How to solve the problem of price difference

The difference between producers' price and retail price of commodities, especially agricultural commodities, in our country is increasing day by day. There is no sign of mitigation of this problem. Recently we dealt with the price of watermelon in  an article in the Financial Express.  The general producers' price of watermelon is observed between Tk 20 and Tk 60 and general retail price or market price is observed between Tk 60 and Tk 180. The price difference is abnormally large. The question is: what causes this price difference? People often argue that middlemen and syndicates are the real culprits. The observation is apparently correct but it is yet to be supported with rigour. In this article, we will show what causes price difference and whether middlemen and syndicates are the real culprits for causing the price difference.
THE THEORY OF DEMAND AND GEOGRAPHY: To give a proper explanation of the price difference problem in our country, we can start from the basic theory of demand taught in the elementary microeconomic classes. In the previous article we showed how the theory of demand ignores the income distribution fact and how its prediction stumbles in the face of uneven income distribution. Yet another assumption of the theory of demand deserves attention. The assumption is that it doesn't matter whether the demand for a particular good is concentrated on certain geographical region or not. In any case, the price will be same. For example, if half of the total demand for watermelon is concentrated in the small geographic region like Dhaka City, then according to the traditional theory of demand market price of watermelon should be completely independent of such concentration of demand in this geographical area. This is granted as long as market functioning system adjusts over time with changes in the degree of concentration of demand in specific geographical areas. If not, then serious market price distortion is bound to emerge.
Over the past several years, the degree of concentration of people in cities has risen sharply, especially in Dhaka City. As a result, demand on per square kilometre in some region has reduced sharply, for example in villages, while demand on per square kilometre for other region, for example in Dhaka, has risen abnormally. This uneven distribution of demand over geographical areas has not been accompanied by the proper development of market. Instead, market is running on the conventional system based on small vendors and production is carried out by small and marginalised farmers. Therefore, to account for the origin of price difference problem, we need to have deeper understanding how geographical distribution of demand for a particular commodity influences its market price. The point is clearly demonstrated in the following graphical view.
In the above figure, regions are plotted on the horizontal axis and distribution of demand per square kilometre measured by ? on the vertical axis. First, we have considered a symmetric distribution case in which demand is uniformly distributed over all regions. This is shown in the above graph by the horizontally dashed line with distribution per Sq.km. equal to ?0. According to the conventional theory of demand, it doesn't matter whether demand is highly concentrated in certain geographical areas such as Dhaka (DHK) and Chittagong (CTG) with distribution per Sq.km equal to ?1 and ?2 respectively and very sparse in some geographical areas such Village X(VI-X) and Village Y (VI-Y) or not. But we will show that this conclusion is valid as long as market system changes its way of operation with the changes that lead to highly uneven geographical distribution of demand. To show that we assume that the whole country is divided into two regions: Rural and Urban. Demand distribution per Sq.km. in all urban regions is same such as in Dhaka, Chittagong, and Sylhet etc. The same is true for all rural regions. Let the distribution of demand per Sq.km for all rural regions be dr and for all urban areas du. Then we proceed as follows.
From the demand theory we know that demand depends on price; as price increases demand decrease and as price decreases demand increases. So, D = f(p)where D is for demand and p is for price. For price we have: p = f-1(D). This price function says that demand depends on the absolute level of demand not on distribution of market demand. Therefore, there should be no difference between the theoretical equilibrium price and real market equilibrium price. The above price function gives us the equilibrium price and we designate it as: pe = f-1(D) where pe is the equilibrium price. This is valid when [   (q-qavg) = 0] and [(du-dr) = 0] - the first measures the distribution of market demand among individuals and the second one  the difference of the distribution of demand between urban and rural areas.
But when the distribution of market demand is very much uneven and the distribution of market demand between urban and rural areas is also uneven, the market price will not be equal to the theoretical equilibrium price and the significant price difference will emerge. In this case market price will not simply be governed by the absolute level of demand. We can say more clearly as:

The above price difference function has three arguments on the right side:   (q-qavg), (du-dr), and D. First one explains why market price difference persists once the price difference emerges. The second one explains why price difference originates and the third one simply states how price adjusts to demand only. Since we are interested in explaining the origin of price difference, we will make price difference as a function of (du-dr). On the other hand, if market and production system adjusts with the changes in distribution market demand over geographical regions, price difference generated by uneven concentration of demand in certain geographical areas will be counteracted by market development yielding almost zero price difference. In other words,

