Is “Fair Trade Coffee” Really Fair? A Lesson in Supply & Demand

At church a Sunday ago I was given a brochure to attend a community service event where “we can buy fair trade coffee to benefit those in Africa”. Immediately I shook my head and said there is a better way to increase welfare. This topic is really important to understand, because many organizations try pushing “fair trade” products yet it is not the most efficient way of increasing public welfare.

First , according to fairtradeusa.org, fair trade is,

“products…from farmers and workers who are justly compensated”.

To show that fair trade products are not an efficient means of redistribution, teaching a lesson about markets, particularly an Econ 101 lesson on supply and demand, will be helpful. In a free society, and by this I mean one in which people are not slaves and do not have to produce goods for an owner/dictator, workers can choose whether or not to sell their products to others in exchange for money to buy goods and services.  This is  best explained with an example. So for example, Mark has a coffee plant and processes the beans to make 36 bags of coffee each day. Now, he can choose to drink an insane amount of coffee each day or he can choose to sell it to others who may want coffee. In exchange for Mark selling coffee at $3/bag, Mark may buy beef or milk from someone else. Mark is not forced to sell coffee at $3/bag, but rather that is the price that the coffee market is in equilibrium.

Let’s look at the linear supply and demand graphs below to fully understand what is going on here. Mark chooses to supply coffee at the local farmer market in town. It may cost him $0.50 to make a bag of coffee, but Mark, like most normal-minded workers, would love to get the maximum amount of money in exchange for the bag of coffee. The supply curve represents Mark’s willingness to supply coffee at desired prices. At a price of $1, Mark is only willing to sell 6 bags of coffee; at a price of $2 Mark is willing to sell $12 bags of coffee and so on. At higher prices, Mark is more willing to sell his coffee beans and not save them or consume them himself.

 fairtrade

On the demand side of things, people who attend the local farmer’s market want to buy coffee, but would prefer to do so at the cheapest price possible. The cheaper they pay for coffee, the more money they have to spend on other products they want. The demand curve represents consumer’s willingness to pay at desired prices for bags of coffee. At a price of $5, consumers only want to buy 6 bags of coffee. At a price of $4, consumers want to buy 12 bags of coffee and so on. Consumers would really be happy to buy coffee at $1/bag, however Mark would not be happy to sell it for such a low price. The intersection of supply and demand gives us market equilibrium, which is the price that no one else has an incentive to alter the price or quantity. Equilibrium in this case is P*=$3/bag of coffee and Q*=18 bags of coffee are sold.

Now, let us say that there is an argument for “fair trade” and by this I mean pay farmers, like “poor” old Mark more money for coffee. Let’s say that a church group goes in and decides to pay Mark $4 for coffee, as opposed to the market price of $3. If this is the case then at $4, Mark is willing to supply 24 bags of coffee, but consumers are only willing to buy 12 bags of coffee. There is excess supply in the market (when supply > demand). What this means is that Mark is willing to supply more than what people want at $4/bag. To get rid of the extra bags of coffee on the shelves, consumers have to buy more coffee. Since we cannot force consumers to buy more coffee, the only way consumers are encouraged to buy the excess 12 bags of coffee (24 bags supplied, 12 demanded) is if the price drops. However, the price cannot drop to $2, because if it does than there is excess demand (demand > supply) in the market.   Consumers want to buy 24 bags of coffee, but Mark is only willing to put 12 bags on the shelf! In fact, at this price a line may start to form to buy coffee. If there are so many people willing to buy coffee, Mark will raise his price until some consumers drop out of line such that there is no more shortage of coffee. Exactly what is demanded is what is sold at the market-clearing price, or equilibrium price. A price other than equilibrium is not stable such that there will be pressure to alter the price up or down depending on excess supply or demand.

We measure welfare simply by a concept called consumer and producer surplus. At a price of $3 and 18 bags of coffee sold, consumer surplus is the triangle from $6 to $3 and 18 bags of coffee (represented by the red triangle, or triangle A). Consumer surplus is thus ($6-$3)*0.5*18= 27. Producer surplus is represented by the black triangle, or triangle B, and is ($3-$0)*0.5*18= 27. Now, if we go back to the fair trade example, where coffee is told to be sold at $4/bag, consumer surplus would be ($6-$4)*0.5*12= 12; while producer surplus would now be ($2-$0)*0.5*12+ ($4-$2)*12= 36. Here we can see that total surplus has gone down. Originally consumer surplus + producer surplus= $54, but now it only equals $48. This is because we have deadweight loss. Deadweight loss is the consumer surplus we lost out by setting a price higher than what market equilibrium in a free market would be, or $54-$48. Consumers are made “worse off” such that they get less surplus with a higher price and are unable to buy as much coffee beans, while Mark gains more surplus.

