Subsidy Example,Inflation,Problems and Solutions by Kampamba Shula

Mealie Meal subsidy example

A lot of people have been having trouble understanding the subsidy in simple terms so I decided to break the ice here with a clear example.

A farmer has two sons and a brother. Every day he wakes up before everyone and goes into the field to work. Before he leaves, he gives his brother money for house essentials and transport for the sons to school.

The two sons go to different schools. One son is called “Biggie” and the other is called “Smalls”. Sometimes the money for house essentials and transport is not enough and one of the sons has to walk to school instead of using transport, Smalls usually walks while Biggie takes transport. Smalls ends ups missing some of his classes because he is usually late.

Exam time comes and Biggie passes while Smalls fails .The farmer asks the teacher why this is so and the teacher tells him that Smalls misses some his classes and comes late. He goes home and finds out that Smalls misses classes because transport is not enough some times.

This is what the farmer chooses to do. He removes the money he usually includes for transport so that both sons walk to school. He saves this money and goes into town to buy both sons quality textbooks.

At the next exam both sons pass with good marks.

Now in this story the Farmer is the Zambian Government, the Brother is the Food and Reserve Agency (FRA).The two sons Biggie and Smalls are The Big Millers and Small Millers respectively. The transport money is the subsidy which sometimes only goes to the Big Millers. The teacher is the economist and the textbook is the expenditure that Zambian Government wants to use to build universities and schools and hospitals.

This is not an accurate example but is the closest by comparison.

Subsidy Explanation

After the recent subsidy removal by the Zambian Government there has been massive speculation that general prices in the country will go up and by extension Inflation will go up.

Now this article addresses those concerns with Inflation data from the last 5 months.

Just so we are all on the same page firstly what is Inflation??

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services (Abel & Bernanke, 2005).

The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation' (Bryan, October 15 1997).

The Inflation rate is calculated as the change in the consumer price index. The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a "typical consumer" (Mankiw, 2002).

We must now look at the fixed basket of Goods and services and their weights in the consumer price index to find out the effect of the removal of subsidies in Mealie Meal.

Now according to the JCTI Basic food item basket which comprises of Foods like Mealie Meal, Cooking Oil, beans, beef, eggs, Kapenta, tomatoes, onions, vegetables  and other essentials.

Mealie Meal

Mealie Meal accounts for 14 % of the basic food item basket. A 7 % change in the price of Mealie Meal would have a 1% change in the basic food basket.

In September 2011, the Government of Zambia started heavily subsidizing the price of maize held by the Food Reserve Agency (FRA) to maize millers. The expectation was that, by receiving maize at subsidized prices, millers would pass along the subsidy to Zambian consumers in the form of lower retail maize meal prices (Jayne, September 2012).

 Retail maize meal prices have remained virtually constant since September 2011. These findings indicate that very little of the treasury costs incurred in providing FRA grain to millers at below-market prices have benefited urban consumers

THE Millers Association of Zambia (MAZ) says the removal of the subsidy on maize does not necessarily mean that prices of mealie-meal will go up.

MAZ president Allan Sakala says the removal of the subsidy will provide a favourable competition in the milling sector and will create a positive impact on the prices of mealie-meal.

Assuming all things remaining equal the removal of subsidies will not change the price Mealie Meal by any significant margin.

Fuel Subsidy

The Fuel subsidy is however a different matter altogether.

This is a graph of Inflation since the beginning of the year. My calculations lead to an inference that the effect of a 15% percent fuel increase will lead to a possible 1/10 or 1/5 of a percentage point. In other words the Inflation might go up from 6.5 up to 6.7% in the short term.

In the more medium term, that is, later in the year however Inflation might spike up further as the poor harvest of 2012/2013 comes into price effect as well as the effects of expected inflation and as I worry built in inflation.

The reasons for this are as follows using the JCTI basic family basket expenditure. First and foremost the Fuel increase will directly affect the cost of production. This will create an incentive for companies to pass that on to their consumers as a higher price, this may be done gradually or immediately but the eventual effect will see more relatively price inelastic goods absorb the price increases.

An example of a price inelastic good is Mealie Meal. Price elasticity refers to the change in demand of a good given a change in its price. Mealie meal is relatively price inelastic because a change in its price will not change its demand by any significant margin. This is for the reason that if the price of Mealie Meal goes up, people will still buy Mealie Meal.

Secondly, transport costs across the board will go up after the 15% increase. The translation of this to a general price increase will depend upon the type of goods sold and the distance covered to get them to their required destination.

Thirdly and most worryingly is what is called in economics as Built in Inflation. In simple terms what people expect Inflation or general prices to be in the near future also matters, If they expect prices to increase this will have repercussions.

Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

The Built in Inflation I speak of will come into effect in September 2013.Let me explain why.

