How can markets contribute to economic growth and development?

On the surface, a bumper crop might just be the breakthrough a struggling farmer needs to overcome poverty; however, in low- and middle-income (LMIC) countries, market frictions and distortions may still derail the path to economic relief. What do we know about these challenges, and how may policy interventions ease them?

Understanding market frictions through the lens of agriculture

In LMICs, farmers face many challenges, from sowing and nurturing crops to harvesting and distributing them. Even if crops withstand the vagaries of the climate and water supply, the efforts of farmers may still be thwarted by obstacles posed by the markets in which they sell their crops. They may have to pay a disproportionately high cost to a local trucker to bring their harvest to a nearby market for sale. There, they may be forced to negotiate with buyers (agricultural intermediaries) who hold most of the bargaining power. If the offer price is too low, they may still feel compelled to sell – a need compounded by a lack of access to credit and storage facilities. Even when government programmes that guarantee minimum crop prices exist, imperfect implementation and/or a lack of awareness about these programmes might prevent them from reaping the benefits.

On a broader scale, the link between well-functioning markets and economic growth is widely acknowledged by economists and policymakers. In a well-functioning market, firms can thrive, and consumers can readily access the desired goods and services. Conversely, when markets fail to function well due to frictions or distortions, they may disincentivise production and/or consumption, leading to economic stagnation or decline. Still, while market imperfections are present everywhere, they are more acute in LMICs than in higher-income countries.

To put this into perspective, consider a farmer in a high-income country for whom the aforementioned concerns may be minimal, if at all present. Once the harvest is ready, farmers in high-income countries have access to a range of logistical and financial services and well-established supply chains, which allow them to focus more on productive agricultural practices and less on navigating market inefficiencies.

Market frictions and market power in low- and middle-income countries

In LMICs, market frictions and distortions pervade intensely across sectors, directly impacting both firms and consumers in these markets. An extensive body of recent empirical research has documented these – quantifying their impact and identifying potential policy solutions. To name a few, recent work in developing countries has highlighted the gains from addressing across- and within-country trade frictions (Atkin and Donaldson, 2015; Chatterjee, 2023; Donaldson, 2018; Shu and Steinwender, 2019), barriers to entry and exit of firms (Leone et al., 2021; Majerovitz, 2023), missing insurance and credit markets (Casaburi and Willis, 2018; Karlan et al., 2014), and poor access to inputs (Bas and Paunov, 2021; Goldberg et al., 2010).

An especially important challenge, one that has been the focus of a growing body of research, is market power. Market power is the ability of a firm to directly influence market-level outcomes such as product quantity, quality, variety, and prices. It commonly manifests in the form of high output prices, which can negatively impact downstream firms and consumers. Market power can also emerge as monopsony power - the ability of a firm to set input prices, such as employee wages or, in agriculture, the prices paid to farmers. Of course, in some instances, it may be optimal to allow firms to wield market power – particularly when the cost of entering a market is prohibitively high. The prospect of exercising market power can incentivise investment and innovation, enabling firms to recuperate their initial costs and promote the growth and development of an industry. Nonetheless, excessive market power can harm consumers and stifle the growth of adjacent industries.

In LMICs, where the state capacity for antitrust regulation and enforcement is often limited, market power can be especially pervasive and unchecked. Recent work has shown the various ways in which market power affects firm and consumer outcomes in agricultural markets. Bergquist and Dinerstein (2020) provide experimental evidence that agricultural intermediaries in Kenya behave like a cartel, and only pass on about 22% of upstream cost savings to their consumers. Chatterjee (2023) shows how policies in India that limit spatial competition between agricultural intermediaries lower farmer incomes. Outside of agriculture, De Loecker et al. (2016) illustrate how market power dampened the benefits to consumers from trade liberalisation in India. Easing of trade restrictions allowed Indian firms to import cheaper inputs, but this decline in input costs did not translate into a similar decline in consumer prices. In addition, Sharma (2023) shows how the wage-setting (monopsony) power of firms can explain part of the gender wage gap in Brazil.

A twin challenge for policymakers

Policymakers in LMICs face a twin challenge: to address these frictions while ensuring sustainable growth.

The two goals are not necessarily at odds with each other, but there may be trade-offs that must be accounted for. For example, policies that encourage firms to engage in trade might also amplify incentives to expand production at the expense of environmental degradation. To mitigate such impacts, these policies should also provide firms with incentives that promote higher production while minimising environmental costs. Atkin et al. (2017) illustrate that the mere availability of a waste-reducing production technology for cutting soccer balls in Pakistan is not sufficient for its adoption by firms unless accompanied by appropriate financial incentives. Similarly, clearing out crop residue is prohibitively expensive for farmers without access to mechanised equipment. As a result, farmers in India often resort to burning their fields after harvest, which causes severe air pollution. Through their study, Jack et al. (2022) provided farmers in India with financial incentives to keep them from burning their fields after harvest. Their findings suggest that policies that generate the right incentives for producers can help prevent environmental degradation.

Policymakers may also choose to offset growth-induced environmental harm through demand-side interventions that help residents of LMICs mitigate the effects of environmental degradation. A recent paper by Barwick et al. (2022) shows how access to a high-speed transportation network can allow people to temporarily escape extreme air pollution and temperature by enabling travel to nearby cities, thereby reducing the adverse health effects of such events.

Conclusion

The pursuit of economic progress in LMICs is intimately tied to the resolution of market imperfections. Policy interventions that address these challenges and enable producers and consumers to engage in efficient trade can help unlock growth and development. But these interventions must also be designed to ensure that growth is sustainable. Designing such policies that tackle these twin challenges is not easy, but new empirical research continues to deliver valuable insights that can inform policymaking in LMICs.
 

To learn more, tune in to the Firms, Trade, and Development conference on 19 and 20 October. This article was published in collaboration with the Yale Economic Growth Center.