Greetings to the Chair of the Committee of Inquiry and to all the members of the COI. I am Dr. Alejandro Nadal, Professor at the Centre for Economic Studies, El Colegio de Mexico, in Mexico City. I’m also the Chair of the Theme on the Environment, Macroeconomics, Trade and Investment (TEMTI), with CEESP-IUCN. My opinion does not necessarily represent that of these two institutions. I present this submission on behalf of the Conservation Action Trust of South Africa.
Thank you for the opportunity to make this submission to the COI in order to share aspects of my experience with market structures and price formation dynamics. I started doing research with an industrial organization perspective in 1973 and since then I have carried out studies on market structures and competition in a wide variety of industrial branches, including some that are close to the natural resource base. I have taken part in multinational research projects on technical innovation in manufacturing industries through an industrial organization perspective. My research provides me with solid experience on how markets and firms operate, especially in the context of cycles and major disruptions such as the introduction of technical innovations in process and product technologies. I have briefed Mexican economic authorities, as well as committees in the Mexican Congress on industrial and technological policies, as well as on various environmental issues, including biosafety legislation.
The rhino population in Africa is experiencing an acute poaching crisis that threatens the survival of the species. This crisis has renewed the debate on whether a legal market for rhino horn should be considered an effective complement to, or even the centre of conservation policy for rhinos. The argument for a market solution to the poaching crisis starts with the premise that poaching and illegal trade are a consequence of high prices for rhino horn, which create incentives strong enough to compensate for the costs and risks of criminal activity. High prices of horn, in turn, are assumed to be the outcome of an insufficient supply derived from the trade ban, and a persistent demand insensitive to price movements, rooted in strong cultural patterns. Demand is typically considered to be price inelastic and based on rigid cultural values that will be difficult to change.
In addition, various estimates have been presented showing that de-horning, confiscated and other sources of horn can supply quantities of horn large enough to meet demand and bring prices down. Suspending the trade ban, the reasoning continues, would increase and stabilize the supply of horn and bring prices down, reducing the incentives to poaching and illegal trade and providing an additional revenue source for private owners and public parks. A market mechanism would thus contribute to conservation by reducing poaching and increasing revenues for conservation.
There are several problems with a market-based policy recommendation based on this line of analysis. The most important one is that the economic reasoning is too weak to provide an adequate frame for a rigorous assessment of this policy approach. Its assumptions are extremely simplistic and some have been shown to be logically inconsistent. All of this makes it impossible to reach robust conclusions as to the merits of a policy that relies on a legalized rhino horn market to solve the current poaching crisis.
In what follows I concentrate on three aspects of the policy proposal to use a market-based approach for rhino horn. They need to be taken into consideration in order to properly assess the policy option of legalizing this trade. I also want to point out that the observations that follow apply mutatis mutandis to crime syndicates as well as to other illegal units that operate as commercial firms (and where the legal definition of organized crime may or may not apply). All of these entities already operating in the illegal rhino horn trade in Asian countries seek to increase and sustain their levels of profitability. They are the incumbent firms against which the legal trade will have to compete.
Firm Level Considerations
Almost nothing is known about the microeconomic features of the individual agents involved in rhino horn trade in Asian markets. These individual agents operate along the value chain and they are probably involved in a sequence of transactions that go from poaching and wholesale operations to retail sales. Whatever the level at which they operate, almost nothing is known about the following: type of firm, size, ownership, costing structures, diversification and their financial profiles and linkages. All of these aspects of a firm’s operation are key determinants to its capacity to undertake and/or withstand a protracted price war.
The size and ownership patterns of the individual agents or firms operating in the rhino horn market are important in order to have an idea of their objectives and strategies. The costing structures are also critical in order to understand the tools at the disposal of these firms to implement their strategies. In some cases, it is possible that scale economies have become an important element of their activities. If this is the case, models relying on the assumption that firms or marketing entities operate at or near full capacity and thus incur in decreasing yields may be unrealistic.
Models of single-product firms are inappropriate for policy analysis when dealing with multiproduct firms. This applies to the activities and strategies of crime syndicates as well. Entities operating in the rhino horn market may behave much like any other firm in a market economy and if this is the case, they must be engaged in several lines of production or marketing at the same time. In other terms, these entities are multiproduct firms and their profitability does not depend solely on its sales or handling of rhino horn.