Government has increased salaries for civil servants with some getting as high as 200 percent effective September 1, 2013 (Lusaka Times, 2013).The windfall follows the successful conclusion of negotiations between Government and the Civil Servants and Allied Workers Union of Zambia (CSAWUZ).

Other benefits in the 2013 collective bargaining include the introduction of the health personnel shift allowance at 15 percent of basic salaries for nurses and other paramedics. The commuted night-duty allowance has been pegged at7%.

Transport and housing allowances have been maintained at the existing rates of 10 and 20% of basic salaries respectively. But given the Government’s recent hike in fuel, workers have valid grounds on which to demand their transport allowances be adjusted to absorb the Price hike, this I fear could cause the Vicious circle.

Solutions

Eleanor Roosevelt said "It is better to light a candle than to curse the darkness". I do not aim to attack the Zambian Government; all I wish to do is give solutions to problems.

Problem 1

High price of Fuel due to in Zambia compared to other countries due to losses in

•          Feedstock Procurement to Dar es Salaam

•          Comparison of CIF Dar es Salaam prices paid by GRZ in 2008 & 2009 with reference (spot) prices shows over-payment. ‘The total “overcharge” vs good international practice was…..US$ 93 million over the two years or 12.5% of total CIF costs 

Solution 1

An agreement is signed to purchase fuel (oil) using futures and options.

What is a Future?

A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration

What is an option?

An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract

Why will this work?

Because the Zambian Government has been procuring Fuel (Oil) at spot rates, in other words they have been paying for what the price of fuel is at the time. This created a 5% loss compared to other countries that use OMC at this stage.

 Fuel prices change every day and month, Options and futures reduce the risk of loss to such volatility.

References

Abel, A., & Bernanke, B. (2005). Macroeconomics (5th ed.). In A. Abel, & B. Bernanke, Macroeconomics (5th ed.). Pearson.

Bryan, M. F. (October 15 1997). On the Origin and Evolution of the Word 'Inflation. In M. F. Bryan, On the Origin and Evolution of the Word 'Inflation. Federal Bank Of Cleveland.

Lusaka Times. (2013, March 27). Civil servants get pay rise. Retrieved May 22, 2013, from Lusaka Times: http://www.lusakatimes.com/2013/03/27/civil-servants-get-pay-rise/

Mankiw, N. G. (2002). Macroeconomics (5th ed.). . In N. G. Mankiw, Macroeconomics (5th ed.). Worth.

Jayne, A. N. (September 2012). Is the Government of Zambia’s Subsidy to Maize Millers. Lusaka Zambia: Indaba Agricultural Policy Research Institute (IAPRI).

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Mealie Meal Subsidy removal analysed by Kampamba Shula

The Government of the Republic of Zambia has resolved to remove the subsidy on Mealie meal.

