In Some Markets, Competition Can Do More Harm Than Good

One might assume, then, that in emerging economies, introducing more competing players into an industry could only strengthen it. But policymakers would be wise to pause before embracing competition wholeheartedly. In some types of markets, it could do harm.

Ameet Morjaria, an associate professor of managerial economics and decision sciences, came to this surprising conclusion after conducting an extensive study of the coffee industry in Rwanda. The key variable seems to be that farmers and mills in Rwanda typically rely on informal agreements with each other rather than legally binding contracts. In areas with more competition among mills for coffee farmers, the researchers found, those relationships tended to break down—leading to higher operating costs for mills, more dissatisfaction among farmers, and lower-quality coffee.

The idea that competition is beneficial rests on an assumption that contracts work properly, that we are in first-best environments, Morjaria says. But when contract enforcement is weak, he says, “competition—this market force that we have all come to adore—might cause more harm than good.”

Testing the Relationship

The study, conducted with Rocco Macchiavello at the London School of Economics and Political Science, arose from two main questions.

First, the researchers wanted to know how policymakers could improve the welfare of smallholder coffee farmers. These farmers’ incomes often hover near the poverty line.

Second, they wanted to explore the effects of competition on informal agreements, also known as relational contracts. The general understanding among researchers is that in markets without strong legal enforcement, relational contracts are important to sustain business transactions. But if the number of players in the market increased, perhaps suppliers would be tempted to break their agreements with clients and sell their wares to another buyer.

“If there’s competition, it’s going to test that relationship,” Morjaria says.

To investigate, he lived in Rwanda for several months in 2012 and worked with the government’s National Agricultural Export Development Board (NAEB) to survey coffee farmers and mills to collect the data necessary to do the analysis. Living in Rwanda was necessary because this sort of relationship data is context specific and can’t be gathered by gleaning secondary data.

In the decade prior to his trip, competition had gradually grown significantly among mills, from there being only a few to a couple hundred, while the number of farmers grew at a slower rate. The reason for the growth in mills was their ability to process higher-quality coffee than that processed by farmers on their own at home.

At the time of Morjaria’s visit, a typical mill bought coffee cherries—the fruit from which coffee beans are derived—from about 400 farmers. Agreements between mills and farmers might consist of a few interlinked transactions over a harvest cycle. First, the mill might invest in the farmer’s success by providing supplies, such as fertilizer, prior to harvest. Second, in return for this support, farmers would be expected to sell their coffee cherries to the mill, both as a spot transaction and the rest on credit, meaning the mill promised a second payment later in the season after selling the coffee to exporters.

The idea that competition is beneficial rests on an assumption that contracts work properly, that we are in first-best

And third, the mill could continue helping the farmer after harvest—for instance, by loaning them money to replant trees. That type of additional transaction—one that goes beyond the simple buying and selling of coffee at harvest time—is “a sign of a healthy relationship,” Morjaria says.

Circle of Competition

Morjaria spent several months with key staff from NAEB to recruit and train a team of enumerators to run a census of the industry. Four survey teams of five enumerators each traversed the country over several months to interview mill managers. They asked about the transactions that took place between farmer and mill within a harvest cycle and captured quantitative data such as operational details on production capacity and detailed accounts of processing costs, as well as qualitative data on farmer welfare.

The team also selected a random sample of five farmers near each mill to survey about information such as the amount of coffee cherries the farmers sold to the mill, how much they processed themselves, the price per kilogram paid by the mill, and their job satisfaction. The goal of all of this was to capture the transactions taking place between the mill and farmer in order to quantify the extent and the depth of those relationships.

From their interviews of both mill managers and farmers, the researchers calculated a relational contract index for each mill. This measure captured the strength of the mill’s relationships with nearby farmers, such as whether the mill provided important inputs prior to the harvest, whether farmers sold cherries on credit, and whether the mill made promises of payment to pay farmers later.

The surveys helped measure informal relationships, which are ubiquitous in emerging markets but typically unavailable in secondary datasets. However, another looming challenge facing the researchers was trying to make causal progress on the impact of competition on these informal agreements. (Competition in this context is how many other mills are competing for coffee cherries in the vicinity of the mill.)

To measure competition, the team then counted the number of mills competing in a mill’s 5 km catchment area. The 5 km radius was chosen due to the perishable nature of coffee cherries: soon after harvest, cherries need to be processed, and typically farmers bring buckets of cherries by foot to the nearest mill. A mill’s 5 km catchment area implies that any mill within a 10 km radius of the mill competes with that mill. In areas with more mills, the researchers found, the relational contract index appeared to be lower, suggesting poorer relationships between the mill and farmers.

