In recent times, there has been growing concern on the looming fiscal deficit situation in India. Reducing subsidies is definitely one of the measures to control the situation.
At the same time, regulating or subsidising prices of agricultural inputs such as urea has political and socio-economic ramifications. But what is the flip side of the current subsidy regime for urea?
How subsidies work?
Basically, the government fixes the price at which producers sell urea to farmers. Since this price is lower than the market price, the government compensates this difference in amount to the producers through its budget expenditure.
Such price supports, in this case to the farmers, are called subsidies. Typically, the government sources these funds from the tax payers. Put simply, the subsidy comes at the expense of the tax-payers in favour of farmers — no different from any other public distribution system.
Economic theory suggests that subsidy of any kind entails dead weight loss — the aggregate loss to the economy owing to government's intervention in market forces of demand and supply.
Is there a paradox
At a subsidised price, the quantity demanded of urea is greater than that supplied. At this artificially increased demand, the price that sellers face is higher than the market price.
Well, if buyers pay less and sellers receive more, where is the question of dead weight loss? Here is the catch!
Seller's and BUYER's Loss
Conventional wisdom suggests that when sellers lower their prices, they would be able to sell more and, thereby, increase their revenue. Sellers are unable to take advantage of this approach when the government transfers a fixed subsidy amount.
Typically, it turns out that what sellers potentially lose because of the subsidy is greater than the transfer payment paid by the government.
From the buyer's side, when the price of a good is high, the (marginal) value of it is high. To explain, every unit of diamond is that much more precious compared to what it is for say, tooth paste. Reason? Higher prices of diamond!
Indian government, for more than a decade, has subsidised and retained the price of urea.
Since this price is fixed (and low) for the farmers, the incentive to efficiently use urea is that much lower. This is not to blame Indian farmers but point to basic consumer theory which states that, in the absence of incentives, resources are less efficiently used.
In essence, subsidy for urea prevents a more efficient use of it, and thwarts the opportunity for sellers to sell more, resulting in dead weight loss.
A costly substitution
Farmers typically substitute the use of alternative fertilisers with urea, since the prices of substitutes are not subsidised. It has been well documented that such excess use of urea affects soil quality, lowering agricultural productivity and output.
What is the fix?
Providing “non-price” support and ensuring that farmers increase their productivity would be the appropriate and positive step in fixing this issue. The Government could provide technical support to marginal land owners to increase productivity.
Improving infra-structural facilities such as providing better and efficient power and water supply is another focus area.
The Government could also consider making social investments in acidic soil — to correct the degradation caused by excessive use of urea.
The Government is already exploring a direct subsidy targeted at farmers. A recent World Bank report shows that targeted compensation (identifying the most deserving farmers for subsidies) is a much better alternative to general subsidies with respect to effectiveness and efficiency of resource utilisation.
As the Chinese proverb goes, teach a child to fish rather than give him the fish.