The price difference equation tells us that price difference between urban and rural market in our country is contributed by the uneven geographical distribution of market demand for goods. The geographical demand concentration effect should have been counteracted by the simultaneous development of market. But unfortunately such development has hardly occurred in our country.
THE THEORY OF ARBITRAGE AND SIZE OF FARMS: Formal economic theories tell us that if information diffusion is perfect, then arbitrage by market actors will correct the price difference between markets. That means price difference is only an information asymmetry problem in those theoretical treatments.  If information is perfectly spread, then no price difference will exist for similar goods bought and sold in two markets. Nothing is said about the size of economic operation of entities and arbitrage. We argue that even if information is perfect, arbitrage will not happen to correct the price difference between markets if the size of operation of economic entities has negative relation with price difference between the two markets. If producers exploit price difference between urban and rural markets, price difference will vanish in the ultimate.
But we have hardly seen this in our country. Even if information is perfectly diffused, several factors limit the ability of exploiting price difference between two markets for small farmers. (1) They often lack the necessary financial resources for carrying the goods to different areas and (2) the size of their economic operation, the foremost one, severely limit their ability of bearing costs incurred in sending goods to different markets. For example, small farmers who produce potatoes in the rural areas can't send potatoes to urban market to exploit higher price in urban market because transportation and carrying costs are not worthy to bear compared to the quantity of potatoes they will sell. (3) Sending goods to different markets often requires taking risk in terms of losing the goods in roads due to accidents or bad incidents. For a small farmer taking such risk is very much impossible and they are unable to exploit the price difference in different markets. (4) Small farmers instead of taking the initiative of sending the goods on their own sometime take joint effort with big farmers and share the transportation and carrying costs. This kind of activity helps them get a good price form the market in which price is higher. Let's say the total production of watermelon is Y and number of total farmers producing watermelon is N. So, the average size of farm is given by SF = Y/N. Now, we postulate the following functional relationship between price difference and farm size: pU - pR = f (SF). This is shown by the following graphical illustration:
In the above figure, (pU-pR)  is measured on the vertical axis and SF on the horizontal axis. It shows that the relation between  farms' size and the price difference between the urban and rural markets is negative; the larger is the size, the smaller is the difference and vice versa.  The graph shows that when the size of farms falls below some hypothetically fixed threshold level designated as SF0, price difference becomes positive, and at the threshold size of farms, the difference between the urban and rural market prices is zero. The arbitrarily fixed size SF0 is fixed and taken under such reasonable assumption that there exists a threshold size that will render zero price difference. As shown, at  farms' size SF1, the price difference is DP and this price difference will not be corrected by arbitrage  since arbitrage will not happen.
FARM SIZE AND GEOGRAPHIC CONCENTRATION: From the above we have seen whether arbitrage will correct price difference urban and rural market depends on the size of farms. If the average size of farms is small, then significant price difference will prevail between the two markets. Now the question arises: Is there any relation between farms size and geographic concentration of demand measured by (du - dr)? Yes, there is a connection. As the value of (du - dr) increases, the size of farms must increase and vice-versa. Otherwise, market will malfunction. Precisely, we say:

MIDDLEMEN AND SYNDICATES: The common and usual belief is that price difference is due to middlemen and syndicates. Therefore, the popular appeal is that we should implement laws or the government should do something to curb the power of the middlemen and syndicates. This argument is not stripped of truth and reality. But this naked reality is a deceptive reality that often deceives us. The deception is that price difference is exploited by the middlemen and syndicates but not created by them. This crucial point has been missing from this common belief. The middlemen and syndicates can't anyway create price difference; they just exploit it.

SOLUTIONS: So, what are the solutions to the price difference problem? Does the above theoretical underpinning of the price difference problem give us any clue to solve the problem? Yes, it does. Solving the problem requires two radical changes. First the conventional small vendor-based selling must give way to the transition to large corporate-based selling and procurement such as department stores. Second, the production system has to be upgraded with the changes in economic geography or concentration of demand in urban areas. Therefore, the exact policy prescription that follows from the analysis is that the government should try to solve the problem detecting the exact origin of the problem. The government rather than wasting its energy and money on making cumbersome laws and regulations should devote sufficient time and fund to help market and rural production system upgrade with the changes in economic geography.
Therefore, the policy prescription is decomposed into two parts. First, the problem must be solved detecting the exact origin as we have mentioned above and the government must step forward to help market and production system upgrade. Second, once the first measure is completed or taken in hand, the government should supplement the market system with proper laws and regulations so that remaining frictions are also removed.
The contributor writes from the University of Denver, USA.
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