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Market failure and the role of government in the food supply chain: an economic framework

Ismo Rama and Sallyann Harvey
Economics and Policy Research Branch Policy and Strategy Group

June 2009

Acknowledgements

The authors acknowledge Clive Noble, DPI Chief of Science and Technology, and Ragini Wheatcroft, DPI Strategic Relationship Manager Food and Plant Industries, for their strong support and valuable ongoing feedback to this project.

The authors thank Bob Douglas, Bill Fisher, Anna Heaney, Arthur Ha, Mark Taylor, John Rakopoulos, Kristoffer Larson, and Veronica Fil (DPI Economics and Policy Research Branch), Russell Sully (DPI Future Farming Systems Research), Margaret Darton (DPI Agriculture and Rural Policy), Brendan Tatham (DPI Biosecurity Victoria), Anthos Yannakou, Gary Dykes, and Ingrid Appleqvist (Food Science Australia) for input and comment to the paper. We are grateful to Associate Professor Bill Malcolm (University of Melbourne and DPI Economics and Policy Research Branch), Professor Julian Alston (University of California), and Roger Rose for their review and comments. The authors also acknowledge the assistance of Rachael Dullahide (The Launch Box), who edited this report. All errors and shortcomings remain the responsibility of the authors.

Foreword

This working paper prepared by the Economics and Policy Research Branch of the Department of Primary Industries examines the role of government in the food supply chain in Victoria and Australia. Dr Clive Noble, Chief of Science and Technology, and Dr Ragini Wheatcroft, Strategic Relationship Manager Food and Plant Industries, requested that the branch undertake research in this area.

The aim of this working paper is to develop an economic framework to guide policy makers when considering whether a case exists for government intervention in the food supply chain.

This paper describes the food supply chain and current government interventions, and examines potential sources of market failure. The paper then brings these elements together to examine where market failure may be present, and where there might be a role for government. Importantly, where market failure is present, the paper discusses policy considerations to be taken into account before concluding government intervention will enhance outcomes along the food supply chain.

The Economics and Policy Research Branch hopes this research will help policy makers better understand the operation of markets in the food sector, and design and target policy interventions in a way that maximises benefits to the community.

Dr Deborah Peterson

Deputy Secretary
Policy and Strategy

Contents

Acknowledgements
Foreword
Executive summary

1 Introduction and scope

2.The food supply chain
2.1 Food supply chain —key components
2.2. Existing government intervention along the food supply chain

3. Market failure and the role of government
3.1 Market failure
3.2 From market failure to a role for government
3.2.1 Net benefits of intervention
3.2.2 Opportunity cost of intervention
3.2.3 Selection of policy instrument
3.2.4 Selection of level of government and agency
3.2.5 Cost sharing

4. Role of government in the food supply chain
4.1 Activities along the food supply chain where market failure suggests some role for government
4.1.1 Practice change and extension
4.1.2 Research and development
4.1.3 Biosecurity
4.1.4 Animal welfare
4.1.5 Food safety
4.1.6 Verifying credence claims
4.1.7 Food and public health, nutrition and healthy eating
4.1.8 International market access
4.1.9 Trade practices
4.2 Activities along the food supply chain where market failure is not evident, suggesting no role for government

5. Summary and conclusion

6. References

7. Glossary

Executive summary

This paper examines the likelihood of market failure and the role of government in the food supply chain in Victoria and Australia. It seeks to develop a broad framework for helping identify cases in which government intervention in the food chain can be expected to enhance economic efficiency, and cases in which such intervention is not warranted. This paper does not provide a detailed review of current government programs and initiatives in the food supply chain. It discusses the role of government and outlines principles to help clarify and define a role for government in general and for the Department of Primary Industries (DPI) more specifically.

The food supply chain

For this paper, the food supply chain in Victoria (and Australia) includes a range of activities, including production, manufacturing, imports, exports, retailing and food services. The efficiency of the food supply chain would be enhanced by the development and application of a clear framework for considering the role of government along the food supply chain. Such a framework would assist government to ensure that any intervention is carefully targeted to areas of market failure where the intervention’s benefits will exceed its costs, and that the form of intervention used will achieve the greatest possible net benefits.

Market failure

Market failure occurs when markets substantially and systematically fail to allocate resources to their most highly valued use. The main types of market failure include those associated with public goods, externalities (sometimes referred to as spillovers), market power and imperfect information. Establishing the nature and extent of market failures in the food supply chain is an important component of deciding (1) whether it may be appropriate for government (including DPI) to intervene and (2) what form that intervention should take.

From market failure to a role for government

Evidence of a market failure that results in an inefficient allocation of resources is a necessary but not sufficient condition to justify government intervention. Government intervention in markets is costly, and the benefits must outweigh the costs to justify it. The policy instrument and its design should thus be chosen to maximise the net benefits of intervention.

The relevant measure of the cost of government intervention in the food supply chain is the opportunity cost. When resources used for intervention are thus constrained elsewhere, the net benefits of intervention in the food supply chain have to be weighed against the net benefits of other important activity.

When a market failure is present and government intervention is justified, decisions remain about which agency of which government (Commonwealth, state or local) should intervene. The answer depends on the nature of the market failure; the benefits of centralisation, decentralisation and cooperation between agencies; the constitutional division of powers between the states and the Commonwealth; and other specifics. Intervention by the Victorian Government might not involve DPI.

Components of the food supply chain where market failure suggests some role for government

Market failures are apparent to varying degrees along the food supply chain, justifying some government intervention in a number of areas, including extension and practice change; research and development (R&D); biosecurity; animal welfare; food safety, food standards and quality assurance; credence goods; food and public health, nutrition and healthy eating; international market access; and trade practices. In these areas, well designed government intervention may enhance efficiency.

Components of the food supply chain where there is no clear role for government on market failure grounds

In other areas of the food supply chain, clear market failure is not evident, and there is no rationale for government intervention on efficiency grounds. This is particularly the case for the facilitation of agribusiness activity in domestic and international markets. Where government intervention in these areas of the supply chain takes place on grounds other than market failure, objectives must be clear and intervention must be as cost effective as possible.

1. Introduction and scope

This paper examines the likelihood of market failure and the role of government in the food supply chain in Victoria and Australia. It seeks to develop a broad framework for better understanding where government intervention may enhance efficiency within the food supply chain, and where such intervention should be treated with caution. This paper does not provide a detailed review of current government programs and initiatives in the food supply chain. It discusses the role of government and outlines principles to help clarify and define a role for government in general, and for the Victorian Department of Primary Industries (DPI) specifically. DPI has undertaken earlier and more detailed analyses of components and activities along the food supply chain, as noted in the bibliography.

Section 2 of this paper describes the food supply chain, and important government interventions that are relevant. Section 3 discusses possible sources of market failure in the food supply chain, and section 4 discusses the role of government. Section 5 contains the conclusion.

2. The food supply chain

For this study, the food supply chain includes primary production, food manufacturing, retailing, food services, and trade.¹ This paper does not consider inputs to the food supply chain where government intervention has an important role. Natural resources such as land and water are such inputs, for example, and government plays an important role in ensuring these scarce resources are efficiently allocated. Consideration of these inputs, however, is beyond the scope of this study. Figure 1 summarises the food supply chain, and is followed by a brief description of activities along the supply chain.

¹ Other activities along the supply chain (such as transport) are not specific to the food sector so are not examined in this paper.

Figure 1 Food supply chain

2.1 Food supply chain—key components²

Primary production includes the production of agricultural commodities and products on farm. Key products in Victoria include meat (livestock), milk, grains, oilseeds, and fruit and vegetables (DPI 2008).

Food manufacturing involves the processing and transformation of primary products for further use and consumption. Some manufacturing processes are relatively simple, such as cleaning, grading and packing eggs, or slaughtering and boning livestock. Others involve substantial transformation of primary products, such as making wine from grapes. Others again involve multiple steps, such as processing milk to make either consumer goods (for example, cheese) or specialised ingredients for inputs into other manufactured food (for example, fractionated milk fats suitable for chocolate).

Food products reach consumers in two main ways: retail outlets and food service outlets. Retail outlets for food products include supermarkets, grocery stores, convenience stores, and specialist retailers such as butchers, fruit and vegetable shops and retail bakery outlets. Food service outlets include cafés, hotels and clubs, bars, restaurants and other services.

