Consumer Welfare Impacts of Imported Organic Foods: A Vertical Differentiation Model
By Erin Sawyer
Organic markets are becoming global markets. This increase in trade is due to increasing consumer demand for organic goods. However, due to differences in consumer quality perceptions, organic standards and labels have developed differently around the world. These differences can result in trade barriers and unless equivalency is negotiated can often mean costly delays at borders or even a total ban of imports. Equivalency agreements allow exporters from one country to trade freely with importers from another. They reduce transaction costs and increase both consumer and producer welfare. Conversely, increased trade and equivalency agreements can have negative effects on the domestic industry. Consumers often perceive imported organics as being subject to less stringent standards than their domestic counterparts and therefore are not willing to pay as much for them. This perception does not harm the domestic organic industry provided consumers can differentiate between imports and domestically produced goods.
In order to demonstrate the effects of trade on the organic market this paper will examine three situations. The first situation will act as a benchmark and will examine consumer welfare changes when consumers are able to differentiate between domestic organics and conventionally produced food. The second scenario studies the welfare effects if differentiable imported organic foods are allowed. Examples of such products include apples, potatoes, or anything else that can be individually labelled. Finally, we will consider the case where consumers know that a good may be produced using both imports and domestic organics, but due to the nature of the good they are unable to differentiate between them. Products such as tortilla chips or flour are examples of goods that may be produced using organic inputs from more than one geographic location. This model will lead to a discussion of both the consumer welfare effects as well as the effects on the domestic organic industry.
The structure of the paper will proceed as follows. Some background information on the current situation within the global organic industry will be provided. This will be followed by an explanation of the organic paradigm and how it affects consumer perceptions. This will lead into the modeling process and a discussion of the welfare effects. Finally, the paper will conclude with a brief examination of the implications for the organic industry.
Organics Worldwide
As consumer incomes rise, consumers have voiced concerns about food safety and the environmental consequences of conventional agriculture. These concerns have helped to increase the demand for a broad range of food products. Consumers’ search for differentiated products extends beyond the physical attributes of food to include the production and processing practices (Hobbs, Kerr, and Phillips 567). Consumers are concerned about how the agricultural process used impacts the final quality attributes of a good, as well as the impacts on the environment, animal welfare, human rights and more (Caswell 155). These preference changes are especially evident in the organic industry which has seen dramatic increases in demand in recent years. In 1997, the organic food market in the European Union (EU) was estimated to be worth $4.5 billion (Lohr 1125). The EU consumer is strongly committed to purchasing organics, with 30-38% regularly or occasionally purchasing organic foods (Lohr 1125-26). Worldwide, organic consumption is led by Denmark and Austria with 37.4 and 34.0 Euro per capita consumption per year respectively (Sylvander and Le Floc’h-Wadel 99).
The Codex defines organic agriculture as “…a holistic production management system which promotes and enhances biodiversity, biological cycles and soil biological activity. It is based on the low use of external inputs and non-use of artificial fertilizers and pesticides…” However, there is no universal definition of organic agriculture and, thus, many nations have defined the term differently. Organic agriculture standards have also been developed separately. It is the belief of the organic industry that standards should reflect the local or regional environment and climate. As well, the costs of providing a certain quality differ around the world, which implies that a uniform standard would not be economically efficient (Bureau, Marette, and Schiavina 438). This lack of harmonization has led to trade difficulties and in some instances has threatened the expansion of the organic industry. Besides the differing costs, consumers around the world do not have the same expectations regarding food quality and safety (Bureau, Marette, and Schiavina 438). This may be due in part to differences in culture and history or because of country-specific eating habits (Bureau, Marette, and Schiavina 438).
In many countries there is little competition between organic certifying labels within specific regions (Lohr and Krissoff 212). This will likely change as trade in organic products expands; organic consumers will see increased imports and additional certifying bodies competing in their markets. According to Sylvander and Le Floc’h-Wadel, “traditionally in Europe, consumer demand has been greater than production, leading to a significant level of importation of organic products, generally coming from Northern Africa or Eastern Europe” (103). However, as consumer demand grows, imports will come from a broader range of sources including the United States and Canada. Within the EU import shares are highest in Germany and the UK, which are major food processors, and in the Netherlands, which is primarily a re-exporter (Lohr 1126). This paper will discuss organic food in terms of “domestic” and “foreign” produced goods. In some contexts, specific references to the US and the EU will be made. In these instances, US organics are referred to as “foreign” and EU organics as “domestic”.
