Fair Trade and Free Entry: Generating Benefits in a Disequilibrium Market

Fair Trade (FT) markets have been introduced as a mechanism to improve the economic livelihoods of smallholder farmers by translating consumers’ “ethical demand” into higher prices for producers. Unlike other certification mechanisms such as organic, dolphin-friendly, and shade grown that intend on affecting the production process, FT explicitly seeks to deliver rents to producers via the price mechanism. We provide a simple theoretical setting in which to understand FT coffee markets and show that producer entry will naturally tend to dissipate the rents that the system seeks to create. Even when the system successfully holds floor prices above the market price, overcertification will tend to continue until producer profits are the same as they would be under the traditional system. The tremendous quality heterogeneity in coffee prices, combined with FT prices that do not explicitly recognize quality, generates an inverse relationship between market prices and FT quality and provides an additional mechanism through which market behavior tends to drive down producer rents. We use data from a unique second-tier producer cooperative in Central America to measure FT premiums empirically, and find that the non-organic FT premium has been minimal. As predicted by our theory, the quality of non-FT coffee has improved in recent years while the quality of coffee sold on the FT market has stagnated. We suggest how the certification mechanism could be restructured to create greater producer benefits from FT markets.