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Market imperfections and farm level diversification in Nepal

Sridhar Thapa1 Department of Ecological and Sustainable Economic Development, Universit Degli Studi Della Tuscia Via S. Giovanni Decollato, 01100, Viterbo(Italy) __________________________________________________________________________
Abstract Increase in agricultural productivity and the shift from a subsistence to commercialized farming through agricultural diversification and increased market access are the main objectives of Nepalese government to raise the living standard of rural people. There has been a strong tendency to view rural market imperfections that lead farmers ration out from credit and labour markets as the major causes of declining productivity. The question thus arises: are reductions in rural market imperfections through increased market access the best solutions for increasing agricultural productivity. It is often believed that increased market access and agricultural diversification will lead to increase agricultural productivity by softening the credit and labour constraints and thereby enhancing the commercialization and modernization of agriculture. The impact of rural market imperfections should be taken into consideration to increase the productivity of the agriculture sector, when analyzing the impact of agricultural diversification and increased market access. These findings have policy implications at the micro, meso, and macro levels. Keywords: market imperfections, agricultural diversification, agricultural productivity, Nepal

_________________________________________________________________________ Introduction and Motivation Nepal is predominantly an agrarian country. The agriculture sector accounts for 40.2 percent of total GDP and more than 73 percent of total employment(WB 2006), and the bulks of the countrys export earnings(WB 2005). In addition, major share(38.79 percentage) of industrial sector in GDP comes from the agro-based industries (MOF 2006). Recognizing the largest source for broad based growth, high priority has been given to this sector with a significant amount of the Governments budget being allocated to it during the last decade, and rapid growth in agriculture has been emphasized as having the potential to reduce poverty. As the latest policy tool for this sector, the Government of Nepal has implemented a 20-year agricultural development plan called the Agriculture Perspective Plan2 (APP) in order to increase agricultural productivity since 1997. The APP was designed to promote annual agricultural growth of about 5 percent and was regarded as a visionary document that could increase agricultural productivity and transform the farming system from a subsistence to a commercialized level (APROSC and JMA 1995). The APP
Correspondence: and The Agriculture Perspective Plan was prepared in 1995. It emphasized mainly high value crops like vegetables and other cash crops like tea, sugarcane, coffee, etc. at farm level. Small and marginalized farmers are the main target groups of this program. Sridhar Thapa 1
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especially emphasizes the diversification of agriculture as an instrument by which farmers can grow the most profitable commodities on their land. This is achieved by managing key inputs, namely need-based research and extension, easier fertilizer supply, controlled yearround irrigation, linkage of potential production pockets to market through rural agricultural roads and the expansion of rural electrification. Crop diversification, which entails the growing of a variety of agriculture commodities that are commercially viable and locally acceptable (Sharma 2001), has been considered as essential to the transformation process from a subsistence to commercialized farming. Moreover, the APP encouraged the production pocket concept and farmers group approach for commercialization. It is widely believed that that commercialization and diversification of agricultural systems is a universal phenomenon that is triggered by economic growth (Pingali 2004). Despite these endeavours, the agriculture sector has not really been successful in making any substantive change in the structure of poverty and deprivation. As a result, Nepal is still one of the poorest countries in the world with a GNP per capita of US$270 in 2006 (WB 2006) and more than 31 percent people live below US$1 a day (CBS 2005). Hence, agricultural diversification and commercialization have yet to occur in a substantive manner. Agricultural diversification has been adopted as an important strategy to overcome many challenges in developing countries. In Nepal, as in many developing countries, diversification is being pursued as a way to improve the long-term viability of agriculture by enhancing the profitability and overall stability of the sector. However, it is a natural response to the changing economic and political environments inside and outside the sector (Barghouti 2004). The definition of diversification of agriculture has changed over time. Initially it implied the addition of other crops and other enterprises at the farm household level (Dorjee et al 2003). In other words, it is a process of change in business activities based on the response of market signals and production technology in the particular region. Pingali and Rosegrant (1995) defined it more specifically as change in product (or enterprise) choice and input use decisions based on market forces and the principle of profit maximization. Diversification in agriculture is also regarded as the most suitable crop based on the agro-ecological zones. Under agricultural diversification, it is assumed that farmers selected the crops or commodities that have higher comparative advantage and higher marketability and grow them on a commercial basis. At the farm level, diversification will represent a change in the underlying characteristics of the farm system such that farm practices and products are more aligned with the social, environmental, and economic contexts, as well as the constraints and opportunities that exist (Barghouti 2004). In spite of the virtue of agricultural diversification, many developing countries have not substantially achieved the targeted goals of agricultural growth in order to reduce poverty and unemployment. It is perhaps a failure to identify the factors that determine the effective implementation of agricultural diversification programs. Increases in agricultural