The Organic Paradigm
Organic agriculture not only represents an agricultural process but also a way of integrating agriculture into the ecosystem. This organic paradigm includes consuming goods that have the least amount of environmental impact. Therefore it is possible that organic consumers prefer domestic goods or local goods over imported organics not only because of the perception of stricter standards but also because of the environmental effects of transporting food great distances. Local food may be bought straight from the farm gate, from a farmer’s market or from a local retailer. The consumer knows that the food was not transported by gas guzzling trucks, boats and planes and therefore their consumption of locally produced organics reduces their ecological footprint. In a study done by Torjusen et al. it was found that locally oriented consumers were more likely to purchase organic foods (214).
Consumers with different preferences will choose different bundles of foods. The consumer, in making a choice, is attempting to maximize his or her utility from their food purchases. This maximization will likely be achieved as long as their perceptions about the quality attributes of foods are correct (Caswell 151). Consumers are willing to pay more for foods they perceive to be of higher quality (Caswell 151). In most countries, consumers prefer locally grown foods, this preference which may be due in part to their reduced “ecological footprint”, has also developed out of a belief that domestically produced organic foods are superior to imported foods (Lohr and Krissoff 212). Even if standards are identical, consumers are still likely to view imported organics as inferior products, because of perceptions surrounding the stringency of the standards.
Opening the domestic market to imported organic products that are thought to be inferior can lead to market inefficiencies and multiple equilibria (Bureau, Marette, and Schiavina 437). Market inefficiencies arise when it is difficult to differentiate imports from domestic products. Using Arkerlof’s “Lemons theory”, we can see that if consumers believe the market is becoming saturated with low quality (foreign) organic products, their willingness to pay for these products will be reduced until the market no longer exists. This is due to information asymmetry. The producer or seller has more information regarding the origin of the product than the buyer does.
These ideas generate several questions. What will be the impact on consumer welfare if differentiable foreign organics are sold on the domestic market? What if the products are non-differentiable? It has been suggested that domestic producers will promote the idea of inferior foreign organic goods in order to increase consumption of their domestically produced organics, however if the products become non-differentiable this perception could harm the domestic industry. How will domestic producers react if consumers can no longer differentiate between domestic and foreign organics?
The Model
To determine consumer welfare effects we will use a vertical differentiation model similar to that developed in Giannakas. Three situations will be outlined, the case where there are no foreign organic goods in the market, the case where foreign goods are allowed but they are differentiable and finally, the case where organic goods are allowed but are non-differentiable. Bureau, Marette, and Schiavina state that welfare changes will depend on consumers’ beliefs, on their aversion to certain qualities and on the production costs of the foreign goods relative to the domestic ones (439). According to Lohr and Krissoff, the greatest welfare gains occur when equivalency is accepted by consumers (227). In this situation it would make no difference whether or not the products were differentiable as they would be treated as homogenous goods. In our model, similar to the model designed by Fulton and Giannakas, the concept of consumer heterogeneity is crucial to understand how there can be a demand for both domestic and foreign organic goods even when country-of-origin labels differentiate them (2). This heterogeneity can also help us to understand how consumers will react to unlabelled foreign organic goods.
-No imports-
In the first scenario, consumers merely have to choose between domestically produced organic food and conventional food. There are two separate utility curves, the first represents the utility consumers’ gain from consuming a unit of conventional food, and the second represents the utility consumers’ gain from consuming domestically produced organic food.
In this case po and pc represent the prices of organic and conventional food respectively, and represents the increase in utility from consuming organic food. The parameter represents the heterogeneity of consumers and takes a value between 0 and 1 while the parameter is a utility enhancement factor (a scalar). Consumers with a larger value of are willing to pay more for organic food as they value the quality more. It is assumed that po is greater than pc and that the utility enhancement factor θ is greater than po-pc. If this were not the case, there would be no demand for organic food.