Victorians benefit from both imports and exports of food products to other jurisdictions and the rest of the world. Food imports allow Victorian consumers to enjoy foods not produced locally, and to consume foods at lower prices. Exports provide opportunities for Victorian producers to access larger or new markets, and/or to receive a price premium for their output.

² Figure 1 source: DPI (2008), ‘Food supply chain background’, Agriculture and Rural Policy Branch – Food Policy, September, Melbourne (unpublished).

2.2 Existing government intervention along the food supply chain

The Commonwealth and state governments actively intervene throughout the food supply chain. Table 1 summarises the range of interventions. It also identifies the component of the food supply chain being targeted by each intervention. Some interventions apply to a specific component of the supply chain (for example, primary production), while others apply to a number of components. This table is qualitative rather than quantitative because data on DPI spending by intervention type are not available. It indicates, however, how governments intervene in various ways along the food supply chain. The interventions in table 1 have been ordered as they take their main effects, from primary production to transport.

Table 1 Existing government intervention in the food supply chain

Intervention type	Description	Example	Component of supply chain being targeted
Practice change/ Extension	Improving policy implementation and service delivery in the primary industry and natural resource management sectors, in areas including adoption, compliance and natural resource management	DPI Farmview videos—aseries of informationvideos containing horticulture industry information, expert agronomic and technical news, research findings, management options and policy developments	Primary production Retail Food services Traded sector Transport
Research and development (R&D)3	Funding and conducting R&D and technology development in the food sector	DPI Future Farming Systems Research (FFSR) Division, focused on two platforms: agrifood production systems and agricultural resources DPI Biosciences Research Division (BRD), focused on two platforms: bioscience and bioprotection	Primary production Food manufacturing
Biosecurity	Preventing and responding to unwanted animals, pests, diseases and weeds that could affect production, food safety and/or market access	Biosecurity Victoria (BV), which develops and manages the delivery of the Victorian Government’s biosecurity and market access programs for the livestock, plant, fisheries and forestry industries Biosecurity Australia, which provides science based quarantine assessments and policy advice that protect Australia's pest and disease status and enhance Australia's access to international markets for plant and animal products	Primary production Retail Food services Traded sector
Credence goods	Ensuring claims about credence goods (for example, organic products) are accurate	Australian Competition and Consumer Commission (ACCC), which is responsible for enforcing the Trade Practices Act 1974, including unfair market practices, industry codes and product labelling Consumer Affairs Victoria (CAV), which enforces compliance with consumer laws	Primary production Traded sector

³ R&D can be part of the input chain, but it also takes place at other points along the food supply chain so falls within the scope of this study.

Intervention type	Description	Example	Component of supply chain being targeted
Animal welfare	Undertaking disease monitoring and mitigation to facilitate the marketing of livestock and livestock products, and to promote the welfare of farmed animals. Development and delivery of the programs involve policy, legislation, advisory, research and regulatory activities.	DPI Bureau of Animal Welfare, which provides liaison, coordination and cooperation in animal welfare matters across the states, the Australian Government, local governments and animal welfare agencies in Victoria	Primary production Transport
Food safety	Ensuring food is safe to consume	PrimeSafe, which is a Victorian Government statutory authority that implements food safety requirements for meat processors, wholesalers, transporters and butchers, commercial fishermen and seafood manufacturers and businesses, along with the pet meat and pet food industry	Primary production Food manufacturing Retail Food services Traded sector
Domestic marketing	Marketing Victorian and Australian food products into domestic markets (other states and territories)	DPI Food Trail initiative: a six part television series sponsored by the DPI that promotes food from Victorian producers	Retail Food services
Food, public health, nutrition, healthy eating	Improving nutrition and promoting healthy eating	Victorian Department of Human Services (DHS) GoFor Your Life initiative: information including diet, food and nutrients, nutrition and illness, healthy weight, body image, weight management, food safety and food recipes	Retail Food services
International market access	Reducing barriers toVictorian and Australian food products accessing export markets	DPI Agribusiness Group,which provides information and advice to Victorian businesses to overcome market barriers Department of Foreign Affairs and Trade (DFAT), which negotiates free trade agreements (FTAs)	Traded sector

Intervention type	Description	Example	Component of supply chain being targeted
International agribusiness marketing	Marketing Victorian and Australian food products into export markets	DPI Agribusiness Development initiative,which assists Victoria's agrifood producers via strategic market analysis, international market development and regional agribusiness development Austrade New Exporter Development Program (NEDP), which provides small and medium sized Australian businesses with advice and information, tailored export coaching and assistance on the ground in selected overseas markets	Traded sector
Trade practices	Ensuring markets along the food supply chain are competitive	ACCC, which is responsible for enforcing the Trade Practices Act Consumer Affairs Victoria (CAV), which enforces compliance with consumer laws	Retail Food services

3. Market failure and the role of government

This section discusses potential sources of market failure in activities along the food supply chain. It then examines additional issues to be considered when identifying a role for government after detecting market failure.

3.1 Market failure

Market failure occurs when markets systematically and substantially fail to allocate resources to their most valuable use. Well functioning markets have demonstrated themselves to be effective mechanisms for the efficient allocation of scarce resources to their most efficient use (Stiglitz 1988). In practice, markets rarely, if ever, correspond to the ideal of a perfectly competitive market as defined by economic theory.⁴ Nevertheless, these imperfectly competitive markets often function well in efficiently allocating resources in society. Certain conditions (known as market failures), however, render markets inefficient in a systematic and substantial way, and may provide a rationale for government intervention. Establishing where market failures occur in the food supply chain is important when deciding where government intervention may be appropriate. The main types of market failure include those associated with public goods, externalities (or spillovers), market power and imperfect information.

Public goods have the properties of being non-excludable (that is, non-payers cannot be excluded from consuming the good or service once it is provided) and non-rival (consumption by one person does not diminish the availability of the good or service to others). As a result, public goods tend to be underprovided by private markets because they are subject to ‘free riding’ (those who receive the benefit from consuming a good can do so without paying for it).

An externality arises when one person’s production or consumption activities results in spillover costs or benefits to another person, for which the person making the original transaction did not account. The market transaction thus does not compensate for these external costs or benefits, so there is either an over- or underprovision of the production or consumption activities. Externalities can occur in the food supply chain in a number of areas, such as market access, quality assurance, and environmental and health consequences of food production and consumption.

In some cases, parties can negotiate to overcome externalities. Adjoining landholders, for example, may negotiate to overcome the spreading of weeds from one property to another (a negative environmental externality). This negotiation process depends on well defined and enforceable property rights—in this case, the right for an owner of land to manage it as they see fit. If a landholder has this right and allows weeds to flourish on their property that then spread to their neighbour, the neighbour may offer incentives for the landholder to control weeds. On the other hand, if the landholder’s property right includes an obligation to manage weeds on the property so they don’t spread, the neighbour may be entitled to some compensation. Such bargaining, however, can be prevented by circumstances such as multiple landholders causing and being affected by weed problems, difficulties in identifying the source of the weeds, and difficulties in organising landholders to come together.⁵ Consequently, externalities are likely to prevail in these circumstances.

Market power exists when an individual firm can influence the market price of goods for increased profits. Conditions where market power might prevail include markets where there are few buyers (for example, monopsonies), few sellers (for example, monopolies) or barriers preventing other firms from entering or exiting the market. The exercise of market power by firms either as buyers or sellers distorts the allocation of resources, with consequences for efficiency and the distribution of income.

Imperfect information can take two broad forms. First, information asymmetry refers to the case where one side to a transaction has information that the other side does not possess. A food consumer, for example, may have little information about the quantity and types of chemical applied in primary production of food (let alone information about the implications of chemical use for food quality) whereas the food producer does. This may reduce incentives for the producer to achieve efficient levels of food safety. Similarly, a consumer may know little about the cleanliness of a kitchen in a restaurant. The second form occurs when information is imperfect for both the consumer and producer—for example, a food borne disease may be transmitted through meat without being apparent to either producer or consumer (Antle 1996). Both forms of imperfect information can result in market failure and inefficiencies along the food supply chain.⁶

⁴ A perfectly competitive market is characterised by ‘a large number of consumers maximising their utility and producers maximising profits. Everything is owned and the property rights are clearly defined … the product is homogeneous, there are no barriers to entry, returns to scale are constant, and relevant information is generally available and free of charge. Each firm has no market power and hence is a price taker … There are no supernormal or monopoly profits’ (Helm 1989, p. 14).
⁵ For a discussion of the reciprocal nature of externalities, see Coase 1960.
⁶ Imperfect information does not refer to cases where information is unknown by one or both parties to a transaction but the costs of obtaining that information exceed the benefits.