But that result didn’t necessarily show that competition was to blame; it was just a correlation. Other factors might have influenced both competition and the nature of informal agreements. For example, incompetent management at mills in a particular area might weaken relationships with farmers and prompt new mills to deliberately move in nearby. Or other local conditions, such as farmers’ skills or entrepreneurial attitude, might be conducive to establishing informal relationships and attracting more mills to the area. These concerns make it difficult to pin down whether it is competition per se or something else that is driving the negative relationship between competition and prevalence of informal relationships, which are essential for productivity gains in the sector.

To make progress on making the causal statement that it is competition among mills that is breaking informal relationships between the mill and farmers, the core challenge lies in finding an economic variable that correlates with competition but does not directly impact informal relationships.

Here is where being in the field was very helpful for the project. Morjaria, who has had a lifelong interest in maps, started spending time at the GIS lab of the Rwandan government. The relationships he developed there allowed him to tap into the tight-knit community of professional mappers and geographers in Rwanda. While discussing his coffee project with them, he learned about a USAID project that created a map of the optimal places to locate a mill, based on geophysical characteristics.

He tracked down the authors of this study, who had only covered a small pilot area of the country. Morjaria spent “endless hours” replicating the model for the whole country. This allowed him to figure out the suitability of each square kilometer in Rwanda for mill placement based on geophysical characteristics.

Using the model, the researchers calculated an average suitability score for all sites in Rwanda—and the key variable was one that was correlated with competition (the number of mills within a 10 km radius of the mill) but did not impact the informal agreements. Here, the researchers used geographical suitability between 5 and 10 km from a mill, the “donut” area, to predict competition. The intuition for this was as follows: The donut suitability, which is how good the area is for mill placement, is correlated with good geophysical characteristics. But placement would have to be within this donut area, because placement too close to the mill (i.e., within 5 km) would impact the performance of the mill itself. Good suitability in a mill’s catchment area might mean higher productivity, and that in turn would impact the relationships the mill has with it farmers. Hence, the 5–10 km ring around each mill was considered.

Upon completing this more involved exercise to tease out causality, the researchers found that the results held up: in more competitive areas, relationships tended to be weaker. “There is a breakdown in this relational contract index,” Morjaria says.

Higher Costs, Worse Coffee

Morjaria and Macchiavello then looked more closely at how this breakdown affected mill and farmer operations.

First, they found that adding one extra mill as a competitor—and thus weakening relationships between mills and farmers in the area—increased a mill’s total unit operating costs to produce one kilogram of the output by an average of 4.6 percent. In this situation, mills received fewer cherries from farmers, and the amount of cherries that arrived at the mill each day was unpredictable. This meant mill workers were idle more often, leading to higher labor costs.

Why were farmers selling fewer cherries to mills? The survey data suggested that they were processing more of the cherries at home instead. From a financial perspective, this decision might not seem to make sense; selling cherries to the mill was more lucrative. But with weaker relationships with the mills, the farmers could not rely on getting that second payment from the mill after the processed coffee was sold. So, they wanted to have a reserve of (home) processed coffee on hand to sell later so that their income was spread throughout the season. Conversations with farmers suggested that they typically stored savings as cash, which didn’t feel secure; neighbors might ask to borrow money, for instance, or a family member might spend it on alcohol.

And despite having more mills to choose from, farmers who were in areas with more mills didn’t see much increase in coffee prices; an additional mill in the area raised prices by only one percent. Overall, farmers’ revenues decreased by eight percent, largely because they were processing a larger fraction of the coffee at home, which was earning them much less than had they sold the coffee as cherries (in its raw form) to the mill. Lastly, when the researchers tried to solicit responses to welfare questions, farmers expressed less satisfaction with their work.

“They’re more unhappy,” Morjaria says. “They’re not getting higher prices; they’re selling less of their coffee to the mill.”

One reason the extra competition didn’t raise prices for framers may come down to quality.

When Morjaria took coffee samples from mills to be tested at a lab in the capital of Kigali, he found that having more mills in the area was linked to lower-quality coffee cherries. Moreover, that drop in quality appeared to be due to farmers’ practices—such as not applying fertilizer or protecting crops from insect damage—perhaps because they lacked support from mills.

Getting into the Field

In the end, neither farmers nor mills were better off. “If industrial policy is trying to encourage competition, well, that’s not working,” Morjaria says. He cautions that the paper is not saying there should be monopolies, but simply that there can be excessive competition.

One government policy that could help is improving contract enforcement. Encouraging farmers and mills to create legally binding contracts could prevent relationships from crumbling.

But simply encouraging more mills in the area would likely have the opposite effect. In markets that rely on informal agreements, “we need to be careful of the normal prescriptions we give for industrial policy, like ‘Let’s foster more competition,’” Morjaria says. Sometimes, he says, markets in emerging economies are complicated and do not conform to our textbook models.