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productivity through diversification and increased market access is important for raising the living standard of rural people. Increased market participation through road access would increase commercial agriculture and agricultural wage labour (Fafchamps and Shilpi 2000). In Nepal, proximity to markets and the size of cities are strongly associated with different patterns of production. Improving road access to agricultural markets would confer substantial economic benefits on average, much of them going to poor households (Jacoby 1998). Market participation varies with distance as well. This variation in market participation leads to rural market imperfections characterized by limited access to off-farm employment, price bands for outputs and labour, a constrained rental market for land through share tenancy, an oxen rental market through exchange with labour only, and constrained access to formal credit in kind (for fertilizer) or to informal credit at high interest rates (Holden and Shiferaw 2004 ). In Nepal, research shows that there is evidence of labour market imperfections (Abdulai and Regmi 2000; Thapa 2004), limited access to formal credit, and a strong variation in interest rates (from 25 to 60 percent) for informal credit (Thapa 2003). Another study done by Agricultural Development Bank (2004) shows that diversification towards high value agricultural products have been constrained by lack of access to adequate credit in the rural areas. Constraints on credit and labour may limit the farm households agricultural production decisions about diversification and commercialization. The question thus arises of whether reductions in rural market imperfections through increased market access and agricultural diversification are the solutions for increasing farm productivity. The impact of increased market access and agricultural diversification may be positive with productivity. These may lead to reducing market imperfections by softening the credit and labour constraints and thereby enhancing the commercialisation and modernization of the agriculture sector. The impact of rural market imperfections should have taken into consideration increases in the productivity of the agriculture sector when analysing the impact of agricultural diversification and increased market access. There has been a strong tendency to view rural market imperfections that ration out farmers from credit and labour markets as the major causes of declining farm productivity. Justification In Nepal, the agriculture sector has been given top priority since the inception of a planned economy in 1956 (Aryal et al. 1999). The APP is the latest policy attempt to increase agricultural productivity. Despite several efforts made by the Government of Nepal to increase agricultural productivity, the country has gradually shifted from food sufficiency to food deficit. The data show that Nepals agricultural sector grew at roughly 3 percent per year from 1993 to 2003; this is slightly higher than the comparable population growth of 2 percent per year (World Bank 2005). The countrys dependence on agriculture therefore makes it critical to the countrys overall economic growth and poverty alleviation goals. An
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understanding of the stagnation in agricultural growth even after implementation of the Agriculture Perspective Plan is likely to be critical in the formulation and implementation of agricultural policies. Such issues are matter of concern for policy makers and economists. An understating of farm investment decisions is likely to be essential in order to increase the agricultural productivity for the reduction of severe poverty, which is the single most important objective of the current Tenth Five-Year Plan of Nepal(NPC 2002). The study of farming systems and poverty suggest that diversification is the single most important source of poverty reduction for small farmers in South and Southeast Asia (FAO and World Bank 2001). In addition, diversification of agriculture increases labour requirements (Pingali 2004), and agricultural diversification may play a key role in absorbing excess farm labour and developing alternative income opportunities (Chaplin et al 2004). Development of rural labour markets enables farmers to grow more market-oriented crops through by reducing constraints on family labour endowments (de Janvry et al., 1991). Moreover, liquidity is also one of the constraints for rural farmers that hinder the process of diversifying and commercializing the agriculture sector. Formal credit and necessary inputs are usually considered as preconditions for increasing competitiveness in the agriculture sector. It is often discussed in the literature that rural markets in developing countries are generally poorly developed and characterized by high transaction costs, arising from transportation costs, high search, recruitment and monitoring costs, and limited access to information, capital, and credit (de Janvry et al., 1991; Sadoulet et al., 1996). The literature also suggests that increased access to credit could generate pro-poor economic growth (Nelson and Temu 2005). Hence, the study of rural factor markets such as labour and credit of farm households under diversification may be policy relevant for the rural economies. Consideration of such issues in a study would be more relevant in a context where nontradable inputs are the dominant form of factor inputs, as in most farm households in developing countries. The impact of labour and credit constraints should have policy implications during the transformation process from subsistence to commercialized agriculture. Such constraints are likely to lead inefficiency in production resulting from high transaction costs. A competitive farming system is desirable for the policy makers and planners in resource poor economies. The use of econometric models such as farm households and other regression analyses has its own significance. In Nepal, few studies of rural factor markets and agricultural diversification have been done so far using such models, especially the at micro level. So this study will fill up such a gap and will help to formulate effective policies at