3.2 From market failure to a role for government

If there is no market failure, there is no case for government intervention on efficiency grounds. Further, the presence of market failure is necessary but not sufficient to justify government intervention in the food supply chain: other conditions must be met before intervention by the Department of Primary Industries (DPI) or other arms of the government is justified.

3.2.1 Net benefits of intervention

To justify government intervention to correct a market failure, it is appropriate to compare real world alternatives with and without the government intervention. A real world government has to accomplish its roles under the same constraints and imperfections that contributed to the market failure. Just as markets are rarely, if ever, perfect resource allocators, so are governments rarely, if ever, perfect in their correction of market failures (Helm 1989). Government intervention can be costly, such that the benefits of intervening in the market need to outweigh the costs to justify the intervention in economic terms—that is, net benefits must result from the intervention. If all the benefits and costs are not considered, government intervention might add to the costs arising from the initial market failure. In such a case, it would be better to do nothing and live with the market imperfections.

3.2.2 Opportunity cost of intervention

Even where net benefits justify government intervention in the food supply chain, it is important to consider the opportunity cost of such intervention. Given a constraint on total resources available to the government, if it spends resources intervening in the food supply chain, then a smaller quantity of resources will be left for other purposes (such as public investments in health and education). Government typically faces a budget constraint and must allocate resources to those interventions that generate the greatest net benefits for the community. The opportunity cost of intervention is also an important consideration at an agency level. If DPI, for example, allocates resources to the food supply chain, then a reduced quantity of resources will be available for intervention elsewhere in the portfolio.

Further, a dollar of government spending costs the community more than a dollar—that is, the social opportunity cost of a dollar of tax exceeds a dollar. These social opportunity costs arise because taxation imposes costs on the economy by changing incentives to work, consume and invest. Studies suggest these costs are around 20 to 24 cents per dollar raised (Freebairn 1995; Campbell 1997), implying that government spending must have a benefit–cost ratio of at least 1.2 to justify the taxation needed to finance it.

3.2.3 Selection of policy instrument

Governments have available a range of policy instruments (including information and education, taxes and subsidies, regulation, and government production, and options within each of these categories) that they might apply to a situation where intervention is judged to be worthwhile. Alternative policy instruments have different implications for the total costs and benefits from intervention, and for the distribution of those costs and benefits. Consequently, the choice of policy instrument and its design are important in maximising net benefits.

Selecting the optimal policy instrument is necessarily done jointly with deciding whether to intervene, to what extent and by which government agency.

3.2.4 Selection of level of government and agency

Where a market failure is present and government intervention is justified, it is important to consider the question of efficient jurisdiction—that is, which agency from which level of government (Commonwealth, state or local, or some combination) is best placed to intervene? Where intervention is best undertaken by the Victorian Government, it may or may not involve DPI.

One consideration in the selection of efficient jurisdiction is the existence of geographic spillovers of benefits. If a research and development (R&D) intervention in one state, for example, results in benefits spilling over to other states whose residents are not parties to the transaction, then an interjurisdictional externality is present. In the same way that externalities result in inefficiency among individuals, they can also result in inefficiencies among jurisdictions. The efficient jurisdiction for an intervention thus aligns with the way in which net benefits from the intervention are spread. If the benefits of an intervention flow beyond a state, then that state will be too small a jurisdiction to efficiently manage the intervention because it will face incentives to underinvest from a national perspective. If an intervention generates benefits in every state (or most states), then the nation is likely to be the efficient jurisdiction (Alston and Pardey 1996).⁷

⁷ In some cases, political jurisdictions (such as state borders) may not align with economically efficient jurisdictions. It may be possible to identify beneficiaries in other ways, including by production or consumption of particular commodities, or by a particular input to a region (Alston and Pardey 1996).

An additional consideration is what mix of institutional centralisation, decentralisation and cooperation to apply to an intervention. A centralised approach, in which one level of government or one agency undertakes an intervention, can generate benefits as it reduces duplication and overlap between agencies. However, centralisation can also reduce competition - full centralisation can end competition - between governments and agencies. A decentralised approach, where agencies intervene in the same area simultaneously, can stimulate competition between agencies and lead to beneficial innovations in intervention, however it also implies the presence of some duplication and overlap. Agreements between governments and agencies for cooperative action lie between these alternatives, they tend to reduce competition but can leave room for it. The right institutional balance for any particular intervention will be the one that generates the greatest net benefits for the community (Pincus 2008).

Also, a constitutional division of powers among national, state and local governments may assign responsibility for a particular intervention to a particular level of government.

When determining which agency, at a selected level of government, is best placed to manage an intervention, issues include the following:

• Which government agency has the appropriate skills and resources to undertake any intervention?
• Which government agency has the appropriate incentives to undertake any intervention?
• Can the selected agency efficiently exploit potential economies of scale or scope relating to the intervention?
• Which government agencies are already active in a particular policy area or geographic area?
• Do particular government agencies have legal or regulatory requirements to undertake particular interventions?
• Is an existing government agency well placed to intervene, or is a new agency needed?
• Can existing legislation or regulation be modified?

If insufficient attention is given to identifying the appropriate Commonwealth, state or local government agency, the net benefits of intervention along the food supply chain may not be maximised.

3.2.5 Cost sharing

If a proposed government intervention has passed the net benefits test, then an important issue concerns how the costs of intervention should be funded and, perhaps, shared. Economics focuses on questions of efficiency, so cannot provide definitive advice on issues of equity and fairness such as ‘who should pay’. Three approaches often discussed include ‘polluter pays’ (those creating the problem should bear the costs), ‘beneficiary pays’ (those who benefit from an intervention should bear the costs) and cost sharing (beneficiaries should share the costs according to their share of benefits) (Pannell 2004).

DPI has developed a ‘beneficiaries and funders’ framework to guide the development of cost-sharing arrangements between government and other stakeholders (DNRE 2000). In broad terms, this framework identifies beneficiaries from a proposed activity, and aligns funding obligations with those beneficiaries. It identifies three categories of beneficiary from government policy or programs: private, industry and community.

Private beneficiaries: the benefits from a project flow to private stakeholders. The purchase of new farm machinery, for example, would directly benefit private enterprises through increased profits. As a result, it is appropriate that they pay for such equipment. Under the ‘beneficiaries and funders’ framework, private beneficiaries will fund projects that generate only private benefits.

Industry beneficiaries: market failure exists at an industry level when projects generate benefits that accrue to industry yet a single enterprise has insufficient incentives to undertake the project. Under the ‘beneficiaries and funders’ framework, industry groups/bodies will fund certain projects undertaken by a single enterprise if benefits accrue to industry. An example is the marketing of Victorian beef to an overseas market, which would benefit the wider beef industry.

Community beneficiaries: community benefits are those that are unrelated to private and industry benefits. Market failure exists at a community level when projects generate benefits that accrue widely across the community. Markets will not provide the activity efficiently or at all. An example is agricultural research and development that generates knowledge that produces environmental benefits for all states and territories. Under the ‘beneficiaries and funders’ framework, the Australian Government will fund certain projects from which benefits accrue to the community.

Government intervention may result in benefits being distributed across private, industry and community beneficiaries. A project may, for example, produce benefits that divide equally (50–50) between an industry group and the wider community. In this case, under the ‘beneficiaries and funders’ framework, government and industry groups would share funding of the project in equal proportions.

In some cases, applying a ‘beneficiaries and funders’ framework can be difficult. Some government interventions, such as R&D, can produce benefits over long timeframes and after long time lags, making it difficult to identify beneficiaries accurately at any point in time (particularly at the start of the project). Also, beneficiaries may not coincide neatly with the above categories. Research into beef cattle grazing practices, for example, may apply to only certain geographic areas such as high rainfall zones in southern Australia, while an industry-wide levy may source contributions from regions where the research generates no benefits to beef producers (in, say, rangelands). Another example would be Victorian Government funding provided to climate change research on behalf of the broader Victorian community. The beneficiaries of reduced carbon emissions include the rest of Australia and the international community, yet they are not contributing to fund the research.

