Credit-Product Interlinkage, Captive Markets and Trade Liberalization in Agriculture: A Theoretical Analysis

This paper builds a model of fragmented duopsony in backward agriculture following Basu and Bell (1991) in which the purchasers (traders) have captive markets each but compete in a contested market. We focus on the formation of captive markets through trader-farmer interlinkage in the form of interlinked credit-product contracts (ICPCs). ICPC (or the formation of captive markets) is not an entry-preventive strategy in the model. Its motive is to push the farmers to their reservation income level. However, the captive and the contested markets are linked by the requirement that the reservation income of a captive farmer has to equal the income of a farmer in the contested market. In general, in our model strategic considerations determine the extent of use of ICPCs rather than explaining their existence. In this set-up we examine the effects of trade liberalization in agriculture on the village economy. We show that a reduction in the credit subsidy will raise the size of the captive market, leads to deterioration in the welfare of the farmers and may lower the agricultural productivity of the economy. On the contrary, an increase in the international price of the crop unambiguously improves the welfare of the farmers but the effect on the agricultural productivity is ambiguous. The paper argues that unless the developed countries liberalize trade in their agricultural sector, it would be premature for the developing countries to go in for agricultural trade liberalization and remove all farm subsidies, as this policy may in fact be counterproductive.