So, in reality “fair trade” is not really fair at all…at least for consumers. However, if the intent of fair trade coffee (or other products) is to make the farmer better off than perhaps it will and  in this case it did. But, it isn’t efficient! In the fair trade example above, Mark gains $9 while consumers lose $15 worth of surplus. $6 of surplus is deadweight loss and thus no one receives this money. If instead the price was at market equilibrium, then Mark receives $27 and consumers receive $27 of surplus. Consumers could then donate to give Mark the same extra $9 (thus leaving $36 for Mark and now $18 for consumers in surplus). In this example, Mark is just as well off as with fair trade coffee and consumers are better off! There is no deadweight loss, consumers can buy more bags of coffee and pay a lower price! This to me seems like a more efficient way to redistribute money than setting what is like a price floor via a fair trade platform.

To give a bit more background on the fair trade movement in recent year. The founding of Fairtrade International occurred in 1997 with a goal to give “producers in developing nations a minimum price—a safety net to cushion farmers and producers against market fluctuations—as well as a premium, a separate payment (for example, 20 cents per pound for coffee) that workers and farmers can invest in environmental, educational or infrastructure projects.”

This safety net, however, comes at a cost. Besides the, now obvious, decrease in consumer surplus and increased costs to consumers what else is the problem with fair trade?

  1.  Fair trade does not help out the world’s poorest countries. “We might think of sub-Saharan subsistence economies when we think of fair trade, but the biggest recipient of fair trade subsidy is actually Mexico. Mexico is the biggest producer of fair trade coffee with about 23% market share.” Roughly 200 of 300 fair trade coffee producers are located in South America or the Caribbean. 
  2. There is a question about how much of this extra price actually goes into the hands of farmers or whether there is an institutional cut before farmers see any increase. A George Mason policy series study shows that after paying a fair trade co-operate program and its employees, farmers may only seek to make an extra 5 cents.
  3. Farmers outside of fair trade product networks stand at a disadvantage or those who use the fair trade product as an intermediate good. Fair trade encourages producing more in one industry at the expense of another when there can be better uses of employee time than coffee production.

To be clear, economic inequality between third-world farmers and CEOS on Wall Street is large and concerning to many. However, demanding reallocation of resources by inefficient means is not the best or fairest solution.

A great quote by Gene Callahan at FEE sums this up great,

“The belief that any group with power – government officials, economic experts, or social activists – can establish a price that’s “fairer” or “more just” than the actual market price is a fallacy that bedeviled communism for decades and it’s bedeviling the fair-trade movement today.”

Advertisements

10 thoughts on “Is “Fair Trade Coffee” Really Fair? A Lesson in Supply & Demand

  1. I think your point about it being an inefficient way to give is obviously correct. However, I think that it is incorrect to say that welfare falls if people choose to buy fair trade coffee rather than to trade at what appear to be market clearing rates. People choose to do this because they value giving, the life outcomes of the receivers, or some sense of fairness. When someone at church tells you to buy fair trade coffee, this actually changes your demand. The price is higher because people demand more because they value that (admittedly strange) service. This is not at all like a case where a government sets a minimum price. I think that you are implying that people are not rationally evaluating the costs and benefits of this program, but that story is observationally equivalent to one in which people have a relevant subjective sense of fairness that gives them value. So while this may be an inefficient way to give, giving may not be the goal, and it may not be an inefficient way to achieve the actual fairness goals of the supposed givers.

    But I still think Fair Trade is dumb.

    • I agree with Randy in that fair choice is generally a choice. It looks like a transfer between consumer to producer surplus when modeled this way and leads to no DWL. I think a large question is the distribution of this transfer of surplus, as in who gets the higher profits? The workers? The farm-owners? I doubt those who purchase fair-trade coffee would be happy with the answers and thus I like the end point that it is more efficient to simply transfer this wealth directly.

      • Tim, thank you for your comment. Charity can be utility enhancing and if that maximizes personal utility, by all means I encourage those to do it. However, it just is not the most efficient way for the reasons mentioned. Markets do not shift to this arbitrary higher price, because not everyone is willing to pay that price. Now, we can complicate the analysis and assume two different demand functions and use a form of price discrimination to set one price higher than another, but I am not completely convinced the market is in equilibrium in that case because farmers are not setting prices to discriminate with usually price discriminatory market power, rather consumers are. Further, fair trade supporters usually pay different, higher prices for the same product because they have different degrees of how “fair” a price is. In which case finding a true demand to fit their willingness to pay would be difficult. So, a company may form to set one “fair trade” price for coffee such that some supporters are left paying a higher price than they wished and some paying a lower price. Perhaps in this case, DWL may be overstated as in my example, BUT there still would be DWL. Now, you may say, “Well, if he paid the higher price than that is revealed preference and that is his willingness to pay”, but you can imagine peer pressure and once you get caught up in the “fair trade” movement, you may, reluctantly, want to continue in it. You can imagine that a supporter of fair trade coffee who has a willingness to pay of $4/bag for 5 bags, ends up paying $4.50/bag for 3 bags of coffee because a company selling “fair trade” coffee sets a minimum price of $4.50/bag. This would create some small DWL. But, all in all, direct donation is more efficient and a heck of a lot less complicated.