Alternative approaches to funding government intervention can have different advantages and disadvantages in different contexts,⁸ and should be treated as ‘rules of thumb’. While funding and cost sharing are primarily equity issues, economic analysis can be helpful in quantifying the distributional effects and limitations of particular approaches (Pannell 2004), and in considering whether a proposed approach has implications for efficiency through, for example, changing incentives and behaviour.

⁸ For a helpful discussion of alternative approaches, see Pannell (2004) and Aretino et al. (2001). For a discussion of cost sharing in particular, see Pannell (2009).

4. Role of government in the food supply chain

This section draws on the discussion of market failure in section 3 and the activities identified in table 1 to discuss where market failure could be present along the food supply chain. This informs discussion of whether government intervention might be justified. This section does not present a detailed review of existing government interventions; rather, it seeks to apply the broad framework developed in section 3 to types of intervention taking place along the supply chain.

4.1 Activities along the food supply chain where market failure suggests some role for government

Along the food supply chain, several types of market failure are apparent. Government intervention is thus justified where it generates net benefits—for example, in the areas of practice change and extension, research and development (R&D), biosecurity, animal welfare, food safety, food standards, quality assurance, nutrition and public health, international market access, and trade practices. In these areas, well designed government intervention may enhance efficiency.

4.1.1 Practice change and extension

Government uses practice change and extension programs to improve policy implementation and service delivery in primary industry and natural resource management. The programs are often delivered at the primary production stage of the supply chain—for example, Department of Primary Industries (DPI) extension officers provide on-farm extension advice to landholders. But they are also delivered at subsequent points—for example, the Victorian Government Statutory Authority PrimeSafe may provide extension advice on safe food handling during transport, and Biosecurity Victoria provides advice concerning disease prevention and management at many stages of the food supply chain.

Government intervention in practice change and extension can be justified on economic grounds where it helps produce public goods, such as natural resource management or environmental outcomes. If, for example, extension modifies a farm’s production process in a way that also enhances biodiversity on private land, members of the wider community also enjoy these non-excludable and non-rival benefits from biodiversity.

Practice change and extension can also help produce positive environmental externalities where the benefits spill over to others. Reduced soil erosion, for example, on one property may produce tangible benefits for neighbouring properties and the wider community.

It is important, however, to distinguish such public good outcomes from practice change and extension that results in private benefits captured by the primary producer. If, for example, advice leads to a change to a production process that results in increased profits, then producers face strong private incentives to seek such advice, and there is little role for government to provide it. Government funded practice change may simply displace or ‘crowd out’ extension advice that would have been sought through normal market transactions.⁹

⁹ For a discussion of extension activity in Victoria see DARA (1990) and DFA (1992).

4.1.2 Research and development

Research and development (R&D) is the process of knowledge creation and technology development. R&D undertaken in the public sector is often directed at enhancing productivity at the primary production stage of the supply chain.

R&D is widely considered to be subject to market failure, mainly given the difficulty in appropriating the resulting benefits:

Often those who invest in R&D cannot capture all the benefits—others can ‘free ride’ on the investment in research, using the results and sharing in the benefits without sharing in the costs. Hence private benefits to an investor (or group of investors) are less than the social benefits of the investment, and as a result some socially profitable investment opportunities remain unexploited. When private returns are less than returns to society as a whole, the private sector will underinvest in research from the nations’ point of view. (Alston and Pardey 1996, p. 231)

This inability to appropriate benefits can arise from the nature of agricultural enterprises, and from the nature of R&D.

Agricultural enterprises

The farming sector is generally characterised by competition among a large number of relatively small firms, whereby individual producers can have little, if any, effect on prices of either outputs or inputs. New technologies tend to be generally applicable, making it more difficult for producers to exclude others from adopting new technologies that may emerge from investment in R&D. Market failures in R&D are more likely to emerge in this context (small similar firms, using generally applicable technologies that others cannot be easily excluded from also using), and production agriculture often meets these conditions (Alston and Pardey 1996).

Nature of research and development

R&D can have important public good characteristics leading to market failure. It can generate knowledge that is both non-excludable (nonpayers cannot be excluded from consuming the resulting knowledge) and non-rival (one person’s consumption of the resulting knowledge does not diminish the availability of that knowledge to others). These two characteristics diminish the economic returns derived by the R&D producer, which acts as a disincentive for firms to invest in knowledge creation. If the knowledge generated from their research can be appropriated by others at no or low cost, then the market may ‘fail’ to produce sufficient R&D even though it would be beneficial from a community-wide perspective (Alston and Pardey 1996; Alston, Norton and Pardey 1998).

While market failure can arise at any point along the R&D continuum, from basic research to applied research to technology development and dissemination, the degree of market failure can vary along this spectrum (Alston and Pardey 1999). Basic research involves observing and investigating natural phenomena. This is critical to subsequent technological innovation because such innovation is built on a foundation of basic understanding. A classic example of a basic research project is Albert Einstein’s Theory of Relativity, which became the cornerstone of modern physics (and a great deal of subsequent innovation).

The degree of market failure in basic research tends to be high because such knowledge is difficult to appropriate and is both non-excludable and non-rival. As R&D becomes more applied in nature, the extent of appropriability tends to increase, and non-excludability and non-rivalry tend to diminish. An investor is more likely to be able to capture the benefits of the R&D for themselves (excluding others from capturing these benefits). As a result, the incentives for market players to invest in applied R&D increases, and the role for government tends to decline. Further along the R&D spectrum (moving towards the development and dissemination of specific technologies), the extent of market failure tends to decline further. At this stage, private investors and firms often face strong incentives to invest in profitable technologies.¹⁰

¹⁰ For a more comprehensive discussion and application of the R&D spectrum to the DPI, see Ha (2006).

A further market failure can arise from the presence of externalities (when the production or consumption decisions of one person involve spillover effects on others for which markets do not compensate). An agricultural producer’s activities may, for example, pollute air and water resources. Agricultural R&D can generate knowledge and technologies that could reduce these externalities, but the spillover nature of the benefits means the producer does not face a strong incentive to invest in such R&D. While inappropriability influences the quantity of R&D investment, externalities can distort the composition of R&D investment away from negative externality reducing activities and towards negative externality generating activities (Alston and Pardey 1996).

Risk is a further issue when considering the role of government in relation to R&D. R&D is an inherently risky activity, and the amount of risk (which depends on the stage in the R&D process) also influences whether government may have a role. R&D is subject to two key forms of risk. The first is technical risk, caused by the technical complexity of the research. Technical risk flows from uncertainty about whether the research problem is solvable given current knowledge and tools. The second is market risk, which flows from uncertainty about whether there will be sufficient demand for an innovation that results from R&D. If demand is too low, then funds invested in R&D may not be recovered. This discourages private investment in R&D, particularly at early stages of the R&D spectrum because the results’ potential applications are unknown. As R&D progresses, possible applications become more apparent, allowing firms to forecast future demand better (and reduce market risk).

Both technical and market risks appear to be higher at early stages of the R&D spectrum, given the ‘cutting edge’ nature of that research (Tassey 2005; Ha 2006), suggesting that government intervention may be better targeted at basic R&D. Conversely, where producers invest in a large portfolio of R&D projects, it may be possible to pool research risks along the R&D spectrum so they are relatively insignificant. As a result, the presence of risk may not be a strong justification for government intervention, but rather an element contributing to economies of size, scale and scope in R&D (Alston and Pardey 1996).

Government intervention to correct underprovision of R&D can take various forms (Alston and Pardey 1996), including:

• the creation and enforcement of property rights over R&D output, to increase the degree of appropriability. Patents and plant variety rights are examples of property rights applicable to agricultural R&D.
• the creation of institutions, whereby industry can cooperate to support R&D. This intervention type can include levies and other mechanisms to raise revenue, in an effort to reduce free rider problems.
• the provision of incentives for private firms to undertake R&D, through tax concessions, grants and subsidies
• the provision of funds from general revenue to support R&D.

Where government intervention takes place, the maximisation of net benefits should guide the form of intervention selected. (Note that this paper’s assessment of the role of government in relation to R&D focuses on market failure, rather than the supply chain stage at which the R&D takes place, for example, pre- or post-farm gate.)

4.1.3 Biosecurity

Biosecurity involves the prevention and management of risks to primary producers from pests and diseases. A range of activities can be used to manage these risks (including pre-border risk reduction, border control and post-border strategies), by intercepting or interrupting the transmission of disease threats. Biosecurity also has a quality assurance function to provide consumers with information about the attributes of primary products. Both the Australian Government (for example, the Australian Quarantine and Inspection Service) and the State Government (for example, Biosecurity Victoria) undertake these activities.

