1) The document discusses food safety regulations and dairy value chains in Kyrgyzstan, specifically whether private or government inspections are better for monitoring compliance. 2) A game theoretic model is used to analyze second-party monitoring (by sellers) versus third-party monitoring (by independent auditors or government). More frequent inspections are found to reduce compliance when done by sellers due to wasted monitoring costs. 3) Third-party monitoring can improve welfare by inspecting less frequently but maintaining high compliance, especially when suppliers face greater liability and buyers are more forgiving of occasional low quality.

1. REGIONAL RESEARCH CONFERENCE
AGRICULTURAL TRANSFORMATION
AND FOOD SECURITY IN CENTRAL ASIA
Food safety, SPS regulations and dairy value chains in
Kyrgyzstan: private or government inspections?
Alexander Saak
(collaborator Nurbek Omuraliev, Center of the Methodology of
Science and Social Research, Kyrgyzstan)
International Food Policy Research Institute

2. Introduction
Provision of food safety is subject to moral hazard
- consumers learn quality after purchasing
This problem is compounded in developing countries
- unstable supply chains
- limited private liability for health losses
- limited public funding for oversight
Policy question: private or government monitoring of
compliance with food safety regulations?

3. Food safety policy in Central Asia
• important for consumers and producers
• 50% of food exports was SPS-sensitive: meat and
preparations, dairy, eggs, fish, fruits and vegetables
(Kyrgyzstan, 2005)
• access to international markets requires compliance with
SPS and veterinary regulations
• reforms of inspections and food safety standards

4. Government monitoring of agricultural producers in Kyrgyzstan
Investment Climate as seen by Small and Medium Enterprises in the Kyrgyz Republic
(World Bank)
- survey of 623 farmers (owners of private agricultural firms, total 321856) in 2009
- farms are small: annual profit $1200 on sales $3100
- government oversight:
farmers were least subject to inspections
29% were subject to investigation by at least one inspectorate in 2008
- informal payments: 24-44% gave bribes to government officials
- cost of government inspections relative to profit is 2.5%
- current standards for processing firms are particularly burdensome
Quote from the report:
“It is therefore recommended that the Kyrgyz Republic moves away from the
[mandatory government standards and certification] for food products, and ensures
instead (i) that all food business operators implement and adhere to HACCP, GMP
and GHP and (ii) the traceability of all food products, starting with meat and milk.
These approaches are in line with Codex Alimentarius food safety practices.”

5. What determines the choice between private and government inspections?
- intrinsic motivation (public health vs profits)
- monitoring technology (obsolete test for nitrates vs innovation)
- size and scope (69% of permits to farmers were issued by local governments)
Some monitoring is technologically necessary
- testing and grading by fruit size or milk fat content
Some monitoring is technologically unnecessary
- inspections of compliance with food safety regulations
Our focus is compare which inspection system is better:
downstream party inspects upstream party (second party monitoring)
or
government or private auditor inspects upstream party (third party monitoring)

6. Model of value chain
Second-party monitoring Third-party monitoring
supplier
seller + monitor
buyers
supplier
seller
buyers
monitorvs

7. Stage game
1. Seller is matched with a random supplier with limited liability
2. Seller privately proposes contracts ),,( lh www and ),,( lh fff
to supplier and monitor
3. Supplier and monitor publicly decide whether to accept contracts
4. Supplier and monitor play a simultaneous move game:
supplier privately chooses high or low effort (e=h or e=l) at cost c(e)
monitor privately chooses to monitor at cost k or not
5. Monitor publicly reports },,{ lhr and contractual transfers are made
6. Seller sets the final good price p
7. Buyers get pev )( if they purchase
8. Quality },{ lhq is publicly observed if buyers purchased
Trade repeatedly with discount factor )1,0(

8. Institutional choice
Compare performance (social surplus) in two regimes:
- second-party monitoring (seller inspects)
- third-party monitoring (independent party inspects)
Incentive compatibility conditions
suppliers are willing to
- randomize between compliance and non-compliance
- participate
monitor is willing to
- inspect
- report truthfully the outcome of inspection
seller is willing to offer contracts to supplier and monitor
buyers are willing to buy

9. Endogenous variables
contracts between the players
z(r,q) – probability that the game continues (reputation is good)
x – probability of compliance with food safety standards
y – probability of inspection
Two types of inefficiency
- costly inspections
- no trade or trade in low quality
happen in equilibrium

10. Second-party monitoring
Inspections are frequent
Compliance frequency is determined by
   
payoff
deviation
sseller
hh
effortlowof
yprobabilitthebydivided
costmonitoring
value
reputation
discounted
sseller
hh cv
x
k
kcvx
''
1
1
))((
- no information rent for suppliers maximizes sustainable compliance rate
- social surplus is wasted on monitoring
=> third-party monitoring may improve welfare
- if supplier’s liability is large, infrequent monitoring is optimal and social surplus is not dissipated

11. Third-party monitoring
For small discount factor

  
rent
reputation
smonitor
payoff
deviation
sseller
h
value
reputation
chainsupply
hh
xx
k
v
kcvx
'
'
)1(1
)(
(contracts deviation constraint)
- low compliance
- frequent inspections
- buyers never forgive low quality
For large discount factor
    
rent
reputation
smonitor
payoff
deviation
sseller
lh
value
reputation
chainsupply
hh
xx
k
z
vxxv
zxx
cvx
''
)1(1
)1(
))1((1
)(
(contracts deviation constraint)
- high compliance
- infrequent inspections
- buyers sometimes forgive low quality

14. Intuition



effortlowof
yprobabilitthebydivided
costmonitoring
revenue
current
sseller
value
reputation
discounted
sseller
gain
ldeviationa
sseller
value
reputation
sseller
x
k
cvkcvx
vkcvx
'
'
1
'
'
1
1
1
))((
))((
monitoringparty-second
  
  
third-party monitoring with frequent monitoring



rent
reputation
smonitorgain
deviation
sseller
value
reputation
chainsupply
xx
k
vkcvx
'
' )1(
))((
1
1
third-party monitoring with infrequent monitoring
  
rent
reputation
smonitor
gain
deviation
sseller
value
reputation
chainsupply
xx
k
z
vx
zxx
cvx
''
)1(1))1((1
)(

15. Empirically testable hypotheses
- compliance is greater under infrequent inspections than under frequent inspections
Compliance costReputation
concern
small large
small frequent, third-party infrequent, third-party (low-risk products)
frequent, second-party (high-risk products)
large no trade or low
quality
frequent, second-party
SPS-sensitive products
private inspections:
big downstream party (national or international brand, export, large market share)
high cost/price ratio, competitive markets
government inspections
small downstream party (sells in local market, small market share)
small cost/price ratio

16. Evidence from survey (coming soon)
Dependent variables
Frequency of inspections
Frequency of compliance
Who inspects
Bribe extortion?
Explanatory variables
Frequency of sales and size (to measure reputation capital or discount factor)
Premium for high quality products and compliance costs (to measure returns to quality)
Upstream penalties for non-compliance (to measure whether liability is limited)
Cost of monitoring
How are public and private food safety inspectors incentivized?