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micro, meso and macro levels to reduce poverty by increasing agricultural productivity through farm level diversification3. Study Goals The following research questions guide this study; 1. The study will cover three agro-ecological zones (mountain, hills and Terai, i.e. plains southern part of Nepal) especially by focusing on agricultural diversificationby building up a standard Agricultural Diversification Index, and the status of rural factor markets like labour and credit, and access to markets fro their agricultural commodities in order to identify the impact on different agroecological zones. The question here is whether household labour supply decisions and access to credit vary in different agro-ecological zones? 2. what are the factors that determine the agricultural diversification at farm level in Nepal? 3. Have areas under subsistence and traditional agriculture led to the failure of rural factor markets? 4. Do agricultural diversification and increased market access soften the labour and credit constraints and boost agricultural productivity? 5. Does agricultural diversification lead to more specialization in the agriculture sector and then to an increase agricultural productivity? 6. Do increased market access and agricultural diversification reduce the wage disparities among farm labourers in terms of genders and regions? Based on the above research questions, the following are the objectives of the study: to identify the factors determining agricultural diversification at farm level, to examine labour supply decisions under agricultural diversification and increased market access, to find the effect of credit constraints on the farmers decision on crop diversification and commercialization of agriculture,

to assess the impact of market integration and agricultural diversification on farm productivity. Theoretical Framework The theoretical framework of the study is based on agricultural household model, where the household is jointly engaged in production and consumption (Bardhan and Udry 1999). Household-farm models are a useful tool for studying how household-specific transaction costs shape the impacts of exogenous policy and market changes in rural areas (Taylor and Adelman 2003). A key motivation for using agricultural household analysis is to guide policy analysis. Empirical models using micro-survey data make it possible to

Barghouti et al. (2004) have classified agricultural diversification at three stages viz. national level, community level and farm level. Sridhar Thapa

estimate the magnitude of supply and market-surplus elasticities in a number of different settings, which confirm quantitatively the importance of using household-farm, rather than simply household or farm models to analyze rural economies (Taylor and Adelman 2003). These models were first developed by Singh, Square, and Strauss (1986) and then elaborated by de Janvry, Fafchamps and Sadoulet (1991) in the case of household nontradable inputs and missing factor markets. However, the theory of farm household behaviour developed by Binswagner and Rosenweig (1986) deals with the interlinkages of production and exchange of outputs and primary factors of production in rural areas. In order to define the interlinkage markets, the theory incorporates the analysis of risk, risk aversion, and information problems jointly and simultaneously with the material features of agriculture and the material features of attributes. The theory further explains the production relations of the overall rural setting, and how such relations affect the current and intertempotal decisions of the farm household. According to the theory of farm household behaviour, the production relations are jointly determined (i) by aspiration for higher incomes, for lower risks, for dealing with misfortunes; (ii) by the material and technological constraints faced in the specific environment; and (iii) by behavioural and technological constraints on information acquisition and transmission. Research Methodology Data sources will be both primary and secondary. However, primary data will be the major source of information. Secondary data will also be considered for the analysis of some research questions and descriptive analysis. Data collection I will collect primary data through a cross-section household survey in three different agro climatic zonesviz. mountain, hill, and Terai (plain and most fertile area) of Nepal. Stratified random sampling technique will be applied to select the study area from each agro-climatic zone and then survey households will be selected through a random sampling technique. Households are the sampling unit of primary data. The personal interview method4 will be applied to collect primary data. Agro-climatic zones will be drawn on the basis of government classification5. Approximately 3506 households will be surveyed, with at least 100 households from each agro-climatic zone in order to find the impact of agroclimatic zone on farm diversification. A structured questionnaire will be designed for the
The personal interview method is most commonly used in surveys. This procedure requires the interviewers to ask prepared questions and to record the respondents answers. 5 The Government of Nepal has compiled a list of districts in each agro-climatic zone: mountain, hill, and Terai regions cover 16, 39 ,and 20 districts respectively. 6 This is tentative figure of sampled households, but not a final one. The exact number of households will be determined after stratifying the sample area during the field survey. Sridhar Thapa 6