Agriculture and Livestock Minister Bob Sichinga has announced that cabinet has approved the removal of Maize subsidies He said if the current subsidy was to be maintained, it would mean FRA would continue to be in a loss making position and for it to survive it had to stop depending on Government to support such subsidies. Mr Sichinga said currently the FRA had been buying maize at KR65 and selling it to millers at KR60, with a resultant loss of KR5 for every 50 kg bag sold or KR100 per tonne. He said the FRA would this farming season purchase 500, 000 tonnes of maize and any maize that would be left after the private sector buys the maize from the farmers (Lusaka Times, 2013).
In 2010 and 2011, Zambia achieved record maize harvests of 2,795,483 and 3,020,380 metric tons respectively (Nkonde et al. 2011). Towards the year of elections (2011), the FRA purchased roughly 1.5 million metric tons of maize that it could not fully store, mainly due to inadequate storage facilities. Further, the state could not sell its surplus maize profitably, either in the region or in international markets due to the high price at which it purchased maize locally (Mason and Myers 2011). Moreover, regional transport capacity constraints have limited the volumes that Zambia could export even at a financial loss. Hence, in mid- 2011, and leading into national elections later in the year, the country faced the dilemma of how to offload the large and partially deteriorating maize stocks from the 2010 harvest to make room for incoming maize purchases from the 2011 harvest. Starting in September 2011, the government via FRA offloaded maize to millers at US$140 per metric tonne (roughly 35,000 kwacha per 50kg bag). After accounting for the FRA’s marketing costs and storage losses on top of the 65,000 kwacha per 50kg bag purchase price, it is likely that the FRA lost at least 85,000 kwacha ($340 per tonne) on every bag traded during this period. Further, the government continued to subsidize maize exports within the SADC region at a loss despite the country having to incur high production costs. Thus, while the FRA was spending K65,000 (roughly US$260 per metric tonne) to purchase maize from farmers and incurring additional marketing and storage costs of at least $100 per tonne, it was selling the same maize to other countries within the region at a cost of not more than US$170 per tonne (Lusaka Times 2012).
In September 2011, the Government of Zambia started heavily subsidizing the price of maize held by the Food Reserve Agency (FRA) to maize millers. The expectation was that, by receiving maize at subsidized prices, millers would pass along the subsidy to Zambian consumers in the form of lower retail maize meal prices (Jayne, September 2012).
Over the eleven-year period from 2000 to 2011, inflation-adjusted retail prices for breakfast meal have declined. However, after the subsidy was conferred to millers in September 2011, the mill-to-retail marketing margins have increased significantly. Retail maize meal prices have remained virtually constant since September 2011. These findings indicate that very little of the treasury costs incurred in providing FRA grain to millers at below-market prices have benefited urban consumers.
Moreover, the FRA maize subsidies are only conferred to some millers, not all of the maize millers in Zambia. Millers that did not receive the FRA subsidized maize, in particular the informal and small/medium-scale millers were greatly disadvantaged because they could not acquire maize grain at as low a price as millers receiving subsidized maize from the FRA. This has led to an unbalanced playing field between the millers who benefited from the FRA subsidized maize grain and those who did not. Such an un-level playing field will negatively affect the future competitiveness and market structure of Zambia’s maize milling industry.
Policy Implications
First, because the FRA maize subsidies to millers have so far not been transmitted to Zambian consumers, policy makers might reconsider the policy of providing maize to selected millers at highly subsidized prices, if the aim of doing so is to reduce the price of maize meal to consumers. Second, selective subsidies to particular millers disadvantage other millers plus many informal small-scale millers who are not able to receive the subsidy. Over time, this is likely to entrench the market share of the selected millers having access to subsidized maize supplies, force non-selected millers out of business, and adversely affect the degree of competitiveness within the milling industry. Third, for the Government to achieve its goal of lower maize meal prices to help poor urban consumers, policies should be considered that encourage rather than disadvantage the informal and small/medium-scale food millers and retailers, on whom a large share of Zambian consumers rely.
Conclusions
Research findings agree very well with Chapoto and Jayne (2006) as well as Kuteya and Jayne (2011) that maize meal prices in real terms have been declining over time. However, the rate at which these prices were decreasing after state intervention was less than that of maize grain. As such, the impact of this costly move was not felt by consumers. The mill-to-retail market margins increased tremendously immediately after FRA offloaded maize grain to commercial millers at 400 kwacha per kilogram. These maize grain subsidies which drained the state treasury appear to have benefited large millers alone since the move did not reduce mealie meal prices at the same rate as maize grain from FRA. If government’s objective from these subsidies was also to reduce maize meal prices for the benefit of consumers, it does not appear to be supported by the econometric model results (Jayne, September 2012).
Maize subsidies are perceived as government’s indirect support to commercial millers. But it is a well-documented fact that even small millers (hammer mills) play a major role in ensuring competition in the grain milling industry in the country. Therefore, if the playing field is not leveled, their activities are hampered by selective subsidies and as a result lessening competition in the grain milling industry. The end results are high marketing margins between wholesale maize grain and breakfast meal retail prices. The foregone analysis indicates that selective subsidies conferred to certain players in the market do not necessarily have desired consequences when the market is not fully competitive. If the market were competitive, then subsidies conferred to millers would be passed along fully to consumers, which appear not to be the case in Zambia. Subsidies to maize millers have instead proved to be a drain on the government treasury without trickling down anticipated benefits to intended beneficiaries – urban consumers in this case.


References

Jayne, A. N. (September 2012). Is the Government of Zambia’s Subsidy to Maize Millers. Lusaka Zambia: Indaba Agricultural Policy Research Institute (IAPRI).
Lusaka Times. (2013, May 15). Mealie Meal prices set to go up as Government announces removal of Maize subsidies. Retrieved May 16, 2013, from Lusaka Times: http://www.lusakatimes.com/2013/05/15/mealie-prices-set-to-go-up-as-government-announces-removal-of-maize-subsidies/
Nkonde, C., N.M. Mason, N.J. Sitko, and T.S. Jayne. 2011. Who Gained and Who Lost from
Zambia’s 2010 Maize Marketing Policies? FSRP Working Paper No. 49. Lusaka: Food
Security Research Project.
Mason, M.N. and J.R. Myers. 2011. The Effects of the Food Reserve Agency on Maize
Market Prices in Zambia: Are There Threshold Nonlinearities? FSRP Working Paper
No. 60. Lusaka: Food Security Research Project.
Chapoto, A. and T.S. Jayne. 2006. Trends in Breakfast Meal and Maize Marketing Margins
in Zambia. FSRP Policy Synthesis No. 14. Lusaka: Food Security Research Project.
Kuteya, A.N. and T.S. Jayne. 2011. Trends in Maize Grain, Roller, and Breakfast Meal
Prices in Zambia. FSRP Policy Synthesis No. 47. Lusaka: Food Security Research
Project.

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