“Fair Trade,” Market Failures, and (the Absence of) Institutions

Abstract

This paper presents an analysis of Fair Trade using a general equilibrium model of an economy where externalities are present and where the institutional or legal framework needed to regulate these externalities may be weak. Weak institutions and externalities are common in the developing world, where Fair Trade is targeted, making perfect competition models inappropriate measures of the value of Fair Trade. Members of Fair Trade cooperatives are required to adopt sustainable production methods, and not employ other socially harmful practices such as child-labor. Thus, Fair Trade organizations can serve as a complement to the existing weak institutions in the economy, creating incentives for entrepreneurs to move from the informal to the formal sector. Specifically, the analysis confirms that in many cases an increase in the Fair Trade premium can reduce the overall level of harmful activities, even from those producers who are not Fair Trade certified, and thereby raise welfare.

Keywords::

• Fair Trade
• efficiency
• institutions
• externalities

Notes

¹ The exception is Richardson and Stahler (2007) who study Fair Trade cooperatives within an oligopolistic market. Fair Trade cooperatives produce a higher quality product; however, the quality of this product depends on the effort of each member in the cooperative. Since effort is unobservable, there is moral hazard, and expanding the size of the cooperative increases the moral hazard problem, which in turn lowers both product quality and welfare.

² It should be noted that there is a growing literature on Fair Trade, the majority of it focus on the equity implications of fair trade. Therefore, much of this literature conducts impact studies of Fair Trade (see Kadow 2011). Since our paper studies the efficiency implications of Fair Trade, we choose not to discuss these studies, except where relevant to our paper. Also, it should be noted that there is a large literature on Fair Trade in the popular press that we do not discuss in this paper.

³ It should be noted that in addition to the above criteria, admission to a Fair Trade cooperative is typically restricted to small and family-based producers. See Nichols and Opal (2004, Chapter 6) for a detailed discussion of these restrictions.

⁴ Although we specify a model where the formal sector produces a positive externality and the informal sector 0 positive or negative externality, it is isomorphic to a model where the informal sector generates a negative externality while the formal sector 0 externality. The results in both cases are identical, but we choose the former approach because it was intuitively easier to graph the impact of the formal sector in the positive quadrants (e.g., see Figure 1).

⁵ The support of this distribution may be the result of normalization. For example, if , then by dividing all parameters in this model by all costs and prices in this model are denominated in this cost . Note also that e represents the cost conditional on working in the formal sector. If agents work in the informal economy or for the government, this cost is avoided.

⁶ Fraction may be interpreted as the probability that a farmer's application to become Fair Trade certified is approved. Nicholls and Opal (2004, Chapter 6) state that certification requires a prior inspection and regular audits by the certifying organization in order to ensure that producers are compliant with Fair Trade requirements. Thus, not all producers can become certified (see also footnote 3). Alternatively, suppose the cost of becoming Fair Trade certified is 0 with probability and c>0 with probability , and these costs are revealed only after the farmer joins the formal sector. If c is sufficiently large, a fraction of the formal sector will become Fair Trade certified.

⁷ Our result that an increase in the Fair Trade premium is welfare enhancing only under some conditions should be contrasted with the welfare results in Kadow (2011) who shows that Fair Trade is only sometimes welfare enhancing. In our framework, an expansion of Fair Trade improves welfare because it strengthens institutions, whereas Kadow's model Fair Trade improves welfare because it makes ethically produced products more available to altruistic (ethically conscious) consumers in the North. Our welfare results should also be distinguished from those of Richardson and Stahler (2007) who find that an expansion of Fair Trade always reduces welfare because it aggravates the moral hazard problem. This result, however, depends on their assumption that increased effort reduces costs. If this assumption were relaxed, then the welfare effects of expanding Fair Trade would also be ambiguous.

⁸ Given that Fair Trade is common in developing countries, where institutions are weak, this is an unlikely case.

⁹ This can be seen by substituting into the expression for and recognizing that (derived in the appendix).

¹⁰ Substituting the expressions for and into the expression for yields . As and approach , the expression becomes strictly negative because . Since , if or is small, the government cannot afford to incentivize the formal sector regardless of .

¹¹ Acemoglu (2005) makes a similar assumption by assuming that agents choose to hide some of their output, where hidden output is not subject to taxation.

Additional information

Notes on contributors

Andrew Samuel

Andrew Samuel is Assistant Professor of Economics at Loyola University MD, where he teaches courses in Game Theory, Contract Theory, and Microeconomics.

Fred W. Derrick

Fred W. Derrick is Professor of Economics at Loyola. He teaches statistics but is interested in research that seeks to integrate issues of social justice into economics.

Charles Scott

Charles Scott is Professor of Economics at Loyola University MD, where he teaches applied microeconomics at the MBA level. He is interested in the intersection of microeconomics and socially responsible business practices.