household survey. The information will include crop specific data, farm size and its characteristics, crop intensity, tradable and non-tradable inputs, household labour supply, credit status, different sources of income, and other demographic, market and regional characteristics. Both open and close-ended questions will be designed for collecting the information. A training session will be conducted for enumerators about the purpose of study, methodology and to clarify and familiarize them with questionnaires. Questionnaires will be pre-tested before conducting the field survey. Secondary Information Secondary data will be collected mainly form the office of the Central Bureau of Statistics in Nepal and Food and Agriculture Organization office in Rome. Additional information which is relevant for the purpose of my study will be collected from various other sources such as academic institutions, libraries, governmental offices, and national and international publications to improve the strength and reliability of the study. Data Analysis Data analysis of the study will be both descriptive and exploratory . Descriptive analysis will include simple statistics like the mean, standard deviation, and minima and maxima. Multiple regression models will be applied with the help of standard statistical software packages like STATA as exploratory analysis. Econometric Models Econometric models will be used to analyse the determinants of agricultural diversification and the impact of rural factor markets on farm level diversification and productivity. Simple as well as two-stage regression models and binary choice variable models will be used for econometric analysis. Possible econometric models for specific objective are as follows: Model 1 (objective 1): two-stage regression (Joshi et at 2003). ADI=f(Demand side, supply side, climate and temp.) Where ADI is the Simpson index of diversity and it is calculated as: ADI = 1 Pi
i =1 n 2

where Pi is the proportionate area (or value) of ith crop/livestock/fishery

activity in the gross cropped area (or total value) of output. The index 0 indicates complete specialization (mono-crop). Demand side includes per capita income and population of the study area. Supply side includes infrastructure (roads and markets), technology (relative profitability and risk in different commodities), resource endowments (water and labour), and socio-economic variables.

Model 2 (objective 2): log linear approximation form of equations (Cameron et al. 2001, Laszlo 2003, and Ahamad and Isvilanonda 2003).
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log h = + (ADI or) CDIi + Zn n + where h=total hours of work, = wage return to ADI/CDI, CDIi=1/[Xij/Xi]2, CDIi is the diversification diversity index of household i(i=1,2,..,n), Xij is the gross value of production of commodity j(j=1,2,,m) by household i, and Xi is the total value of all crop production by household i(the value of CDI is one implying that total specialization or monoculture), and Z= demographic, market and regional characteristic. And log w = + log h + (ADI or)CDIi + Zn n +

Model 3 (Objective 3): The model will apply a switching regression technique in which a probit model is used to explain which households are credit constrained. Using output from the probit regression, I will then estimate separate regressions for credit constrained and non constrained households in order to find the impact of credit on the diversification of agriculture (Freeman et al. 1998; Nelson and Temu 2005). Model 4(objective 4): The integration is to estimate farm productivity elasticities with respect to agricultural diversification (Ahamad and Isvilanonda 2003).
log (ADI or)CDIi = + ln[Value Added/Land] + log (ADI or)CDIi = + ln[Value Added/Labour] + log (ADI or)CDIi = + ln[Value Added/Land] + ln[Value Added/Labour] + where value added = net of the costs of intermediate inputs, i.e., this remains the cost effects of intensification that results from an increased amount of modern inputs and is thus closer to a measure of total factor productivity than total output based measures. Expected Results This research will improve knowledge about the overall shape of agricultural diversification in Nepal. More importantly, it will shed light on how farm level diversification programs function in relation to improvement of the living standard of rural people. More specifically, the following results are expected from the study: a. the factors determining farm level diversification in Nepal will be known. It will also be identified to what extent demand side and supply side parameters affect on farm level diversification in Nepal. b. The findings will identify the impact of labour and credit markets on farm level diversification and their extent, and also show diversification patterns in different agro-climatic zones. c. the study will also identify the causality between farm level diversification and productivity and wage rates in the study area. Policy Implication The study will suggest certain policy measures that need to be adopted at micro, meso and macro levels for the improvement of agriculture sector. This could be applicable to Sridhar Thapa 8