Engaging in several lines of production and/or marketing simultaneously leads to very important scope economies. The impact of product bundling on the costing structures of firms is significant and it is also well known. Bundling can lead to extremely reduced costs for some products in key phases of production, distribution and marketing. If that’s the case for entities involved in rhino horn trade, the component of marketing and distribution costs for rhino horn may be a very small element in the final price. This costing structure will provide a significant amount of flexibility to entities operating in the rhino horn market when determining prices and may allow them to survive a protracted price war.
Besides lacking information on costing structures of entities engaging in the rhino horn trade in Asia, almost nothing is known about their financial profiles. How retailers and middlemen are financed or how they provide credit to their clients is an important part of the equation as it allows firms to withstand price wars in a given product. In the case of large commercial firms, gross profit margins and other profitability indicators, as well as debt/equity indicators are important for management. For small sized retailers financial ratios are also important to understand liquidity, working capital and profitability ratios. Once again, the capacity for leverage and financial support from middlemen can result in greater flexibility in price manipulation or in withstanding price reductions. Strong financial backing or strategies can provide traders with greater capacity to survive downturns in the economic cycle. It may also help traders, middlemen and their retail networks to launch or resist a price war if the rhino horn market is legalized.
Another typical assumption is that firms maximize profits. However, firms do not always put profit maximization at the top of their strategies. In its place firms may engage in revenue or sales maximization. Sometimes firms may be more concerned with increasing or protecting market share. And in many cases, surviving a recession or a financial crisis may be the overarching goal. Firms’ strategies depend on a number of critical factors that need to be taken into account in a rigorous policy analysis. Some of these factors can depend on the firm’s own decisions (for example, launching a new product or engaging in an aggressive advertising campaign), while others depend on factors beyond the control of the firm (if the particular market is expanding, if there is a recession or if the cycle is in its downward phase). The most important channels of competition between firms operating in a given market are a crucial aspect of any branch of activity and need to be considered in policy analysis.
Summarizing, the relevance of this analysis for the debate on rhino horn trade stems from the fact that the incumbent firms may prefer to remain in the trade with lower rents. The presence of scope economies reinforces this argument. Thus, even if price reductions are achieved in one product, a multiproduct organization may be able to remain in operation for a long period of time.
Market Structure, Competition and the Value Chain
At the level of the market in which individual firms operate we find another set of variables that needs to be considered when evaluating a market-based policy. The most important variable pertains to the concentration ratios that exist in a given market or industry. The proportion of the market cornered by the top four firms is a widely used indicator of the level of concentration of market power. High ratios are indicators of market power that can be used to engage in strategic behaviour. It is also a frequent sign of the presence of entry barriers in the industry. All of these indicators reveal the scope and limitations of a policy based on the premise that a segment of the incumbent firms will be eliminated (or out-competed) by the new policy. Whether this is a valid proposition or not depends critically on the existing market structure. This point has been made even in the limited context of a partial equilibrium model where increasing costs prevail and single product firms operate.
Market structures, as well as the physical characteristics of products and production processes determine how firms compete with each other and how differential advantages develop amongst firms. This affects the evolution of future market structures and concentration ratios, as well as the process through which prices are formed.
What will happen when new entrants have to start operating next to the incumbent firms in a legalized rhino horn market? There is no easy answer to this question, but considerations from the theory of industrial organization may illuminate this point. It may be of interest to consider here the case of contestable markets where potential competitors are in conditions to effectively challenge the practices of incumbent firms. Just as in other oligopoly models, incumbent firms are supposed to react to the threat of a new competitor setting a lower price and taking away their share of the market. It could be thought that this is enough to exert pressure on the incumbent “firms” and bring the prices down. However, for this to happen, the theory of contestable markets requires that entry barriers, as well as exit barriers, remain non-existent and that scope economies remain weak. These two conditions are almost never met.
To summarize, information on market structures and channels or forms of competition is crucial when evaluating a policy response such as the proposed legal market for rhino horn. If the objective of this policy is to put out of business a segment of incumbent firms (or all of them) it is essential to know how these firms will compete with the new entrants in the emerging market environment.