Biosecurity is generally considered to be subject to market failure because public good characteristics are present—for example, biosecurity benefits flow to all primary producers in Victoria (non-excludability), and the provision of biosecurity to one primary producer does not reduce the benefit flowing to other primary producers (nonrivalry). Individual primary producers, and even industry bodies, thus have little incentive to invest in national, state or regional surveillance and border security. As a result, where the benefits of biosecurity exceed the costs, and the benefits flow around the state or nation, government often intervenes to provide biosecurity.

Biosecurity can also be subject to externalities arising from differences among agricultural producers. Professional farmers differ from hobby and lifestyle farmers in their objectives (profit seeking and utility seeking respectively), use different technologies and occupy differing parcels of land. In relation to biosecurity, professional farmers may face stronger incentives to monitor and manage biosecurity hazards carefully because they directly reduce profits. Hobby farmers may have less interest in biosecurity issues, because they place less weight on lost profits arising from an incursion, and they derive utility from the work input and existence value of the farming activity. As professional farmers and hobby farmers often coexist geographically, these differences in attitude towards pests and diseases may generate externalities from one group to another. Biosecurity policies may thus need to be tailored to provide incentives specific to different groups of landholders (Ceddia, Heikkila and Peltola 2008).

Also, effective biosecurity activity often requires legislative support to convey powers to manage disease threats, such as the ability to search for incursions or to enforce particular actions. This cannot be provided by private firms and thus requires government involvement.¹¹

¹¹ For a more detailed discussion of the role of government in biosecurity and application to the DPI, see EPRB (2005).

4.1.4 Animal welfare

Animal welfare can be subject to market failure due to the presence of public goods, externalities and information asymmetries. It has public good characteristics because the benefits of animal welfare are both non-excludable and non-rival. As a result, the social benefit of animal welfare exceeds the private benefit, leading private markets to underinvest in the provision of animal welfare.

Externalities in relation to animal welfare can arise where individual producers have lower standards for animal welfare than desired by the wider community. An individual producer, for example, may have relatively low welfare standards when controlling flystrike in sheep. This has a negative (non-monetary) impact on members of the community who would prefer greater animal welfare in wool production. This negative externality reduces overall wellbeing in the community.

Information asymmetry may also be present in relation to animal welfare because consumers cannot readily check the credibility of a claim about animal welfare standards along the supply chain. A producer may, for example, claim to supply free range chickens. It would be costly for a consumer to verify this claim. If consumers were not able to have confidence in the accuracy of this claim they may not be willing to pay the price premium associated with free range chickens. The result would be an undersupply of such goods from a community wide perspective.

Governments have responded to market failure in this area in a number of ways. In Victoria, for example, the Bureau of Animal Welfare is located in the Biosecurity Victoria branch of DPI. It was formed to be the focal point for liaison, coordination and cooperation in animal welfare matters between the Commonwealth, state and local governments, and animal welfare agencies in Victoria. The bureau’s functions include (DPI, 2009a):

• providing administrative and technical support to a range of animal welfare organisations
  
• resolving issues raised by animal welfare agencies and organisations responsible for animal welfare and management
  
• facilitating the operation of relevant Acts and Regulations
  
• reviewing and developing codes of practice, guidelines and standards
  
• regulating the use of animals in research and teaching
  
• providing representation on the Primary Industry Standing Committee's Animal Welfare Committee
  
• monitoring animal welfare developments in other states/territories and countries
  
• establishing minimum standards—for example, caged hens must be provided with minimum amounts of cage floor space.¹²

4.1.5 Food safety

A breakdown in food safety can generate significant costs and cause substantial distress for those affected and for the wider community. The 1997 outbreaks of salmonellosis in Victoria, for example, affected over 800 people and caused two deaths. Food Standards Australia New Zealand (FSANZ) estimated in 1999 that Australia had over four million cases of food borne illness per year that cost the Australian community over $2.6 billion annually (FSANZ 1999).¹³ Food safety is also increasingly important due to improvements in our understanding of food borne illness, the evolution of new pathogens that present new risks to food safety, and increased public awareness of new food borne risks (Unnevehr and Roberts 2002). Food producers face consumer demand to supply safe food, so as to protect their own reputation and enable access to markets (Fulponi 2006). Food safety can be subject to market failure, however, particularly in relation to information problems.

¹² For a more detailed discussion of the role of government in relation to animal welfare, see DPI (2004).
¹³ It is difficult to obtain reliable data on the incidence and full cost of food borne illness in Australia, partly because food related illness is underreported, and it is difficult to attribute costs to outcomes such as pain, death and grief (FSANZ 1999).

Food safety and information

Food safety is an important quality attribute of foods, along with taste and nutritional value. Where accurate information is readily available to both producers and consumers, markets will likely produce efficient levels of food safety (namely, the amount of food safety that consumers are willing to pay for). Both producers and consumers can readily observe, for example, whether fruit is rotten or contains wormholes, and make well informed decisions about sale and consumption (Antle 1996).

Where information is poor in quality and/or costly to obtain or transfer between parties, food safety concerns become more significant. As discussed, imperfect information in the area of food safety can take two broad forms: information asymmetry and imperfect information for both producers and consumers. The likelihood that government need intervene will depend on the nature and degree of information failure.

Information asymmetry

Where information asymmetry is present, private incentives may still be sufficient to produce efficient levels of food safety by way of a reputation mechanism, or through product certification and labelling. Consumers may not have perfect information about the safety attributes of meat before purchase, for example, but if they become ill after purchase and consumption, then they may be able to attribute the illness to the meat. Here, the presence of a reputation mechanism can help to produce efficient levels of food quality. If consumers are repeat customers, then suppliers of safe (unsafe) food will build a good (bad) reputation and be able to charge higher (lower) prices, thus signalling safety attributes to consumers. Even in cases where consumers are not repeat customers, markets may still produce efficient levels of food safety if consumers can obtain or exchange accurate information about food safety at low cost. Businesses face incentives to provide safe food to consumers to generate repeat business and increase profits, and to avoid the loss of business and reputation damage that may follow a food safety breakdown (Antle 1996; Edwards 1997; VCEC 2007).

In other cases of information asymmetry, consumers may not be able to gain information about food safety either before or after purchase and consumption. Chronic low exposure to toxins in food, for example, may not result in immediate illness but may have a negative health impact after a delay of many years or decades. As a result, it may be difficult for consumers to attribute illness to consumption of a contaminated food, so a reputation mechanism will not be effective. Product certification and labelling, however, can be effective in addressing such information asymmetry. A third party, for example, may certify that a product is organic and no chemicals were applied during the production process. This information can be included in the labelling, allowing producers to charge a higher price for chemical-free foods (Antle 1996).

Where information asymmetry is present and mechanisms such as reputation, certification and labelling emerge, producers of higher quality and safer foods will be able to charge a price premium. Where such mechanisms do not emerge, however, a process of adverse selection can result, whereby low quality producers drive out high quality producers in a market where quality is not readily observable (Starbird 2005). As a result, markets may fail to produce higher quality foods, so an efficient level of food safety will not be achieved. In some cases, it may be efficient for government to intervene (by, for example providing product certification services) to overcome such information asymmetry.

Imperfect information for producers and consumers

When information is imperfect for both producers and consumers, two cases can be distinguished. First, the food safety status of particular foods may be unknown to both producers and consumers, but can be revealed through, for example, scientific/laboratory testing. Where such testing is accurate, the producer will know this information, and information asymmetry may occur. In this case, markets may achieve efficient food safety through reputation mechanisms, certification and labelling as discussed (Antle 1996). If these mechanisms do not emerge or are not effective, and market failure persists, then government may have a role to address the information asymmetry.

Second, food safety status may be unknown to both producers and consumers, and cannot be readily revealed—this is a case of true uncertainty about food safety. Accurate tests for the presence of particular contaminants may not be available, or the link between a contaminant and food safety status may be unclear. The problem is thus not one of information asymmetry, and solutions such as reputation mechanisms, certification and labelling will not be effective. Rather, research will be needed to improve understanding of contaminants and their relationship to disease (Antle 1996)

Implications for government intervention

Markets are well placed to deliver efficient levels of food safety where producers and consumers are well informed, and information about food safety is available at low cost. Even where information asymmetry is present, private incentives can deliver efficient food safety through reputation mechanisms, certification and labelling if these mechanisms can be established at reasonable cost. The areas of greatest concern for public policy occur where information asymmetry is present and information costs are high, or where food safety information is imperfect for both producers and consumers. In these cases, markets are unlikely to produce efficient food safety outcomes. Importantly, these features appear common in cases of food borne disease and chemical contamination, suggesting a role for government in these important areas of food safety (Antle 1996).

