## Tuesday, October 26, 2010

### The lemons model' in milk procurement

One of the classic stories of India of old is that of Amul, which brought new technology into milk procurement. When the farmer brought his shipment of milk to the Amul front-end, a centrifuge was used to measure the characteristics of this shipment, and based on this payments were made. See this blog post by Alok Parekh, Naman Pugalia and Mihir Sheth. This eliminated the incentives for aduleration of milk by the farmer, which used to be done by adding in water or by skimming the cream.

We can think about this differently. Suppose the centrifuge was not there at the front end. Then the buyer of the milk faced asymmetric information about the characteristics of the milk that were being offered to him. Generally we expect that faced with this lemons' problem, the buyer would bid low prices for the milk.

So to some extent, the ability of Amul to pay higher prices for milk is not about the greatness of cooperatives when compared with profit-oriented firms: it was about the injection of new technology which removed this asymmetric information.

The interesting puzzle is: in that age, why was Amul the pioneer in buying centrifuges? Why did no private firm buy centrifuges and create a winning business model around milk?

### Penalty structure under incomplete detection

Another nice idea that we have understood is the relationship between the probability of getting caught and the penalty. Suppose the fee required for parking is Rs.10 and suppose the probability of getting caught when illegally parked (i.e. without paying the fee) is 10%. Then it's sensible to set the penalty for getting caught at Rs.100 so that even a risk-neutral person will prefer to play by the rules.

This can be applied in the problem of milk procurement. Suppose we say to the farmer: We'll trust you and accept your milk, but on a sampling basis, one in ten farmers will be tested.

Suppose a person added 2 litres of water to his shipment of milk and suppose the price of milk was Rs.10 a litre. In that case, he was trying to steal Rs.20 by palming off low quality milk. But there was only a 10% probability of getting caught, because only one in ten farmers is tested. So the penalty he should face should be Rs.200. If this is done, the risk-neutral farmer is agnostic between playing fair and cheating, even if only one in ten farmers is tested.

The advantage of this strategy is that for 90% of the farmers, the deadweight cost of putting a sample into the centrifuge is eliminated.

This idea is, of course, general:
• Sometimes, we are in situations (as in market manipulation in finance) where we know that even the best regulator in the world will only catch some of the crooks. So we should estimate what fraction of the crooks are getting caught, and then multiply up the size of theft that was attempted. That is, the right way to think of disgorgement is not that the bad guys should fork up the money that was stolen, but that the penalty imposed by the government should be equal to the size of theft divided by the probability of detection.
• Sometimes, while comprehensive checking is feasible, it's quite expensive, and it's efficient to deliberately only do checking on a sampling basis. A fairly modest scale of randomised checking (e.g. 5%) can do the trick, coupled with a 20x multiplication factor against the size of the theft that was attempted. This would yield a 95% reduction in the amount of checking that is required. This is the idea in the milk example above.

1. Ajay, interesting piece. Incidentally in the world of milk procurement, before Amul,access to technology due to controls was very restricted. Amul had access to the world of operations flood money and interaction with donors in Europe hence awareness and hence checking at source. Others did not have this access. Private players did not procure milk directly and worked through bulk contractors who ensured quality ( example Nestle at Moga and Glaxo at Aligarh )

2. incidentally, the same logic works in policing. Speeding and traffic signal violations are expensive stuff ( atleast in Delhi ). Of course, corruption defeats the purpose and people try to negotiate the unoffical fine quantum.

3. Sir, A good piece of information... a couple of days back I was discussing with one of my friend about the possibilities in the unorganized market of "Bidis" in western India. He is in this business in West Bengal for last 20 years and so and trying to enter in the market of western India. He says in those regions, end-users are so much used to the low-quality bidis for over 2-3 decades that today even if someone offers them better quality "Bidis" even at cheaper price they are not ready to try it.. we are continuously trying to figure out what innovations can be made here to penetrate this market... Of course, tobacco is injurious to health and one shall not advertise... it is still early days but I am sure something new just like the Amul story will come up going forward..

4. Isn't there a small error in the penalty structure for milkman.

Potential Gain = Potential Loss
=> 90% x 20 = 10% x Penalty
=> Penalty = Rs 180

ofcourse, its irrelevant to the broader point in the article, but still thought would point it out

5. Last year we saw how lemon market also contribute to China's food safety woes. Take infant formula scandal, the San Lu dairy and other milk giant groups have for years lowered the prices to buy in fresh milk, which severely harms the interests of cow farmers and lures them to devise ways to dilute milk to gain some margin, the use of chemical additives being among them. Meanwhile, a morbid and fierce competition plaguing the entire milk industry and involving all the milk groups is unfolded nationwide, with competitors fighting one another in whatever way they could imagine for a larger market share. This has inevitably evolved into a vicious circle, in which costs will be constantly brought down, and to beat rivals and win a slice of market, milk groups will have to squander a good part of their revenues on advertising and marketing. The price will be finally paid for by consumers, and it has already proven much too high.

6. Indeed very interesting analysis. However I would also like to think how this would work when there are externalities for the evaluator for example incentive (read bribe) by the car owner to the cop

7. Ajay,
Thanks for sharing your views about how to wisely use penalty to check adulteration. Here I would like to question the idea of fixing the penalty in proportion to the attempted theft. Why should we have a 20X (for 5% random checks) or 10X (for 10% random checks)? Why not more? Much more? Say 50X or 100X. One drawback is that an extremely hard penalty can become a deterrent for many joiners.
(=> But why should a rule abiding player fear?)
Also, with an extremely high penalty it becomes ever more necessary to have a full proof system which ensures that no innocent is ever penalised due to a loophole in the checking system.
(=> A reasonable penalty to cover up for a non-perfect checking system?)

Are there any other reason for having such reasonable penalties which essentially say that you are WELCOME to cheat, although, in the long run your cheating may not yield any gain?

1. The purpose of punishment is deterrence, not retribution.

If stealing leads to getting your hand cut off with a probability alpha, Yes, that will yield extreme safety (e.g. in Saudi Arabia) but that's not the society that we want to live in. We want to achieve the desired goal (low crime) using the smallest possible interference in society by the State.

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