    • I would like to add, however, that branding such overpaying for coffee as “fair trade” would imply that the free market sale of coffee is branded with the “unfair” stigma. If a farmer is willing to accept the marginal cost of coffee as his price, why term that as a bad thing? The Luddites must be educated and hence I support the author

      • I think you make a great point, Abir. The stigma that free markets are “unfair” when determining prices is short-sighted. I think consumers get caught up in product prices as the cause of income inequality when income inequality is usually due to lack of education, too much/too little government support and family. Product prices are determined fairly (if there is no gov’t intervention) and thus, if someone is unhappy to accept the prices they do not have to sell the product!

    • Charity can be utility enhancing and if that maximizes personal utility, by all means I encourage those to do it. However, it just is not the most efficient way for the reasons mentioned. Chris Coyne, GMU Econ Professor, is making his career off of a book he wrote, “Doing Good By Doing Bad” related to how humanitarian efforts fail both by the gov’t and private sector. Although, I agree that economic analysis is not perfect and I am not fully in love with his arguments I do agree that private markets usually can provide more of a good than the gov’t. Usually this is due to a better channel, but not always. In the case of fair trade, I am not so convinced. Fair trade is not free trade, it is “fair” by the means of arbitrarily setting a higher price than the free market because personal feelings are that the farmer should be paid more. Markets do not shift to this price, because not everyone is willing to pay that price. Now, we can complicate the analysis and assume two different demand functions and use a form of price discrimination to set one price higher than another, but I am not completely convinced the market is in equilibrium in that case because farmers are not setting prices to discriminate, rather consumers are. Further, fair trade supporters usually pay different, higher prices for the same product because they have different degrees of how “fair” a price is. In which case finding a true demand to fit their willingness to pay would be difficult. All in all, direct donation is more efficient and a heck of a lot less complicated.

      Also, yes, I do not believe fair trade supporters are rationally evaluating the cost and benefits of the program OR alternative programs (like donations) nor am I convinced that people feel this is the “fairest” way. Now, your suggestion may be absolutely true that fair trade coffee gives them a relevant sense of fairness which therefore gives them value, but the fair trade story is just not convincing to me. There is a lot of “fair” ways to do things that are more efficient and give farmers more money compared to fair trade channels. I would think that people buying fair trade products may not actually know the costs of implementing such programs nor the benefits of other programs. That does not mean they are not rational or utility maximizing given the information they know, rather I am pointing out what we both agree upon… fair trade is not efficient to redistribute money.

  2. I am not entirely sure that this is how fair trade should be modeled. Danielle, you claim that when the fair trade price is above the equilibrium price there will be a surplus in the market, some consumer surplus will shift to producer surplus, and there will be a deadweight loss. Why does that have to happen? The fair trade price is similar to a world price in this case that is above the domestic prices. Assuming people in these countries that have fair trade farmers also drink coffee, couldn’t the farmer sell his “excess” on the domestic market at the equilibrium price? I am arguing that there are two markets in this case, a market where some foreign countries are paying a fair trade price and adjusting their demand curves appropriately, and then a domestic market that buys at the equilibrium price. If this is the case the deadweight loss does not occur.

    If there is not a domestic market, then the consumer surplus loss you mention is likely much higher since I assume less coffee will be bough by the relatively poor natives of this country. This may not show up as a deadweight loss per se, but could just be a decrease in supply in the domestic market as the supply of coffee is shifted to selling to the fair trade buyers. But a supply shift back will still decrease consumer surplus in the domestic market from what it otherwise would have been.

    Also, you omitted the supply effects of fair trade. Harberger talked about this in the class he taught. There will be employment distortions that will draw more resources into the production of coffee if there is an artificially higher price. So resources that would be better put to use building factories or growing a different crop will be employed in the coffee sector. If fair trade ever ends, there will be some mal-investment in coffee production that will have to wind down. Fair trade prices also crowd out other investment such as “sweat shops” since again labor would prefer the artificially high returns in the coffee market as opposed to working in the factories. There will also be distortions in coffee farming itself if every farmer does not have access to the fair trade market. This could lead to large farms with access to that market putting smaller farms out of business by buying them out or other means.

    I agree with the basic premise that fair trade is anything but fair. To Tim’s point, I am not sure where most of the artificial gains go either, but if not to the laborers but rather some large farm conglomerates or middle men then it is doing little to alleviate poverty. If we want to help poor countries we simply need free trade. Free trade will encourage foreign investment, assuming there is the necessary minimum rule of law and property rights protection, and that will help lift these countries out of poverty.

    • Thanks for commenting, Adam. I think you are reiterating a lot of Randy and Tim’s points. To which I would just say, I think the replies back to them will also sufficiently respond back to you. However, you bring up an interesting alternative when you speak about world price and domestic prices that both the previous commentators didn’t get at persay, but, like what I said to them, I think it could be modeled in that way and then there would be no DWL. Although, I think it is much more complex than that in reality, but look into my replies to them as it gets more into it. I do think I did not touch upon supply effects enough, as you mentioned, but I did mention that we would be putting resources in the least efficient places when talking about other issues with fair trade products at the end.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s