Where government intervention in relation to food safety provides net benefits, options include consumer education and labelling, regulation, traceability, and quality assurance.

Consumer education and food labelling

Commonly, governments introduce labelling requirements to enhance the information provided to consumers and to enhance food safety. Food produced for sale in Australia, for example, is subject to packaging and labelling requirements specified under the Australia New Zealand Food Standards Code. The code’s part 1.2 requirements that have implications for food safety include mandatory warning and advisory statements and declarations, date marking, and directions for use and storage (FSANZ 2009).

Food regulation

Governments may seek to improve food safety through regulatory tools. These take two main forms: design standard regulation and performance standards. The former may, for example, prescribe the design and management of a production process to enhance food safety. The latter establishes, for example, permissible levels of bacteria or contamination in a food product but allows producers flexibility in how they achieve a given performance standard. Economists tend to favour performance standards because they allow producers to find least cost methods for achieving or exceeding any standards (Antle 1996).¹⁴ In practice, regulatory frameworks often include elements of both design standard regulation and performance standards. Further, regulation is usually supported by inspections and penalties to strengthen private incentives in relation to food safety by increasing the financial risk associated with supplying food that does not meet food safety standards (Starbird 2005).

Traceability

Traceability systems are an information management tool that allows agents along the food supply chain to prevent or respond to food safety incidents. Firms invest in traceability for a range of reasons,¹⁵ one of which is to improve food safety. Firms face private incentives to invest in traceability where the private marginal benefits exceed private marginal costs. Private benefits of traceability include an improved ability for firms to identify the source and extent of a food safety problem, and to track product distribution and target recall activities. This ability can reduce the extent of damage and liability from the problem, and achieve a more rapid resolution (Golan et al. 2004; Souza Monteiro and Caswell 2008).

Firms may underinvest in traceability, from a community-wide perspective, where the potential social benefits of traceability exceed benefits to the firm. These social benefits include important avoided costs such as medical expenditures and lost productivity due to food related illness, the costs of pain and suffering, and the costs of premature death. Firms may also under-invest in traceability if there is value in anonymity. Accurate traceability systems may increase the likelihood that a firm will be identified and associated with a food safety problem, so exposed to liability or other sanction (Golan et al. 2004). Where traceability is incomplete and this enhances anonymity, firms may also seek to free ride on the producers of safer food (Pouliot and Sumner 2008).

Government intervention to increase traceability can take two broad forms. The first is mandatory traceability, whereby government determines and prescribes traceability systems for firms. The second is the development of performance standards, whereby firms need to be able to identify and recall food products within certain timeframes and standards. Such standards can be tested by means of simulated recalls. A key advantage of performance standards over mandatory traceability is that it allows firms to innovate and implement least cost approaches to achieve any particular standard (Golan et al. 2004).¹⁶

¹⁴ Whether regulation takes the form of design standards or performance standards, the question remains as to where any standard should be set. Given that increased standards come at only increased marginal costs, this question can be resolved only by benefit–cost analysis (Antle 1996).
¹⁵ Firm motivations for investing in traceability include protecting the reputation of a product, firm, industry or country; differentiating products by suppliers who provide traceability; guaranteeing product origin; improving supply management; monitoring or assuring production and processing methods; improving product recalls; and pursuing protectionism (Pouliot and Sumner 2008).
¹⁶ The development of new technologies can also influence the costs and benefits of tracing. In Australia, food retailers have typically used manual paper based tracing systems, but major supermarket chains have more recently trialled new systems for tracking and tracing foods along the supply chain, using Radio Frequency Identification (RFID). RFID allows a supplier to know the location of a crate of stock in the supply chain at any point in time. However, the costs remain high and the return on investment has not yet been sufficient to allow adoption (Food and Beverage Online 2008).

Quality assurance

Quality assurance programs for Victorian and Australian food sales to domestic and export markets are based on the premise that Australia’s reputation for food production influences overseas buyers of Australian food products. Quality assurance initiatives can manage the risks to market access, in an effort to maintain the price premiums that would be disrupted in the event of a pest or disease outbreak, or a negative spillover from a hygiene breakdown by one supplier. They do so by conveying information about the product or the population from which the product is drawn—a process that is costly and difficult for consumers to undertake (EPRB 2005). Further, some foreign governments require government certification of exports’ compliance with phytosanitary standards as a condition to access their markets, so regulating these standards may enhance market access (Edwards 1997; VCEC 2007).

The need for well designed intervention

Consideration of the role of government in food safety needs to account for existing private incentives for producers to ensure food safety. These incentives appear to be strengthening over time, given improved awareness, surveillance and testing (Roberts 2005) Intervention needs to be sensitive to the nature of any information failure, the circumstances in which private incentives may be insufficient to produce efficient food safety outcomes, the tools available for government intervention, and the relative costs and benefits of those tools. Government intervention may duplicate, facilitate or destroy private incentives and initiatives to achieve food safety outcomes along the supply chain, so it is important to ensure intervention produces net benefits.

4.1.6 Verifying credence claims

Consumers appear to be placing increasing importance on claims regarding credence attributes (such as organic production) for food products. This trend is related to rising incomes and concerns about personal health and the environmental impact of food production (Cole and Harris 2003). Such claims are typically made at the retail and food services points of the food chain.

Credence claims are subject to information asymmetry, but not the type of uncertainty for both buyers and sellers that can arise in relation to food safety (discussed above). Producers of organic products, for example, have accurate information about the organic nature of the production process, but consumers cannot easily verify these claims before or after consumption. Verification would require rigorous inspection of the primary production process to ensure, for example, that chemicals were not used at any place or time.

Further, misleading claims in relation to credence goods may lead to some loss of utility for consumers. This outcome, however, is unlikely to generate the human and economic costs resulting from a food safety breakdown.

In certain circumstances, private markets can develop mechanisms to respond to this information asymmetry and thus provide reasonably full information about credence attributes. These market responses include signalling and third party verification or endorsement. Organic producers, for example, can gain certification from Australian Certified Organics (ACO), an Australian certifier of organic and biodynamic produce. Owned by Biological Farmers Australia (an industry body), ACO certifies about 55 per cent of the Australian organic industry and facilitates marketing of organic produce to both domestic and international markets (ACO 2008). Producers can use this verification to signal to consumers that the credence claims are credible, and thus gain a price premium. Producers who can make a credence claim will do so, and consumers will assume any products not carrying such claims do not possess credence attributes. This process requires, however, that consumers make certain assumptions, that they are aware credence claims are being made, that the claims are truthful, and that credence attributes are not present in any product not making such claims (Caswell and Padberg 1992).¹⁷

¹⁷ An additional form of signalling can take place through investments in reputation. If firms make specific non-salvageable investments that would be lost if they are caught cheating in relation to credence claims, then the potential cost of making inaccurate claims increases (Cole and Harris 2003).

Where these conditions are not present and information asymmetry persists, there may be a role for government intervention. Options for intervention include labelling requirements, support for the development of ‘metrics’, and enforcement activity.

Labelling requirements can include credence attributes. Food produced for sale in Australia is subject to packaging and labelling requirements specified under the Australia New Zealand Food Standards Code. Under part 1.2 of the code, requirements that address credence attributes include labelling of ingredients, the characterising of ingredients and components of food (for example, genetically modified organisms), and country of origin (FSANZ 2009). Importantly, labelling can address information asymmetry through mechanisms other than direct information provision. Labelling regulation can, for example, influence product formulation and re-formulation. Producers may design a product so it can adopt a particular labelling term (such as ‘low salt’) or to provide better results in an important labelling category (such as fibre content). They may also avoid using certain ingredients so they will not be noted on the label. This can take place even if consumers do not widely use label information, so long as consumer groups (or a segment of consumers) use labels and publicise the results (Caswell and Padberg 1992).