Figure 1: Consumption and welfare effects of the no-import scenario
The upward sloping curve in Figure 1 represents the utility gained from consuming organic goods; the curve is upward sloping because organic food is considered to be superior to conventional food. At the point, consumers are indifferent between consuming organic food or conventional food. However, to the right of every consumer will purchase organic food, thus this area represents the market share of organics. The point is calculated by equating the two utility equations:
When consumers are able to differentiate between organic and conventional products; total consumer welfare increases. The gain in welfare is equal to the area:
A complete explanation of the calculations can be found in Appendix A. This scenario will act as a benchmark with which to compare the welfare changes of allowing differentiable imports and non-differentiable imports.
-Differentiable Imports-
In this scenario, imagine that the domestic government has allowed imports of differentiable organic goods. These imports may include oranges, potatoes, and other products that can be packaged or labelled individually. In this situation there are now three utility curves:
Where represents the utility gained from consuming domestic organics and represents the utility gained from consuming foreign organics. The parameters, with the exception of remain the same. is similar to , it is also a utility enhancement factor, but in this scenario, it is the enhancement gained by consuming foreign organics. Again, there are several assumptions made regarding the prices of the varying types of food. The price of conventional food is assumed to be less than that of either type of organics. Due to consumers’ perceptions of the inferiority of foreign organics, foreign organics must be priced lower than domestic organics for a market to exist. In Figure 2, the utility curves for the three types of products are illustrated. Notice that in order for a market for foreign organics to exist must be greater than but if is greater than or equal to there will be no market for domestic organics.
Figure 2: Consumption and welfare effects of allowing differentiable organic imports
Foreign organic products still capture part of the market even though consumers’ perceive them to be of lower quality. This is in part because of the lower price, some consumers who originally consumed conventional food can now afford to consume imported organics. As well, foreign goods have also captured some of the market from the domestic producers. Those consumers that are indifferent between conventional and foreign organics and foreign and domestic organics are located at points and respectively. These points are calculated by equating the utility equations:
In order to calculate consumer welfare changes, the gains in this market must be compared with the gains in our benchmark situation. The change in consumer gains with imports of differentiable organics is calculated by summing the areas of triangles egi and dhi and subtracting the area of triangle dhj and then comparing this with the welfare of consumers prior to imports. Calculating the areas of the triangle gives us the consumer gains with imports:
Clearly consumers gain when differentiable foreign imports are permitted into the domestic market. When compared with the benchmark situation of no trade, there is an increase in consumer welfare of the amount:
With differentiable imports, both the domestic share of the organic food market and the share of the conventional food market have decreased. Changes in market share can occur because of price changes and also because of changes to the utility enhancement factors. If the price for foreign goods decreases, the market share for foreign organics would increase, shifting away from conventional food and domestic organics. If the price of conventional food decreases, this would cause a shift in market share away from the imported organic industry. Figure 2 also illustrates what will occur should the price of domestically produced organics increase, or if the enhanced utility gained from consuming these goods increases. In either case, the domestic organic industry would gain market share, shifting it away from the import market.
-Non-differentiable Imports-
Now let us consider the situation where imports are allowed but they are non-differentiable from their domestic counterparts. This may occur in processed goods such as tortilla chips (made from corn from different regions) or baked goods (made from flour from different sources) or in goods that are not easily traceable, such as grains. With processed goods, there is no way for a consumer to tell how much of the product has been ‘tainted’ by foreign organics.
This scenario can be analyzed using Akerlof’s “Market for Lemons”. In this case, we are discussing organic food and not used cars; however, an analogy can be drawn. If consumers are aware that there is a possibility of foreign organics within the processed organic goods they consume, they will experience a decrease in utility. This decrease will depend on the probability that the good contains foreign organics. represents the probability that there is no foreign organics tainting the product, and 1- is the probability that there are foreign organics in the processed good. The consumer utility under mixing of organic foods is given by:
(where m stands for “mix”)
Mixing of organic food results in reduced utility associated with the consumption of organic foods. This also implies a reduction in the willingness to pay for organics on the part of consumers. Graphically, the reduction can be seen in Figure 3. Non-differentiable imports reduce consumer welfare and market demand for organic food. Specifically, the loss in consumer welfare can be seen as the area CL in Figure 3:
In Figure 3, the consumer who is indifferent between conventional food and organic food is now located at :
The consumption share of the organic market also decreases with non-differentiable products while the share of the conventional market increases. Prior to the inclusion of foreign organics in the domestic market, the share of the organic market was equal to 1-, now it is equal to . This is a reduction of: