Partial Implementation of COOL: Economic Effects in the U.S. Seafood Industry

Transcription

1 University of Massachusetts Amherst Deartment of Resource Economics Woring Paer No htt://.umass.edu/resec/oringaers Partial Imlementation of COO: Economic Effects in the U.S. Seafood Industry Siny Joseh 1, Nathalie avoie 2, and Julie A. Casell 3 Abstract: Mandatory Country of Origin abeling (MCOO as imlemented on seafood in the United States on Aril 4, 25. MCOO exemts the foodservice sector and excludes rocessed seafood from labeling. This aer contributes to understanding the economics of the MCOO la for seafood by shoing that current artial imlementation may have unintended consequences on the domestic suly chain. While labeling satisfies the maret demand for information rovision in one maret, exemtions in the other maret may create incentives for the diversion of imorts, hich are assumed to be loer in quality than domestic seafood, to the non-labeled sector. Analyzing alternate scenarios such as voluntary labeling shos that total elfare may be greatest under this scenario comared ith artial MCOO. Voluntary origin labeling of seafood by some U.S. retailers indicates there is no comelling maret failure argument arranting artial MCOO imlementation. This or is therefore a ste toards analyzing the effect of artial MCOO olicy in the seafood industry taing into consideration the nature of the industry. Keyords: Country of origin labeling, roduct differentiation, information asymmetry, seafood JE Classification: 15, 22, 18 1 Siny Joseh, Deartment of Resource Economics University of Massachusetts, Stocbridge all 8 Camus Center Way, Amherst, MA E: siny@resecon.umass.edu P: F: Nathalie avoie, Deartment of Resource Economics University of Massachusetts, 212D Stocbridge all 8 Camus Center Way, Amherst, MA E: lavoie@resecon.umass.edu P: F: Julie A. Casell, Deartment of Resource Economics University of Massachusetts, 215 Stocbridge all 8 Camus Center Way, Amherst, MA E: casell@resecon.umass.edu P: F:

2 Partial Imlementation of COO: Economic Effects in the U.S. Seafood Industry Introduction The recent sate of incidents ith U.S. imorts has turned the heat bac on the issue of mandatory country-of-origin labeling (MCOO. Prominent incidents are recalls of a number of Chinese-made roducts: farm-raised shrim and catfish, et food laced ith contaminated heat gluten, toothaste containing diethylene glycol a oison used in antifreeze, children's neclaces and earrings, toy trains and oular reschool toys containing high levels of lead. Barboza (27 outlines the degraded conditions in hich some seafood for exort to United States is farmed in China. The media also reorts that at-ris Chinese seafood shiments that are suosed to be tested for safety are going uncheced and that FDA ersonnel insect less than 1 ercent of all imorted food and conduct laboratory analysis on only a tiny fraction of those (A Times, 27;.foodandateratch.org. At the same time, a food labeling oll conducted by Consumer Reorts shos that consumers ant to no here their food comes from and exect higher label standards. According to the oll, 92 ercent of consumers agree that imorted foods should be labeled by their country of origin. The U.S. Congress imlemented MCOO in the United States in Aril 25 for fish and shellfish. The objective as to communicate to consumers the national origin and method of roduction (ild or farm-raised via mandatory labels. oever, the labels are restricted to fresh and frozen seafood at the retail level. Foodservice establishments, small retailers and ingredients in rocessed seafood roducts are exemt. 1

3 On one hand, the resulting artial coverage creates a otentially gaing hole ossibly undermining the effectiveness of MCOO la. On the other hand, is there a maret failure that arrants the imlementation of this la? This aer tacles these issues. The increase in demand for fish and seafood, the groth of cheaer imorts of seafood and articularly the increase in consumtion aay-from-home, and the artial imlementation of MCOO imly that a large art of the maret is not covered by the la. According to ale (25, restaurants are the ey source of seafood, ith 6 ercent of consumers reorting they eat more seafood aay from home. More secifically Keithly (1985 estimates that the quantity of aay-from-home seafood roducts consumed ranges from one-third to to-thirds of all consumtion of seafood. The overall exemt maret (retailers not subject to the rule and foodservice establishments accounts for 62 ercent of fish and 75 ercent of shellfish (USDA-AMS, 24. Steart et al. (24 redict that er caita sending on seafood could rise by 18 ercent at full-service restaurants and by 6 ercent for fast food beteen 2 and 22. Currently, over 7 ercent of the seafood Americans consume is imorted (National Marine Fisheries Service, 27. The significant share of imorts in U.S. seafood consumtion raises concern about their safety. In the United States, the use of the azard Analysis Critical Control Points (ACCP system is considered necessary to ensure quality and safety of seafood. While imorts are required to have the same standards of quality and safety, enforcement may be eaer. ACCP oerates in the context of an extensive set of requirements for good manufacturing ractices and sanitary oerating rocedures. In addition, there are numerous federal and state regulations that influence the location and timing of harvest and the choices of aquaculture oerations 2

4 (Casell, 26. Products from less develoed countries are generally erceived to be of loer quality than roducts of develoed countries (Verlegh and Steenam, According to the U.S. Deartment of Commerce, 8 ercent of the total imorted edible seafood in 27 came from less develoed countries. Although there is no evidence that imorted seafood is necessarily risier, a number of countries exorting seafood to the United States have oorer internal control systems and/or are in troical areas here toxin and bacteria hazards are higher. Imorts become an issue of concern because countries vary in their use of vaccines, feed additives, and antibiotics for farm-raised fish and shellfish (Allshouse et al., 24. The objective of this aer is to examine the elfare effects for consumers and sellers ith MCOO imlementation for seafood, given that more than 7 ercent of seafood consumed in the United States is imorted and most of it (by value is consumed in the foodservice sector. MCOO is a retail labeling rogram and does not cover the foodservice sector. As noted above, exemtions and exclusions of MCOO on covered seafood roducts amount to 62 ercent fish and 75 ercent of shellfish. This effectively means that most of the imorted seafood consumed in United States is not affected by the MCOO legislation. The resence of a non-labeled sector raises the ossibility of diversion of loer quality seafood into this sector, hich might undermine the effectiveness of the la. This aer does not consider hite table cloth restaurants here quality and safety of seafood may not be an issue. To address the economic imact of the MCOO la in the foodservice and retail sector, this aer develos a concetual model that exlores diversion of imorted seafood to the non-labeled sector. The model is a variant of the model of vertical roduct 3

5 differentiation by Mussa and Rosen (1978 and exlicitly accounts for differences in consumer attitudes toards foreign and domestic seafood, hich are facilitated by origin labeling. Consumers are ostulated to differ in the utility they derive from the consumtion of domestic and foreign seafood. We assume that consumers consider foreign fish to be of loer quality comared to domestic fish. This assumtion that consumers erceive domestic fish to be of higher quality than imorted fish is reinforced by a recent safety incidents ith imorted roducts, b media reorts on fish farming ractices in develoing countries and the ineffective insection of imorts, and c resentations in oular magazine and nesaer articles of the healthy seafood guide, hich informs consumers to avoid most imorted fish (.edf.org/seafood. 1 Wimberley et al. (23 found that 8 ercent of U.S. consumers believe that food roduced or raised in the United States is fresher and safer than imorted food. MCOO la is a retail labeling rogram, hich brings us to the question of mandatory labeling in the foodservice sector. The absence of labeling (mandatory or voluntary may result in an information roblem beteen consumers and sellers. More secifically, in the foodservice maret, consumers are not informed of the origin of seafood that sellers no about. 2 This information deficit may lead consumers to mae choices they ould not have made ith full information. We assume as in us et al. (26, that country of origin is often associated ith roduct quality. ie nutritional 1 oever, it is not alays the case that imorted seafood is of loer erceived quality than domestic seafood. For examle, Mexican shrim is considered to have suerior flavor and texture over domestic or other imorted shrim (Cavanaugh, It is reasonable to exect sellers (in this case foodservice oerators are aare of the origin of fish and shellfish. They are better informed about the ingredients used in reared meals, roortions in hich they are mixed, and the cooing methods used. 4

6 attributes, quality is a credence attribute that imlies consumers cannot learn about the characteristics of a roduct readily through insection or even after consumtion (Nelson 197; Darby and Karni oever, a credence attribute can be transformed into a search attribute. With COO, quality becomes a search attribute because the label rovides information about seafood roducts that may affect the consumers ercetion and evaluation of its quality. In marets here sellers are better informed about roduct quality (or origin in our case than consumers, and hen consumers may have ercetions of the ris and hazards of consuming roducts from certain countries, the ey factor in determining hether marets for higher quality attributes oerate effectively is the success of quality signaling (e.g., labeling, advertising, arranties by sellers to consumers (Casell and Mojdusza, Several theoretical and emirical studies on quality-signaling models exlore ho communication (voluntary and mandatory beteen sellers and consumers taes lace. 3 For examle, Aerlof s (197 lemons model rovides the classic argument for ho asymmetric information may hinder marets. In this model, quality cannot be signaled. As a result a maret may not exist or only the loest-quality roduct may be sold. On the other hand, voluntary communication addressed by Grossman s (1981 unfolding model redicts a maret exists for varying levels of quality hen quality signaling is totally effective, costless, and truthful, and consumers can costlessly verify 3 A literature on informational unraveling suggests that voluntary and mandatory disclosure yield the same outcome, as long as the information is verifiable ith zero cost, as first studied by Grossman (1981 and Milgrom (1981. Voluntary disclosure leads to only artial unraveling of information is shon by Jovanovic (1982, Farrell (1986, Fishman and agerty (23, and Jin (23. Jin (23 and Mathios (2 sho emirical investigations of informational unraveling. 5

7 quality after their urchases. Sence s (1977 signaling theory argues that some sellers may voluntarily try to reduce asymmetric information by sending signals to consumers. Warranties are often considered a common tye of signal sent by high quality firms to reduce the consumers information ga on the quality of their roducts. Thus, voluntary labeling ors ell if enough consumers no the value of a roduct characteristic, if roducers have a credible method of labeling their roducts, and if consumers are setical of firms that do not label their roducts. In contrast, Fishman and agerty (23 develo a model in hich a subset of consumers does not either comrehend disclosure or understand the imortance of the undisclosed attribute. Also, Mathios (2 found that in the maret for salad dressings there is less than erfect unraveling of information, meaning some of the firms ith dressings in the middle range of the fat distribution chose not to disclose, and some of the orst chose to disclose. These models indicate that mandatory labeling may have an imact on roduct choices. Mandatory disclosures in contrast to voluntary disclosures mae it racticable for consumers to judge quality before urchasing a roduct by establishing a quality scale, requiring testing of quality, and mandating a reorting format. Casell and Mojdusza (1996 state that the resence of imerfect information, transaction costs in acquiring and using information and externalities may mae rivate marets for quality or inefficiently. Thus, quality signaling through mandatory roduct labeling and information disclosure requirements encourages maret incentives ith relatively limited government involvement. 6

8 Information about food quality may have ublic good characteristics. Information is an economic good that marets do not alays create and disseminate efficiently, as they ould handle other inds of goods and services. The government can ste in to rovide information that rivate marets may not rovide hen that information is needed by individuals to mae better ersonal decisions. In this case, food quality (origin in our case may be over- or undersulied and government often intervenes in an attemt to correct or mitigate imerfections. Mandatory labeling of origin has been in ractice in some states of the United States here roducts from other countries must be labeled according to their origin hereas domestic roducts are not labeled. For examle, Alabama, Aransas, Mississii, and ouisiana have origin labeling requirements for certain seafood roducts. oever voluntary state and regional labeling has also been imlemented in the United States. Some roducts sold in grocery stores are identified ith the area of roduction in the United States. Some examles are: Washington ales, Vermont male syru, Mississii farm-raised catfish, Alasan salmon, Georgia Vidalia onions, Idaho otatoes, and Jersey fresh roduce. 4 The fact that some retailers already label seafood as to its source indicates that maret articiants ill rovide country of origin information in resonse to maret demand. This suggests there is no comelling maret failure argument regarding MCOO imlementation. This stems from a lac of evidence of barriers to rivate rovision of voluntary COO should consumer demand suort the increased costs of such labeling. To analyze the question of maret failure arranting MCOO la 4 State and regional labeling rograms, such as Washington Ales, Idaho otatoes, and California Gron do not meet the la requirement and so cannot be used in lieu of COO (USDA-AMS, 24. ere e consider such labeling rograms as Voluntary COO. 7

9 imlementation, e consider consumer and total elfare under alternate scenarios such as voluntary labeling, no labeling, and total labeling to comare ith artial MCOO. While no one has secifically studied the economic imacts of artial coverage of the MCOO la, others have noted that advantage may be taen of looholes. For examle, in their study of the consequences of COO in the or industry, Iqbal, Kim, and Rude (26 rite (... if U.S. retailers chose not to incur the extra costs of stocing Canadian or, there are alternative outlets for Canadian or including rocessed roducts and the RI trade ( Similarly, USDA-AMS (24 states ( the majority of the sales of the covered commodity are through channels not affected by this rule, hich rovides substantial mareting oortunities for roducts ithout verifiable country of origin claims. Another examle is Tim ammonds (23, the resident of the Food Mareting Institute (FMI, ho says ( ranchers unable to document the history of their animals ill find themselves unable to sell to suermarets forcing their beef into the exort or foodservice sectors, hich are not covered under COO regulation. Discussion on the imlications of MCOO imlementation is not novel. Krissoff et al (24 examined in detail the economic rationale behind the various claims about the effects of mandatory country-of-origin labeling on the beef, or, and fruits and vegetables industries. The assumtions and findings are influenced heavily by the nature and structure of these marets. Other imlications have been outlined in discussing the effects of MCOO imlementation by Peel (28, Meyer (28, and VanSicle (28 for the beef, or, and fruits and vegetables industries resectively. To date there is no 5 RI trade refers to otel, Restaurant, and Institutional trade. 8

10 comrehensive reort on the artial imlementation of MCOO la for the seafood industry. The seafood industry is very different from the meat industry as most seafood consumed in the United States is imorted from develoing countries hile meat consumed in United States is mostly domestic. This or is therefore a ste toards analyzing the effect of artial MCOO olicy in the seafood industry taing into consideration the nature of the industry. The contributions of this aer are its distinct focus on the economic imacts of artial coverage of MCOO in the seafood industry on consumers and sellers, and the question of maret failure arranting MCOO imlementation in the United States. This aer also accounts for imerfect cometition among retailers and the foodservice sectors, and models consumer heterogeneity characterized by different references for quality. A related or is USDA-AMS (24, hich is a detailed study of MCOO in the seafood industry. Using a CGE model, the study determines costs incurred in the suly chain as a result of this regulation. It assumes that retailers are erfectly cometitive and that COO does not result in increased consumer demand for domestic roducts. Plastina and Giannaas (27 account for imerfect cometition among retailers for secialty cros, and consider consumer and roducer heterogeneity in determining the elfare effects on suly chain articiants hen COO is imlemented. Their model assumes total imlementation of COO. The Model The model builds on Zago and Pic (24 ho analyze the elfare imact of labeling olicies on agricultural commodities ith credence attributes. Our analysis considers to scenarios, namely, the absence of MCOO in the maret and the resence 9

11 of MCOO la imlementation. In the absence of MCOO la imlementation, e consider to cases. In the first case, there is no labeling and the origin of seafood cannot be distinguished by consumers. Consequently, quality based on origin cannot be ascertained (roduct aears undifferentiated to consumers, resulting in imerfect and asymmetric information. While consumers are unable to differentiate domestic fish from foreign, e assume that sellers in retail and foodservice sectors can differentiate them. The other case is voluntarily labeling of domestic seafood in the retail sector. We study this case to consider fish such as salmon, hich as labeled rior to the imlementation of the la. This case ill also hel us determine under hich circumstances retailers ould choose to voluntarily label. In the resence of MCOO la imlementation, hoever, the sectors are segmented ith quality differentiation generating a higher rice for domestic than foreign fish. 6 Retail and foodservice establishments that imlement COO can no exercise second-degree rice discrimination, here consumers self-select themselves by choosing beteen to rice-quality bundles. Thus, the sectors ith MCOO imlementation are segmented into lo- and high-quality marets. To cases are considered in the resence of MCOO la imlementation for elfare imlications: current artial MCOO imlementation (retail sector labeled and total MCOO imlementation (both retail and foodservice sectors labeled. The seafood suly chain is characterized by fish farmers (harvesters/roducers, intermediaries (rocessors, imorters, holesalers and handlers and retailers/foodservice 6 Assuming that minimum average cost of roduction is greater for high quality than for lo quality, it follos that maret equilibrium rices and satisfy the condition (Antle, 21. 1

12 establishments. For simlicity e consider to levels: firms and establishments; here firms include fish farmers and intermediaries, and establishments are defined as retailers/foodservice establishments. Firms are further classified as foreign and domestic based on the origin of seafood sulied. In this model, domestic and foreign firms sulying seafood are considered to be erfectly cometitive. Folloing revious literature (Sexton et al., 23; Richards and Patterson, 23, e assume retail and foodservice establishments exercise maret oer over consumers. We consider a one-eriod game under vertical differentiation, ith to qualities for a single good. The domestic country is the United States and the foreign country is the major exorter of seafood to the United States. We assume the quality,, of seafood is exogenous. The quality of seafood roducts is defined here to deend on location and conditions of catch or aquaculture, rocessing, and handling throughout the suly chain (Casell, 26. In eeing ith the assumtion that the domestic seafood industry is regulated by the government ith stricter olicies, and the foreign seafood industry has to follo certain standards, but may not be subjected to stringent enforcement, the domestic firm roduces high-quality seafood and the foreign firm roduces roducts that are assumed to be of loer quality or are at least erceived as such. Thus, quality can be either lo ( or high (. Domestic and foreign firms roduce seafood ith different roduction technologies and costs of roduction. Parameters c and c reflect roduction costs for the to qualities such that c c. That is, foreign fish can be roduced (and sold at a loer rice than domestic fish. 11

13 Suly side Folloing Zago and Pic (24 and Bureau, Marette, and Schiavina (1998, e assume each firm j (sulier of seafood to retail/foodservice, here j 1 to n, maximizes its rofit ij, and roduces a quantity q of the tye i, here i reresents quality. The aggregate suly q is the summation of individual i ij i ( i suly q ij for each quality i. i is the maret rice of selling seafood to the retail or foodservice sector. The overall surlus of the firms, i, is the sum of individual rofits ij. The analytical exression of surlus for firms of quality i seafood is: 7 (1 ij qij i.5ci ( qij 2 We consider a quadratic cost function, i.e., cost increases at an increasing rate and there is no decreasing marginal costs. This ay, the la of diminishing marginal returns is folloed. The exression for aggregate suly function is given as: (2 i ( i i / ci Demand side To analyze consumer elfare, consider a concetual model of heterogeneous consumers. The model is a variant of the classic model of vertical roduct differentiation by Mussa and Rosen (1978 and exlicitly accounts for differences in consumer attitudes toards quality of fish. There is a continuum of consumers indexed by their reference n n 7 ij ij The first order conditions imly : i ci qij i cii. q q ij j1 ij j1 12

14 (or illingness to ay for fish quality, hich is uniformly distributed over [, ] ith density 1 /. 8 We assume that each consumer buys at most one unit of the good ith quality. The associated utility is: (3 U here is the rice of the good of quality. Aggregate demand deends on consumers beliefs about the quality, i.e., consumers information about the origin of seafood available in the maret. Without COO, consumers believe they are consuming seafood of exected quality hile ith COO, consumers relate origin information of seafood to their erceived quality, denoted by and. This assumtion follos us et al. (26 ho rite consumers ill mae an assumtion about the average quality of the roduct on the maret. Because the maret ill contain roducts from a variety of origins, the exected quality of the roduct on the maret might fall ell belo the erceived quality of the domestic roduct ( We assume that ith asymmetric information in the non-labeled maret, consumers evaluate seafood quality using a simle average: ( 2. Pre-MCOO: No abeling In the absence of MCOO la imlementation (no labeling, origin and roduction method cannot be determined by the consumers. That is, there is imerfect information in the maret. Further, there is asymmetric information as sellers are aare of the origin and roduction of fish hile consumers cannot identify them. In the extreme 8 It should be noted that as the loer bound of the taste distribution is equal to zero, the maret ill not be entirely covered, i.e., some consumers refer not to buy the good offered. 13

15 case, if a consumer has no information about the quality of the roduct, sellers ill resort to selling the loest ossible quality of a good. We mae the assumtion that in the absence of labeling, the retail and foodservice sectors sell only foreign seafood because, in the context of this model, they do not have an incentive to sell domestic seafood. 9 Figure 1 anel a shos schematically the seafood maret in the absence of MCOO la imlementation. The retail and foodservice sectors are considered to searate marets. We consider to searate marets because ith the imlementation of MCOO the foodservice sector is exemt from labeling. In both marets, consumers are heterogeneous in their reference for quality and are ostulated to differ in the utility or marginal illingness to ay that they derive from the quality of seafood. We assume that consumers have the same valuation for quality in the to marets. A unique rice develos in both sectors and consumers have an exected quality as mentioned above. The conditional indirect utility function of a consumer ith reference arameter θ in the retail and foodservice maret is given by: 9 The frameor considered here imlies that consumers do not no the actual quality of seafood sulied and ould consume foreign seafood in the absence of labeling because there is also uncertainty about the extent to hich it is otentially unsafe for their health. oever, hen information is available about the origin of seafood, some consumers are illing to ay more for domestic seafood. In the absence of information regarding the origin of seafood, domestic and foreign fish are mareted together and the rice received by establishments is the same regardless of hich roduct is roduced (ooling equilibrium; see Aerlof 197. The absence of a remium for domestic seafood hen they are not segregated, couled ith increased costs of roducing domestic seafood, result in the rofitability of the domestic fish being loer than that of foreign fish. In this case the suly of domestic seafood is not incentive comatible; maret forces lead to failure of the maret to satisfy exressed consumer demands. ence, only foreign seafood is sold in the non-labeled sector. 14

16 (4 U if consumes a unit of seafood of exected quality at rice if consumes nothing The indifferent consumer beteen consuming a unit of seafood and not consuming can be characterized as: (5 Consumers ith valuation for quality greater than ill buy seafood and consumers ith valuation for quality loer than ill not buy seafood. Thus, the demand for seafood in a maret ith no differentiation can be found by aggregating the quantity consumed by consumers ith >. Normalizing 1, the demand at retail or foodservice ith no labeling corresonds to: (6 D ( 1 To determine the equilibrium quantity and rice in the absence of MCOO imlementation, e solve the rofit-maximization function for the retail and foodservice sectors. Then, derived demands at the retail and foodservice levels are equated ith the suly of foreign firms. The to sectors are each characterized by N identical retailers and N identical foodservice establishments cometing ith each other and ho have maret oer over consumers. The individual retailer/foodservice establishment m ( m 1,..., N maximizes rofit given by: NC (7 max m [ ( ] qm q m 15

17 here (1 is the inverse demand for non-labeled seafood in retail or foodservice. ( reresents the rice of foreign seafood aid by retailers and foodservice establishments to foreign firms. 1 The suerscrit NC refers to the scenario ith no labeling. The first-order conditions of (7 imly: NC (8 m q m 1 1 m here q m m reresent the conjectural variation elasticity of the qm retailer/foodservice establishment m. Because e assume identical retailers and foodservice establishments, each firm s conjectural variation elasticity is identical in equilibrium, i.e., m. In this context, the firm s individual first-order condition corresonds to the aggregate first-order condition, i.e., (9 ( 1 (1 Equation (9 reresents the aggregate derived demand facing foreign firms from the retail or the foodservice sector. When the arameter [, 1] is zero, it imlies the establishments have no maret oer, hile 1 imlies erfect collusion. Equating derived demand (9 facing the foreign firms, aggregated over retail and foodservice establishments, ith suly (2 indicates the folloing: (1 2( c 1 We assume the retail and foodservice sector incur the same costs of urchasing foreign seafood and other costs are assumed to be zero for simlicity. 16

18 here ( 1. Solving for gives the equilibrium quantities and rices: (11 (12 * * 2 c 2c 2 c (13 * ( 2c 2c The suerscrit notation * refers to equilibrium. Welfare measures ith no labeling can be considered as a benchmar hen evaluating the effects of MCOO imlementation. Using (13, consumers surlus ith no labeling (indexed by NC can be calculated by integrating consumer utility at equilibrium for consumers ho consume a unit of seafood ith illingness to ay for quality greater than in foodservice/retail: (14 CS NC 1 ( * d 2( 2c 3 2 Equation (14 is used to aggregate consumer surlus in the to sectors to get exected consumer elfare: (15 CS NC 3 ( 2c 2 Equation (15 shos that consumer elfare deends ositively on the exected quality of seafood and negatively on the costs of roducing lo-quality fish and the maret oer of establishments. For the urose of elfare analysis of MCOO imlementation, e also comute real consumer surlus. Real consumer surlus considers that hile consumers believe 17

19 seafood is of quality, it is in fact. The aggregate real consumer surlus for the same set of consumers and rices in equilibrium as before is given as: (16 CS NC real 1 ( * ( ( 2c d 2 ( 2c here. Under real consumer surlus, both the rice and the indifferent consumer beteen buying or not is determined according to the value of the quality actually consumed. Profit earned by retail and foodservice sectors can be calculated by substituting rices and quantities in equation (7 ith equilibrium rices and quantities. The exression for total rofit aggregated over retail and foodservice sectors is given as: (17 NC 3 2 ( 2c 2 Equation (17 shos that rofit deends ositively on the exected quality of seafood and maret oer arameter, and negatively on the costs of roducing lo-quality fish. Total elfare is the summation of real consumer surlus and rofit hich is: (18 TW NC ( ( 2c ( 2c Pre-MCOO: Voluntary COO at Retail Prior to the imlementation of MCOO, some retailers may have voluntarily disclosed origin information for domestic seafood and may have chosen not to rovide information about foreign seafood hose value to consumers may be less than its associated disclosure cost. Disclosing information about domestic seafood may be 18

20 esecially valuable hen consumers have a strong illingness to ay for domestic seafood. The retailer can then segment the maret and imlement rofitable second degree rice discrimination. We examine this case as an alternative benchmar scenario. In this case the retail sector ill differentiate domestic seafood (identified by labels from foreign seafood. In the retail sector domestic seafood is indexed by quality hereas non-labeled seafood is indexed by quality. In the absence of labels consumers cannot identify the origin of seafood and erceive it to be of average quality. Perceived quality is greater than average quality and corresonding rices for seafood at retail are and ith. Again let us consider to firms, domestic and foreign, selling to to sectors: retail and foodservice. We assume all domestic seafood is sulied to retail because it is labeled and foreign seafood is sulied to both the foodservice (non-labeled sector and the retail sector, here it is not labeled. A schematic reresentation of this case is shon in Figure 1 anel b. As in the revious model, there is a continuum of consumers ith reference for quality. With voluntary labeling facilitating differentiation of domestic from foreign seafood in the retail sector, the indirect utility of a consumer is given by: (19 U if consumes a unit of domestic seafood in retail sector if consumes a unit of seafood of exected quality in retail sector if consumes nothing Similarly, in the foodservice sector it is: 19

21 (2 U if consumes a unit of seafood of exected quality in foodservice if consumes nothing sector here. There are to indifferent consumers in the retail sector: one is indifferent beteen consuming domestic seafood and non-labeled seafood (, and one beteen consuming non-labeled seafood and not consuming at all (. Similarly, in the foodservice sector, consumers are indifferent beteen consuming non-labeled seafood and not consuming at all (. Accordingly, the indifferent consumers (using 19 and 2 and the demand for each quality of seafood can be found by aggregating the quantity consumed of each tye in the to sectors and are given at retail by: (21 D ( D (, 1, here D and D are demand for domestic and non-labeled seafood in the retail sector. In foodservice, they are given by: (22 D ( 1 here D is demand for non-labeled seafood in the foodservice sector. Voluntary labeling entails costs to retailers and domestic firms. Domestic fish roducers and harvesters incur the cost of establishing and maintaining a recordeeing system for origin and roduction information, and for roduct identification, labor, and training. Consequently retailers need to incur costs associated ith labeling domestic 2

22 seafood. The cost of labeling/recordeeing borne by retailers is denoted as b and oerating costs (segregation and identity reservation costs are denoted as y. To determine equilibrium quantity and rice, the rofit-maximization function for the individual retailer and foodservice is solved first as each retailer m maximizes its rofit given by: VC (23 max rm [ (, b] q m [ (, ] qm q m, qm here (, and (, (1. The suerscrit VC refers to a scenario ith voluntary labeling at retail. The first-order conditions of (23 imly: (24 ( 1 b i q here ( 1 and. Similarly ( 1 and q i q i q i. ere i can be or. Assume, therefore. Equation (24 reresents the derived demand facing domestic and foreign firms in the retail sector after solving simultaneously for rofit given by: VC (25 max fm [ ( ] qm qm and. Each foodservice establishment m maximizes its here (1 is the inverse demand for seafood in the foodservice sector. ( The first-order conditions of (25 imly: (26 ( 1 21

23 22 here 1 ( and q q. Equation (26 reresents the derived demand facing foreign firms in the foodservice sector. With voluntary labeling, to marets emerge: one for high-quality and the other for lo-quality seafood. Domestic firms sulying high-quality seafood incur an additional cost y hile the foreign firms suly function for lo-quality seafood remains unchanged. Folloing equations (1 and (2, suly in the to marets can be ritten as: (27 c y c / /( Equating aggregate derived demand of the retail and foodservice sectors (24 and 26 ith suly of domestic and foreign firms (27 indicates the folloing: (28 c b y c b 2 ( 2 2( Using (28, equilibrium quantities and rices in the to sectors, and rices of domestic and foreign firms can be derived. Consumers surlus in the retail and foodservice sectors, identified by subscrit r for retail and f for foodservice are given as: (29 1 * 1 * * ( ( ( d CS d d CS VC f VC r The exected consumer surlus ith voluntary labeling is obtained by aggregating consumer surlus in the retail and foodservice sector. Similar to our revious

24 argument, real consumer surlus in retail and foodservice can be derived by substituting real quality sulied in the non-labeled maret in lace of. Profit can be calculated by substituting rices and quantities in equation (23 and 25 ith equilibrium rices and quantities. Total elfare is exressed as the summation of real consumer surlus and rofit. Exressions for equation (29, for rofit, and for total elfare are messy and comlicated for doing analysis through comarative statics, so analysis is done using numerical simulations. Numerical simulation details can be found in the analysis section. Partial MCOO: MCOO Imlementation in Retail The current U.S. regulation requires MCOO in the retail sector, so consumers can distinguish beteen the domestic and foreign seafood indexed by quality and resectively in the model. Domestic seafood is assumed to be erceived to be of higher quality than foreign seafood, i.e.,, and corresonding rices for seafood at retail are and ith. We assume domestic seafood (higher quality is sulied to retail because it is identifiable through labels. Foreign seafood (loer quality is sulied to both the non-labeled foodservice sector and the labeled retail sector, here it is labeled as such. Retailers can no convey roduct quality information to consumers via origin labels and a searating equilibrium may be attained that efficiently sorts consumers into marets for different qualities ith corresonding rices. oever, in the foodservice sector, in the absence of labeling, only foreign seafood is sulied (see footnote 9. Figure 1 anel c shos ho MCOO facilitates quality differentiation at retail. 23

25 is given as: The indirect utility of a consumer in the retail and foodservice sectors in this case (3 U if consumes a unit of domestic seafood in labeled (retail sector if consumes a unit of foreign seafood in labeled (retail sector if consumes nothing Similarly, (31 U if consumes a unit of foreign seafood in non - labeled if consumes nothing sector here. Using (3 the indifferent consumers and the demand for each quality (, of seafood in retail are given by: (32 D ( D (, 1, Using (31, the indifferent consumer and demand for non-labeled seafood are given by the folloing equations in the foodservice sector: (33 D ( 1 As mentioned earlier there are costs associated ith MCOO imlementation. MCOO requires systems to be imlemented to ensure that origin and roduction information is transferred from roducers to the next buyers of their roducts, and that the information is maintained for the required amount of time. With MCOO imlementation in retail, domestic firms bear oerating costs (segregation and identity reservation costs y hereas foreign firms do not. Exorters are assumed to not bear 24

26 oerating costs ith MCOO because they inform the country of origin ith labels to the ultimate urchaser anyay, irresective of MCOO imlementation. Ultimate urchaser has been defined as the last U.S. erson ho ill receive the roduct in the form in hich it as imorted. Similar to the voluntary labeling scenario, retailers incur costs of labeling b. oever, this cost alies to all seafood sold in retail, hich includes domestic and foreign seafood. Each retailer m maximizes its rofit given by: PC (34 max r [ (, b] q m [ (, b] qm q m, q m here (, and (, 1 are the inverse demand for domestic and foreign seafood at retail. The first-order conditions of (34 imly: (35 ( 1 b b Equation (35 reresents the derived demand facing domestic and foreign firms in the retail sector after solving simultaneously for and. Each foodservice establishment m maximizes its rofit given by: PC (36 max f [ ( ] qm q m here (1 is the inverse demand for seafood in the foodservice sector. ( The suerscrit PC refers to a scenario ith artial MCOO imlementation. The firstorder conditions of (36 imly: (37 ( 1 25

27 26 The above equation reresents the derived demand facing foreign firms in the foodservice sector. Suly in the high- and lo-quality marets can be ritten as: (38 c y c / ( /( ( Equating aggregate derived demand of the retail and foodservice sectors (35 and 37 ith suly of domestic and foreign firms (38 indicates the folloing: (39 c b b y c ( ( ( Consumers surlus in the retail and foodservice sectors for this case are given as: (4 1 * 1 * * ( ( ( d CS d d CS PC f PC r The exected consumer elfare after imlementing MCOO is obtained by aggregating consumer surlus in the retail and foodservice sector. The exressions for real consumer surlus, rofit, and total elfare are derived as before. The exressions are not reorted here but analyzed using numerical simulations in the analysis section. Total MCOO: MCOO Imlementation in Retail and Foodservice Finally, e consider the case here MCOO is imlemented in both the retail and foodservice sectors. There is no informational asymmetry, consumers are able to determine the origin of seafood and mae informed choices in both sectors. An imortant

28 27 outcome of uniform regulation in both sectors is that there is no scoe for diversion. Figure 1 anel d shos the case of a totally differentiated maret. ere, labeling cost b is alicable to both the foodservice and retail establishments. As before, cost y is borne only by the domestic firms. The rofit-maximization equation for the individual retailer/foodservice establishment m becomes: (41 m m TC m q q q b q b m m ], ( [ ], ( [ max, here, ( and 1, ( are the inverse demand for domestic and foreign seafood in retail or foodservice. The suerscrit TC refers to a scenario ith total MCOO imlementation. All other variables are as reviously defined. The first order conditions of (41 imly: (42 b b 1 ( The above equations can be solved for and to get the derived demand facing domestic and foreign firms in the retail and foodservice sectors. Equating aggregate derived demand of the retail and foodservice sectors (42 ith suly of the domestic and foreign firms (38 indicates the folloing: (43 c y c 2( ( 2( Consumer surlus at the retail or foodservice sector hen both sectors are labeled is given by: (44 d d CS TC 1 * * ( (

29 Exected consumer surlus is the same as real consumer surlus in a totally differentiated maret as there is no mismatch beteen quality of seafood sulied and consumed. Analysis In this section, e examine the extent to hich diversion occurs as a result of artial MCOO imlementation and the associated elfare effects. Diversion can be related to the concet of leaage in the emissions leaage literature. eaage refers to increases in roduction and associated emissions among unregulated roducers that occur as a direct consequence of incomlete environmental regulation (CCAP, 25; and RGGI, 27. Folie (29 states that hen there is incomlete regulation, i.e., hen ollution regulation is alied to only a subset of firms in a olluting industry, substantial leaage may occur since roduction at regulated firms can be substituted for unregulated roduction. Similarly, the artial imlementation of MCOO may lead to diversion or leaage of loer quality imorts to the non-labeled sector. We define diversion as a ercentage of the relative share of foreign seafood increase in the foodservice sector ith artial imlementation of MCOO. In our analysis, e consider the re-mcoo case (no labeling and voluntary labeling as the benchmar to determine the effect of MCOO (artial and total imlementation on elfare. Our elfare analysis focuses on consumer surlus (exected and real, rofit, and total elfare (consumer surlus and rofit. Using Mathematica 6., e first calibrate the model to have ositive rices and quantities in equilibrium. To calibrate the model, e normalize c and 1, fix = 28

30 .5, set costs associated ith labeling b. 7 and y. 25, and then determine values for c and in the feasible region (ositive rices and quantities in equilibrium. In order to analyze the effect of change in quality on elfare and diversion ithin the feasible region, e fix c at 4 and vary from 11% to 21% of. We allo to have differences in quality from 1% to 1%. Finally, e vary labeling costs b from.5 to.15 for = 1.1 and 2 to analyze the incentive for retailers to voluntarily label domestic seafood as oosed to not label at all, by comaring rofits across four scenarios No abeling, Voluntary COO, Partial MCOO, and Total MCOO. All other arameters are set at the values mentioned above. Table 1 summarizes elfare magnitudes for fixed arameter values for the four scenarios considered. The high quality arameter is set at 1.5, and maret oer arameter is set at.5, b is set at.7, all other arameters are set at values mentioned earlier. The first to ros of Table 1 sho the comarative magnitude of consumer surlus (exected and real across four scenarios, namely, no labeling, voluntary COO, artial MCOO, and total MCOO. For fixed arameter values, exected consumer surlus is greatest ith artial MCOO and real consumer surlus is greatest ith total MCOO. Exected consumer elfare in the artial MCOO case does not tae into account the real quality of foreign fish sulied to consumers in the non-labeled sector. Rather it is based on consumers belief of quality, here >. Thus, hile consumers exect to be getting quality, they are in fact consuming seafood of erceived loer quality. Because consumer utility is deendent on the quality of the 29

31 roduct consumed, consumer surlus is necessarily higher hen consumers believe they are getting rather than. Considering that consumers are truly consuming quality, real consumer surlus is greatest ith total MCOO. When both sectors are labeled, exected quality is equal to real quality, and consumers are aare of the quality of fish they consume and can mae informed choices. Real consumer surlus is greater under voluntary COO than artial MCOO because the quantity of erceived exected-quality fish consumed in retail, in the voluntary COO scenario, is greater than the quantity of erceived lo-quality fish consumed in retail under artial MCOO. Equilibrium quantity comarisons for fixed arameter values under the to scenarios can be seen in Table 2. Profit is greatest under voluntary labeling folloed by artial MCOO, No labeling, and total MCOO as shon in Table 1. A non-labeled maret can lead sellers to tae advantage of consumer misinformation. The absence of labels allos sellers to masquerade sales of lo-quality fish as higher quality. As a result, consumers ay a higher rice for lo-quality seafood, hich increases rofit for establishments selling lo-quality fish in the non-labeled maret. Under voluntary labeling, retailers label domestic fish but not foreign fish. oever, under artial MCOO, retailers must label all fish. Thus, under voluntary COO retailers tae advantage of consumers illingnessto-ay for domestic fish and their ignorance of quality of the foreign fish. This is reflected in equilibrium ith the higher rice-quality ratio for lo-quality fish sold in both the retail and foodservice sectors under voluntary labeling comared to artial MCOO. This leads to greater rofit under voluntary COO scenario. 3

32 Table 1 shos that total elfare is greatest under voluntary COO, folloed by artial MCOO, total MCOO, and No labeling. The raning follos that of rofit, meaning that the rofit comonent in total elfare dominates the effect of real consumer surlus. a. Diversion and the effect of quality on diversion We examine the effect of artial MCOO on the quantity of lo-quality fish diverted to the non-labeled maret. We focus on the foodservice sector for our calculations of diversion because it is exemt under current MCOO la. Before MCOO imlementation, neither retail nor foodservice sectors ere required to be labeled. As a result there is no otential for diversion. oever, ith MCOO imlemented in the retail sector, lo-quality fish may be diverted to the non-labeled sector. One ay to measure diversion to the non-labeled maret is to comare the quantity of lo-quality fish sold to the foodservice sector (non-labeled rior to artial MCOO imlementation, i.e., NC *, ith the quantity sold under artial MCOO, i.e., PC *. Substituting arameter values, the quantity sold to the foodservice sector before artial MCOO is smaller than under imlementation of the la. This ould indicate diversion of lo-quality fish to the non-labeled maret. oever, this measure may be misleading because it is ossible that the total quantity of fish sold in the U.S. maret (high- and lo-quality increases ith the imlementation of artial MCOO. Thus, a relative measure of diversion is more accurate. Diversion is measured by comaring the relative quantity of lo-quality fish sold in the foodservice sector under artial imlementation of MCOO to the relative quantity 31

33 sold in the absence of its imlementation. The formula used to calculate diversion is given as: (45 diversion % * PC * PC * NC * PC * PC * PC * NC * NC * PC * PC * PC *1 * NC 1 * NC * NC *1 Diversion is exressed as a ercentage of relative share of lo-quality fish sold in foodservice ost and re-mcoo imlementation. A diagrammatic reresentation is shon in Figure 2. We find that at fixed arameter values, there is evidence of diversion as shon in Figure 3. At the initial arameter value of 1. 1, the diversion ercentage has a value of 7.5 ercent. This means that the share of lo-quality fish in the foodservice sector ith artial MCOO is relatively larger than the share re-mcoo. Under artial MCOO the rice-quality ratio of seafood in the foodservice sector is loer than ith re- MCOO.. Therefore, non-labeled fish from the food service sector under MCOO is more attractive to consumers. This can be exlained as follos. The re-mcoo maret is characterized by the suly of lo-quality foreign fish only, hich consumers erceive to be of exected average quality. With artial MCOO, high-quality domestic fish is also sulied to the labeled sector hereas the non-labeled sector behaves similarly to the re-mcoo maret. Price cometition in the artial MCOO case beteen domestic and foreign seafood results in a loer rice for exected quality fish in the non-labeled sector than in the re-mcoo case. Thus, the quantity of lo-quality fish sold in the non-labeled sector after artial MCOO imlementation is greater than re-mcoo. 32