Other important roles of labelling requirements include influence over advertising (because firms coordinate label and advertising messages to ensure consistent product image) and a public assurance role (because the presence of labelling regulation gives consumers confidence that ‘someone’ is supervising food claims). Further, regulators’ choices regarding the information required on labels signals to producers and consumers what attributes might be significant (Caswell and Padberg 1992).

Systems of measurement, or ‘metrics’, are also an important contributor to supporting credence claims. They allow accurate measurement of a product’s credence attribute before that claim is communicated to the consumer through, for example, labelling. Developing such metrics may require R&D effort that individual producers have little incentive to undertake, given the presence of public goods. Where metrics are an efficient response to information asymmetry, government intervention may be needed to undertake such R&D and develop the resulting metrics (Cole and Harris 2003)

Government intervention in the form of enforcement activity includes monitoring firms’ conduct and applying penalties for misleading or deceptive product claims. Government agencies—such as the Australian Competition and Consumer Commission (ACCC) and Consumer Affairs Victoria—are active in this area.

In conclusion, goods with credence attributes may be subject to some degree of market failure in the form of information asymmetry. In some cases, markets have developed responses to provide consumers with reasonably full information about credence attributes. Where these conditions are not met and information asymmetry remains, government may have a role in improving the information provided to consumers.¹⁸

¹⁸ For a more detailed discussion of the role of government in relation to credence goods, see Cole and Harris (2003).

4.1.7 Food and public health, nutrition and healthy eating

Nutritious food and healthy eating contribute to good health across the community, and can reduce the risk and cost of various diseases. The estimated economic cost to the nation of the principal diet related conditions (such as coronary heart disease and stroke, and diabetes) is about $6 billion a year (NHMRC 2003a).

Public goods and externalities

Private markets may fail to invest adequately in good nutrition and healthy eating, given public goods and externalities associated with information and illness. Public goods are generated, for example, through basic research into micro-nutrients in food products to better understand their possible interaction and subsequent human health impacts. DPI supports and funds R&D of this type through Food Science Australia. Negative externalities can also be generated where unhealthy eating and lifestyle produce health costs that the wider community then bears.

Food and health—a complex relationship

While market failure, in the form of public goods and externalities, is present in relation to health and nutrition, government intervention must be carefully designed because the relationship between food and health outcomes is complex and not fully understood. Diet is only one factor influencing health status, and it effectiveness depends on the whole composition of the diet, not the nutritional profile of individual foods (Caswell and Padberg 1992). Many factors acting in combination determine the health of individuals and populations. These include broad social factors (such as cultural practices, social systems and public policy settings), socioeconomic characteristics (including education, employment, income and wealth), health behaviours (including tobacco use, physical activity, alcohol consumption, use of illicit drugs, dietary behaviour, sexual behaviour, vaccination status) and biomedical factors (for example, blood pressure, cholesterol, weight, immune status) (AIHW 2008). Genetic factors and random events affecting health may further complicate the relationship between food and health outcomes. As a result, government intervention in relation to any one of these factors in isolation (say, promoting healthy food) may be an indirect, costly and ineffective way to achieve a particular public health outcome.

Also, nutrition and health outcomes vary across the community. The health of Australians living in rural areas is poorer than that of people in the cities. Rural Aboriginal and Torres Strait Islander peoples often face greater nutritional challenges than those of other Australians (NHMRC 2005). Government intervention may thus need to be carefully targeted to achieve health outcomes.

Government intervention

The Commonwealth and state governments have intervened in a number of ways to promote good nutrition and healthy eating. The Australian Government, for example, has been providing nutrition information and advice to the community since the 1920s. In recent decades, the National Health and Medical Research Council (NHMRC) has developed and distributed guidelines providing dietary advice (in a range of formats) for Australian adults, children and adolescents. These guidelines promote the potential benefits of healthy eating, to reduce the risk of diet related disease and improve the community’s health and wellbeing. The NHMRC dietary guidelines recommend consuming a wide variety of nutritious foods, including a high intake of vegetables, legumes, fruits and cereals; limiting saturated fats and moderating total fat intake; choosing foods low in salt; limiting alcohol intake; and consuming moderate amounts of sugars. The guidelines also urge physical activity, encourage and support breastfeeding, and promote careful preparation and storage of food (NHMRC 2003a; NHMRC 2003b). Additional information about food, nutrition and diet is available through local community health centres; Commonwealth, state and territory departments of health; baby, child and youth health centres; hospitals; and community centres (NHMRC 2005).

The Go for Your Life campaign is a Victorian Government initiative that promotes healthy eating and increased physical activity. The campaign provides advice in areas including diet, food and nutrients, nutrition and illness, healthy weight and body image, and food safety, by means of the internet (www.goforyourlife.vic.gov.au) and a telephone information line. Information targets teenagers, young adults, adults, children and families, and older adults.

Government has also intervened via regulatory tools, including labelling requirements in relation to nutrition. Food produced for sale in Australia is subject to packaging and labelling requirements specified under the Australia New Zealand Food Standards Code. Under the code, labelling must provide information about ingredients and nutrition (FSANZ 2009).

Level of government and agency

The above factors mean the question of which level of government (and which agency) is most appropriate to address food related public health issues is particularly important. Government health agencies at national and state level have clear responsibility for health policy. Government primary industry agencies are unlikely to have the skills to lead interventions where health is a primary goal, and appropriate health agencies need to be fully engaged in designing and implementing government interventions in this area.

4.1.8 International market access

Governments and individuals can act to enhance individual and collective access to overseas markets for products sourced from Australia or Victoria—for example, by negotiating to reduce trade barriers such as tariffs, quotas and taxes. Such market access activity is subject to market failure in the form of externalities—that is, gains in international market access accomplished by an individual could provide a positive externality or spillover to other participants in an industry. If, for example, one domestic supplier is able to negotiate access for their product, then other domestic suppliers of that product might also enjoy increased market access. All suppliers would thus have incentives to free ride on the efforts of others, so collective investment in market access activities would be socially suboptimal.

Markets may also underinvest in market access activity where the risk of failure for an individual initiative to reduce a market access barrier is too high for private firms to bear. In some cases, private firms may be able to invest collectively in a number of market access initiatives to diversify, and thus reduce, this risk. Where markets underinvest in market access activity due to the presence of externalities and risk there may be role for government intervention to stimulate additional market access activity.

Government’s role in biosecurity (discussed earlier) can also generate net benefits in relation to market access—for example, through the accreditation of food products to meet phytosanitary standards required for international markets.

Further, changes to trade barriers usually require changes to regulations or legislation that require government involvement in any market access activity. Existing intergovernmental trade relationships may also provide information and expertise (that may be unavailable or prohibitively costly for private firms to attain) to facilitate market access for Australian and Victorian food producers. Information on particular export markets can be made available to private firms, which have an incentive to acquire this information if it will give them an advantage in increasing market share once market access has been negotiated at a government level. Such services are generally provided for a fee by private companies and governments. Austrade, for example, provides general export advice at no charge, and it provides tailored advice to thousands of Australian companies each year based on a quote in advance, at an hourly rate of $190 (Austrade 2009a).

A number of Commonwealth and state government agencies are active in the area of market access, including the Australian Department of Foreign Affairs and Trade, Austrade, the Victorian Department of Innovation, Industry and Regional Development, and DPI. Careful coordination is needed to minimise the risk of service duplication and confusion for private firms about where to source information. Also, issues of efficient jurisdiction need consideration: where the benefits of market access flow to a number of states or to the nation, Australian Government agencies may be better placed than state/territory agencies to invest in market access.

4.1.9 Trade practices

Issues of market power in the food supply chain have received attention in recent years. The focus has been on the retailing sector, in which perceptions of industry concentration and market power have been more acute than in the primary production sector, for example, in which firms are widely considered to be ‘price takers’ with little or no ability to exert market power.

Regulation of market power is provided at a national level in the Trade Practices Act 1974, which the ACCC administers. The role of the ACCC is to (ACCC 2008a):

… promote competition and fair trade in the market place to benefit consumers, business and the community … Its primary responsibility is to ensure that individuals and businesses comply with the Commonwealth’s competition, fair trading and consumer protection laws.