formulating policies on rural factor markets in the country. It will also be an important input to poverty reduction strategies and employment generation programmes. References: Abdulai, A. and P.P. Regmi(2000). Estimating labour supply of farm households under nonseparability: empirical evidence from Nepal. Journal of Agricultural Economics 22: 309-320. ADB(2004). Nepal quarterly economic update, Asian Development Bank, Nepal Resident Mission, Kathmandu, September 2004. Ahamad, Ali and S Isvilanonda (2003), Rural Poverty and Agricultural Diversification in Thailand Scandinavian Working Papers in Economics No 2003:19. APROSC and JMA (1995), Nepal Agriculture Perspective Plan (Final Report), Kathmandu: Agricultural Projects Services Centre and John Mellor Associates. Aryal et al. (1999). Quantitative Techniques, Basic Economics and Nepalese Economy, Sagun Books and Stationary, Kathmandu, Nepal. Bardhan, A. and C. Udry(1999), Development Microeconomics Oxford University Press, 1999, London. Berghouti, et al.(2004). Agricultural Diversification for the Poor: Guidelines for Practitioners Agriculture and Rural Development Discussion Paper 1, The World Bank. Binswanger H. P. And M.R. Rosenweig (1986), Behavioral and Material Determinants of Production Relations in Agriculture, Journal of Development Studies 22 (3): 503-39. Cameron, et al (2001), Education and labour market participation of women in Asia: evidence of five countries, Economic Development and Cultural Change Vol 49, No.3, 459-477pp. CBS(2005), Nepal Living Standard Survey 2003/04, Central Bureau of Statistics, Nepal Government, 2005, Kathmandu Nepal. Chaplin, H., S. Davidova, and M. Gorton(2004), Agricultural adjustment and the diversification of farm households and corporate farms in Central Europe, Journal of Rural Studies, 20, 61-77. de Janvry, Alian, Mircel Fafchamps, and Elizabeth Sadoulet(1991), Peasant Household Behaviour with Missing Markets: Some Paradoxes Explained. The Economic Journal 101, 1400-1417. Dorjee K. et at(2003), Diversification in South Asian Agriculture: Trends and Constraints ESA Working Paper No. 03-15, Agricultural and Development Economics Division, FAO. FAO and World Bank (2001), Farming systems and poverty-improving farmers livelihoods in a changing world. Rome and Washington D.C.

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Hanan, G Jacoby, 1998, Access to Markets and the Benefits of Rural Roads World Bank Policy Research Working Paper No. 2028. Holden, S and Bekele Shiferaw(2004), Land degradation, drought and food security in a less-favoured area in the Ethiopian highlands: a bio-economic model with market imperfections, Agricultural Economics, Vol.30, Issue 1, pp 31-49. Joshi, P.K. et al(2003), Agricultural Diversification in South Asia: Patterns, Determinants and Policy Implications, Markets and Structural Study Division Discussion Paper No. 57, IFPRI. Laszlo, Sonia(2003), Education, Labour Supply and Market Development in Peru, McGill University, MOF 2006. Economic Survey 2005/06, Ministry of Finance, Government of Nepal, Kathmandu, Nepal. Nelson, A.W. and Temu, A(2005). Liquidity constraints, access to credit and pro-poor growth in Rural Tanzania, Journal of International Development, 17, 867-882. NPC(2002), Tenth Plan Unofficial Translation, National Planning Commission, Government of Nepal, 2002/03. Pingali, P., and M. Rosegrant, (1995). Agricultural commercialization and diversification: processes and policies. Food policy. Volume 20, number 3, Pages 171-185 Pingali, Prabhu(2004), Agricultural Diversification: Opportunities and constraints, FAO Rice Conference, Rome, Italy, 12-13 February 2004. Sadoulet, E., A. de Janvry and C. Benjamin (1996), Household Behaviour with Imperfect Labour Markets, Working Paper Series, Dept. of Agricultural and Resource Economics, University of California, Berkeley. Sharma, K.C. Crop Diversification in Nepal, Paper presented at the Expert Consultation on Crop Diversification in the Asia-Pacific Region held in Bangkok, Thailand and organized by FAO Regional Office for Asia and the Pacific. Singh, Square and Strauss(eds,(1986) Agricultural Household Models-Extensions, Applications and Policy. Baltimore: The John Hopkins University Press. Taylor, J.E. and Irma Adelman(2003), Agricultural Household Models: Genesis, Evolution, and Extensions, Review of Economics of the Household, 1, 33-58. Thapa, Sridhar(2003). Estimation of the Agricultural Household Labour Supply: A Case from Mardi Watershed Area, Kaski, Nepal. Dissertation submitted to partial fulfilment of Masters of Science in Development and Resource Economics, Department Economics and Social Science, Agricultural University of Norway. Thapa, Sridhar(2004). Labour Force Participation in Agricultural Households of Nepal: A Probit Model Analysis. The Economic Journal of Nepal, Vol.27, No.4, 204-211pp. World Bank (2006). Nepal at a glance, The World Bank Group World Bank(2005), World Development Indicators 2005 Washington DC.
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