Fair Trade Coffee: A Simple Supply and Demand Analysis

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I was thinking of writing an op-ed for my school newspaper about Starbucks’ Fairtrade coffee and planned to use an old post by Alex Singleton as one of my reference points. In reviewing the argument that Mexican farmers benefit from Fairtrade at the expense of Ethiopian farmers, however, I found the economic analysis unclear.

Singleton notes that the price of coffee has experienced a downward trend, signally that too much coffee is being produced. He cites mechanization and World Bank loans as decreasing the cost of production. These historical facts mean that the supply curve has previously shifted downward, but they play no role in a partial equilibrium analysis of Fairtrade’s effects today.

As Mr. Singleton describes it, Mexican coffee producers are the marginal producers in the current equilibrium, due to their comparative disadvantage in the production of coffee (higher opportunity costs). A drop in demand would cause these marginal producers to exit.

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Singleton argues that Fairtrade induces Mexican producers to stay in the coffee business and that if Mexican farmers switched to growing something other than coffee, Ethiopian farmers growing coffee would benefit. I think that this is incorrect.

Fairtrade is a manipulation of the demand curve, not the supply curve. Singleton agrees by describing participating consumers as willing to “pay a few pence extra for a cup of coffee.” Therefore, the abolition of Fairtrade would cause consumers to offer a lower price at each quantity. This is a downward shift of the demand curve.

How does a downward shift in demand affect the supply curve? There is a change in quantity supplied, but not a change in the supply curve itself. As such, the marginal producers (Mexican coffee growers) will exit until equilibrium is reestablished. Does this help the Ethiopians?

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Facing fewer competing firms may sound appealing at first, but it’s not beneficial if competitors exited due to insufficient demand. Under Fairtrade, producers that export coffee at a cost below the market equilibrium price earn profits; this is the traditional producer surplus triangle. If it is true that Ethiopians are these lower cost producers, then they will remain in the market when demand falls, but their producer surplus will be reduced. The shaded rectangle is the welfare loss Ethiopians experience due to lower demand. The abolition of Fairtrade and exit of Mexican producers corresponds to lower profits for Ethiopians.

Of course, my analysis up to this point has treated coffee as a unified market. In fact, Fairtrade coffee comprises a small portion of total coffee consumption, so we have to draw separate supply-and-demand graphs for unsubsidized and subsidized coffee, which are substitutes.

Foregoing the actual illustrations, as one can easily imagine them, let’s analyze the effect of increasing Fairtrade participation by consumers. This is an upward shift in the demand curve for Fairtrade coffee. However, as Fairtrade coffee substitutes for unsubsidized coffee, the change in consumer preferences causes a downward shift in the demand curve for unsubsidized coffee.

What are the effects upon producers? Producer surplus will increase in the Fairtrade market and decrease in the unsubsidized market. Thus, the result in ambiguous. Those suppliers that are Fairtrade-certified benefit, whilst non-participants lose profits. If Mexicans are more easily able to form a producer organisation eligible for the Fairtrade label (groups exporting more than 44,000 pounds of coffee per year and able to pay the $2,431 fee) than Ethiopians, then they will benefit at the expense of their African competitors. But if Ethiopians are able to join the Fairtrade program as easily as other coffee producers, then we should not expect Fairtrade’s inflation of the demand curve to have disproportionate negative effects upon them.

The only way for Fairtrade to do no harm to coffee producers would be for all of them to participate. Non-participants do face reduced demand for their product. In its current form, Fairtrade may or may not be net benficial, depending upon the elasticities of the relevant curves and one’s willingness to make interpersonal utility comparisons.

[Comments are open; please post suggestions and corrections.]

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3 Responses to “Fair Trade Coffee: A Simple Supply and Demand Analysis”

  1. green LA girl Says:

    Wow — I’m totally not an economist, so I have to say that some of what you wrote about the supply and demand models went over my head. 😮 That said, thanks for your thoughtful analysis — which I found much more nuanced and complex than Alex Singleton’s argument.

    I actually emailed Alex about his post a while back — His site doesn’t seem to allow for comments — to point out his oversimplifications of the fair trade movement’s efforts:

    ***

    Alex —

    Thanks for drawing attention to the fair trade coffee debate. I do want to point out, though, that fair trade isn’t JUST about paying farmers better prices. If they were, I’d have to agree that FT could contribute to the current coffee glut problem. However, FT certification also requires farmers to work on improving the quality of their coffee — and as you know, specialty coffees fetch a fairly decent price for farmers, even on the free market.

    Moreover, FT certification requires that farmers work on diversifying their crops, so that the farmers aren’t so susceptible to the fluctuating prices of a single cash crop. This means that FT in fact encourages farmers to grow LESS coffee, since they’re growing other stuff too, while improving the quality of the coffee they do grow.

    To say that FT leads to “further oversupply in the market” is an unfair, and untrue, simplification of fair trade’s efforts and achievements.

    ***

    Looking forward to reading more of your analysis on the issue —

  2. Fletch Says:

    Excellent analysis of these markets, particularly from an undergraduate. I’ll offer some suggestions to improve this model. The supply function here is based upon the assumption of perfect competition among suppliers – the marginal cost of coffee production. Looking only at marginal costs fails to cover much of Fair Trade. Indeed, the assumption of perfect competition is inappropriate. From my limited understanding of the Fair Trade Movement, it has basically two intentions: increase the price paid to growers at the bottom of the supply chain by distributors and subsidize costs, such as schools.

    The first intention implies monopsony among distributors – growers are large in number whilst distributors are small in number. This is the core of the Fair Trade Movement, which attempts to educate growers on how to negotiate among more buyers in the market. It educates them on basic contracts in which longer-term pricing can be written, a key component of bargaining power.

    We would expect that this education would result in a more horizontal firm demand function and, thus, less exploitation of growers. This is an indispensable quality of the Fair Trade Movement. Why? Because producer surplus flows from the distributors to the growers, thus, granting them a fair price, but consumer surplus flows to me, granting me a fair price as well.

    Your central point above, though, is valid. Under Mr. Singleton’s assumptions, if some producers exit the market, then all producers face surplus losses, whether they exit altogether or swallow lower profits. The apple doesn’t fall far from the tree with this analysis.

  3. Jim Says:

    Nice analysis. I think the second part, in which you treat conventional and Fair Trade coffee as substitutes, gets closer to the reality. And I think the crucial consideration is, as you say:
    “If Mexicans are more easily able to form a producer organisation eligible for the Fairtrade label (groups exporting more than 44,000 pounds of coffee per year and able to pay the $2,431 fee) than Ethiopians, then they will benefit at the expense of their African competitors.”

    As far as I can see, that $2,431 fee is not levied on each of the 800,000 family farmers producing Fair Trade certified coffee, but on the 400 producer organisations they belong to (figures from here: http://en.wikipedia.org/wiki/Fair_Trade ). If there’s an average of 2,000 family farms per organisation, then maybe that fee isn’t such a big cost and African producers are not priced out. I agree this area should be explored further though.

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