabled traceability system that also allows the producers to track any quality problems downstream, will go a long way towards decreasing the SQP by reducing free-rider problems amongst farmer societies, and engendering greater social capital amongst buyers and sellers in general. For example if a first handler gives a lower than expected price for a farmer’s output, his/her claim of quality can be tracked as the produce moves downstream.
Despite structural deficiencies smallholders are calculating economic agents, albeit with lower incentives. Enabling smallholders to “appear” larger can allow them to overcome the smallholder quality penalty. Coupled with shared access to warehousing/cold storage and financing (both of which are lacking) specifically for smallholders, such actions can collectively create the right incentives for greater knowledge and technology utilization in agricultural production. This in turn makes agricultural value chains more efficient and inclusive. The smallholders who make up the large majority of agricultural producers in these countries, will be better off.
(The writer is a Senior Research Manager at LIRNEasia, an ICT policy and regulation think tank based in Colombo. He has been working on issues related to the use of ICTs in agriculture in developing economies since 2002.
He holds a Masters from the Lee Kuan Yew School of Public Policy in Singapore).