The Victorian food retailing industry contains approximately 17 000 businesses, but sales are concentrated through Coles (185 supermarkets) and Woolworths (184 supermarkets). Sales by these two large supermarket chains represent 70 per cent of all packaged goods and 50 per cent of all fresh food sales (ACCC 2008b; VCEC 2007). This apparent concentration in the retail market has raised concerns about market power, and in 2008 the ACCC undertook an inquiry into the competitiveness of retail prices for standard groceries. The inquiry’s key findings included the following:

• Grocery retailing is workably competitive, but a number of factors limit price competition, including:
• high barriers to entry and expansion (particularly in relation to location)
• limited incentives for the two major retailers (Coles and Woolworths) to compete aggressively on price
• limited price competition for the two major retailers from independent retailers, although ALDI has been a vigorous price competitor since its entry into Australia.
• Any possible weakening in the level of competition in retailing is unlikely to have been a substantial contributor to food price inflation in Australia. The majority of grocery price increases in Australia can be attributed to supply and demand changes in domestic and international markets, increased production costs and domestic weather conditions
• The ACCC did not identify anything fundamentally wrong with other components of the grocery supply chain. Generally, movements in farm gate pricing are set by supply and demand in competitive markets, and movements in shelf prices over time reflect changes in the wholesale prices that large retailers pay suppliers.

The ACCC supported changes in areas including unit pricing, zoning and planning laws, and acquisition law. It did not support measures such as capping the market share of retailers or separating wholesale and retail divisions of major retailers, on grounds that these changes would likely have adverse efficiency effects and weaken the competitive environment, so would have the potential to increase grocery prices for consumers (ACCC 2008b).

In addition, price competition is one important factor in generating competitive outcomes, but retail outlets also compete on the basis of other features, including store location, product range and quality, queuing time, opening hours and access to car parking (Spencer 2004).

4.2 Activities along the food supply chain where market failure is not evident, suggesting no role for government

Some activity along the food supply chain does not appear to be subject to market failure, including the facilitation of agribusiness activity in international and domestic markets. There is no clear role for government intervention in these areas on efficiency grounds.

Facilitating agribusiness activity, in contrast to market access, refers to activities supporting private firms or industry groups to increase sales, market share and, consequently, profits in overseas and domestic markets. Exports and imports (both interstate and overseas) produce important benefits for the Victorian economy, but the benefits of trade are greatest when exports are not subsidised and imports are not restricted. Exports that have to be 'facilitated ' by government reduce the benefits from trade because the resources used to produce these exports could have been more productively employed elsewhere in the economy (Industry Commission 1992).

In particular, if agribusiness activity results in increased sales and profits (that exceed the costs of the support and facilitation), then private firms along the food value chain face strong incentives to fund such activity either individually or collectively. If such activity does not produce net benefits, then there are no incentives to fund such activity. This does not mean there is a market failure. If the costs of international or domestic market facilitation outweigh the benefits, then the market is providing valuable information about the value of a particular initiative.

Based on the above analysis, the facilitation of agribusiness activity in international and domestic markets is not subject to public good characteristics or externalities. The benefits derived from it generally take the form of increased profits to the private firm(s) being supported.

Apart from issues related to food safety (discussed earlier), the facilitation of agribusiness activity in international and domestic markets does not appear to be subject to market failure in the form of information asymmetry either. While there may, in some cases, be a lack of information about markets or products, this does not constitute a market failure whereby one party to a transaction has more information than the other party (hidden information) or one party can influence the outcome of a transaction by behaving in certain way that is unobservable to the other party (hidden action). Lack of awareness of Victorian products in foreign markets, or lack of market penetration of Victorian products in foreign markets does not constitute information asymmetry because there is no information advantage to any party.

Given the absence of public goods, externalities or information asymmetry there is no justification for government intervention on efficiency grounds. Further, where government does intervene in the facilitation of agribusiness activity it may simply ‘crowd out’ private sector marketing initiatives that would have taken place, or expanded, in the absence of government intervention.

In some cases, facilitating agribusiness activity in international and domestic markets produces benefits for an industry or a number of firms, in which case industry collectives have an incentive to fund marketing activity. Conversely, if marketing activity does not produce net benefits, then there are no incentives to fund such activity.

Despite the absence of market failure, governments continue to take an active role in facilitating agribusiness activity in international and domestic markets. The Australian Government is active in this area through agencies such as Austrade (including programs such as the Export Market Development Grants initiative, the New Exporter Development Program, Business Club Australia, Women in Export, and Exporting Online) (Austrade 2009b; Mortimer 2008a and 2008b). Similarly, the Victorian Government is active through the Department of Innovation, Industry and Regional Development (including initiatives such as the Export Network Program, the First Step Export Program, the Trade Start Program, the Collaborative Export Marketing program, the Access America and Access China programs, and the Industry Capability Missions program) (DIIRD 2009), and through the DPI Agribusiness group (DPI 2009). Where government intervention takes place in the absence of market failure, objectives must be clearly specified and pursued as efficiently (at least cost) as possible.

5. Summary and conclusion

The food supply chain in Victoria (and Australia) is characterised by a range of activities, including production, manufacturing, imports, exports, retailing and food services. Its economic efficiency would be enhanced by the development and application of a clear framework for considering the appropriate role of government along this supply chain. This would assist the government to ensure any intervention is carefully targeted to areas of market failure.

Markets can fail for a number of reasons, including the presence of public goods, externalities, market power and imperfect information. Evidence of a market failure is a necessary but not sufficient condition to justify government intervention. Government intervention can be costly, and the benefits from intervening in the market must outweigh the costs to justify government intervention. The instrument of policy and its design should thus be chosen to maximise the net benefits from intervention.

The relevant measure of the cost of government intervention in the food supply chain is the opportunity cost of such intervention. When resources for intervention are constrained, the net benefits from intervention in the food supply chain have to be weighed against the net benefits of intervention in other important areas of government activity.

Another element of the optimal policy is the selection of which level of government to intervene—that is, Commonwealth, state or local government, or some combination, and which agencies. The answer depends on the nature of the market failure; the benefits of centralisation, decentralisation and cooperation between agencies; the constitutional division of powers between the states and the Commonwealth; and other specifics.

Along the food supply chain, market failures are apparent to varying degrees in some areas, justifying some government intervention. These areas include extension and practice change; research and development; biosecurity; animal welfare; food safety; credence goods; food and public health, nutrition and healthy eating; international market access; and trade practices. In these areas, well designed government intervention may enhance efficiency.

In other areas of the food supply chain, clear market failure is not evident, and there is no rationale for government intervention on efficiency grounds. (This is particularly the case for the facilitation of agribusiness activity in international and domestic markets.) Where government intervention in these areas takes place on grounds other than market failure, objectives must be clear and intervention must be as cost effective as possible.

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7. Glossary

biosecurity—the prevention and management of risks to primary producers from pests and diseases

credence attributes—attributes that consumers cannot reasonably check before or after consumption

externalities—some benefit or cost to a third party outside of a market transaction, for which the parties to the transaction did not account

food supply chain—primary production, food manufacturing, retailing, food services, international trade and transport of foods

imperfect information—information asymmetry and information uncertainty (see below)

information asymmetry—when one party to a transaction has more information than the other party (hidden information) or one party can influence the outcome of a transaction by behaving in certain way that is unobservable to the other party (hidden action)

information uncertainty—when both parties to a transaction lack information about the characteristics of a good or service that results in an inefficient allocation of resources or imposes costs on the community

international agribusiness marketing—activities to promote particular food products to international markets with the aim of increasing market share, production and, consequently, profits

international market access—activities designed to reduce barriers and enhance access to overseas markets for products sourced from Australia or Victoria

market failure—when markets are unable to allocate resources to their most efficient use

market power—a firm can influence the price/quantity of goods in a market for increased profits, such that allocation of resources in that market is inefficient

market risk—uncertainty that there may be sufficient demand for an innovation that results from R&D, discouraging private investment in R&D because applications from the basic research phase are unknown

opportunity cost—the value of a resource’s alternative uses, forgone when the decision is made to use the resource in a particular way

public goods—goods that are non-excludable (that is, non-payers cannot be excluded from consuming the good or service once it is provided) and non-rival (consumption by one person does not diminish the availability of the good or service to others) in their consumption.

signalling—when a party to a transaction credibly provides information (usually via third party verification) to the other party to overcome some information asymmetry. An example is an employee gaining educational qualifications to signal to a potential employer their ability to learn and their work effort. This is information that an employer cannot observe before hiring.

technical risk—risk from the technical complexity of research, which flows from uncertainty that the research problem is solvable given current knowledge and tools

transaction costs—the costs incurred in procuring or selling goods/services on the market. These costs can include search costs, negotiation/bargaining costs and enforcement costs.