Competition may take place through a variety of channels, one of which may be price reductions. The premise that a legal market with a stable supply will bring down prices and put out of business the illegal trade is based on the notion that this is the main (or even the sole) channel of competition. But if other channels of competition prevail, this result may not be forthcoming. For example, competition may take place through a well-organized network of retailers or through aggressive marketing campaigns aimed at further developing certain market niches. Competition can also take place through superior process and product technologies (including product diversification), through money lending practices where consumers are tied to specific suppliers or through bundling with other products. The predominance or even the mere presence of these alternative forms of competition can have significant repercussions and may thwart efforts to put illegal traders out of business.
Finally, the space between the killing fields where poaching occurs and the place where retail transactions are carried out has several stages. In each one of them particular transaction costs prevail. These costs can be internalized by a single firm or trading unit, or they may be related to separate entities. The capacity to withstand a price war also depends heavily on the particular structure of the value chain. The degree of vertical integration of the entities operating in different segments of the value chain is another key variable that needs to be taken into consideration. Unfortunately, very little is known about vertical integration in the existing illegal rhino horn market beyond some anecdotal evidence.
A legal market for rhino horn will not bring the automatic elimination of the causes for market failure. Whether there is a central selling organization or a different scheme, the need to control corruption will not be eliminated. There may be a greater need to maintain or even enhance oversight or controls over all segments of the value chain to prevent laundering operations that will seriously degrade the capacity of the new policy to achieve its objectives.
Although it has been repeatedly pointed out that demand for rhino horn is rigid (inelastic) to price changes and extremely hard to reduce in view of the cultural values on which it is based, very little is known about the structure of demand and its response to price changes. Aside anecdotal evidence and some data from the IPSOS consumer survey, it remains true that almost no information is available on how final demand may react to price reductions. This is another important aspect of the rhino horn market that needs careful evaluation. If the proposed market-based policy does lead to price reductions, the response from the demand side needs to be rigorously evaluated. Assessing the impact of a legalized rhino horn market on final demand is a minimum minimorum for adequate evaluation of this market-based policy.
Up to date we know very little about market segmentation and diverse consumption propensities. The lack of information on demand applies to potential responses to price changes with respect to different formats of the final product (complete horn, pieces or powder). Each one of these different uses probably has a different sensitivity to price changes, income effects, and market re-organization. None of these uses are substitutes and thus we may observe them in the same individual at the same time. They may entail relationships underlying consumer behaviour that are more complex than those normally assumed by standard consumer theory.
The assumptions concerning consumers and final demand used in simple partial equilibrium models are based on highly restrictive conditions. In these models consumers make fully informed, rational choices, with a schedule of preferences ordered according to (decreasing) marginal utility. But perhaps the most important problem here pertains to the fact that once we relax the over-simplistic assumption that we are dealing with a single commodity, the downward sloping demand curves are logically inconsistent. This is one of the reasons why partial equilibrium modes of reasoning about the rhino horn market need to be abandoned and replaced by a more realistic (and rigorous) framework capable of analyzing both, consumer behaviour and market-level demand dynamics.
Because the nature of firms and the structure of the existing illegal rhino horn market are not well understood, it is impossible to rule out the case where some traders may seek to compensate revenue losses through the market expansion via lower prices or other avenues. Pro-active marketing campaigns are standard strategies in all branches of economic activity and they cannot be ruled out in the rhino horn market. If this takes place the market will grow and develop as prices are brought down.
In the absence of more information on the nature of firms, the structure of markets, price-formation dynamics and the response of final consumer demand, it will not be possible to adequately evaluate a policy proposal to legalize the rhino horn market. Some of the critical features of industrial organization mentioned in this submission reveal that legalizing a rhino horn market can lead to a serious case of policy failure. The extinction of rhino populations could be the end result.
The trade versus no-trade polarisation has not been very constructive and has probably led to shunting aside other potentially valuable policy options. I’m glad the issue of policy options is now being raised. There are indeed many alternatives that need to be evaluated just as rigorously as the market-based option. This is a discussion that has not been taking place and I hope the current debate will open the door to more work in this front.
Thank you for your consideration. If you have additional questions I’ll be glad to address them.
Nadal, A. and F. Aguayo (2014)
“Leonardo’s Sailors: A Review of the Economic Analysis of Wildlife Trade”. LCSV Working Paper Series No. 6. Leverhulme Centre for the Study of Value. The University of Manchester.
 On this point, see Nadal and Aguayo 2014 and references therein.