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I. Introduction

The importance of dairying in a country like India hardly needs emphasizing. India has vast resources of livestock, which play an important role in the national economy and also in the socioeconomic development of millions of rural households. India has one of the largest stocks of cattle and buffaloes: more than 50 percent of the world's buffaloes and 20 percent of its cattle. The Indian dairy sector contributes a large share of the agricultural gross domestic product (GDP). Although the contribution of agriculture and allied sectors to the national GDP has declined during the past few decades, the contribution of the livestock sector has increased from less than 5 percent in the early 1980s to over 6 percent in the late 1990s. Milk and milk products constitute a major share of the value of output from the livestock sector; their share increased from less than 50 percent in 1950-51 to about 65 percent in the late 1990s.

During the 1950s and 1960s, India was one of the largest importers of dairy products, importing over 40 percent of milk solids in the total throughput of the dairy industry. The commercial import of milk powder reached its peak at about 53 thousand tons in 1963-64 (Kanitkar, 1999). This concerned policy makers, and a decision was made to achieve self-sufficiency in milk production. The major step forward, which has had a far-reaching impact, came in mid-sixties with the establishment of the National Dairy Development Board (NDDB) to oversee dairy development in the country. The Operation Flood (OF) program, one of the world's largest and most successful dairy development programs, was launched in 1970; its main thrust was to organize farmers' cooperatives in rural areas and link them with urban consumers. Operation Flood has led to the modernization of India's dairy sector and has created a strong network for procurement, processing, and distribution of milk by the cooperative sector. In 1989, the Government of India launched the Technology Mission on Dairy Development (TMDD) program to support and supplement the efforts of Operation Flood and to enhance rural employment opportunities and income generation through dairying.

India is currently the largest producer of milk in the world, overwhelmingly thanks to the output of millions of smallholder farms. The OF cooperative movement has been important in dairy marketing in different parts of the country and undoubtedly has played an important role in keeping smallholders involved with this fast-growing sector. During the past three decades, milk production in the country has increased from about 22 million tons in 1970-71 to 84 million tons in 2001-02 (GOI, 2003). The per capita availability of milk, which had decreased during the pre-OF period, not only kept pace with the growing population but increased from 107 grams in 1970 to 220 grams in 2000-01.

The Indian dairy industry is poised for dramatic growth in the coming decades. The population growth, urbanization, income growth, high income elasticity of demand, and changes in food habits that fueled the increase in milk consumption are expected to continue well into the new millennium, creating a veritable Livestock Revolution. As these events unfold, not all the changes are good, and they have major implications for poverty alleviation, environmental sustainability, public health, and ethical concerns about the treatment of animals as sentient beings. The rapid increase in demand for dairy products in developing countries has led to the growth of milk-production activities in peri-urban areas, which are essentially detached from their supporting land base. The demand for milk and dairy products is increasingly being met in urban and peri-urban areas by industrial dairy farms, which often generate large amounts of waste.

Traditionally, milk production in India has been closely integrated with crop production. However, environmental problems escalate with the scale and intensity of operations, ranging from the least worrisome in traditional systems to highly threatening in large-scale farms. The pollution problem in rural areas is internalized, as the small amount of manure produced is used as fuel or organic fertilizer to improve the soil for crop and fodder cultivation. In the commercial production system, a large amount of waste is generated, which needs to be treated before its disposal or use. Doing so requires not only careful planning but also large capital investments to create the infrastructure for waste treatment and its economic disposal. The establishment of large commercial dairy farms in urban areas may create some social problems. The growth stimulus coming from the strong demand for livestock products is not transmitted to the rural areas, where it could encourage rural development, more equitable distribution of income, and poverty alleviation. Small producers find it difficult to compete with large commercial units due to policy distortions. Milk production in rural areas generates supplementary income and employment opportunities, which are adversely affected by the growth of commercial dairy farms.

1.1 Overall Objectives

The Indian dairy sector has become progressively more liberalized since 1991, with a major amendment in 2002 in the Milk and Milk Products Order that restricted the ability of private dairies to procure milk in areas being served by the parastatal cooperative sector. One fear is that private dairies will begin to procure primarily from larger scale suppliers, even as they provide tough competition to cooperative milk processors, which will eventually lead to the eclipse of smallholder dairy production that has been so important to so many in India. While it is too early to assess changes in procurement patterns for milk as a result of the recent policy changes, it is important to know whether larger scale producers have cost advantages and higher efficiency that will lead to the displacement of smallholders under a liberalized market. This study is an effort in that direction.

1.2 Specific Research Questions

The main objectives of the study are as follows:

Analysis of the mechanisms through which the growing scale of milk production and marketing operations under a changing industrial organization of the dairy sector marketing affects social, health, and environmental (SHE) objectives.

Estimation of per unit cost differences among small, medium, and large-scale milk producers across different regions of India and decomposition of these differences into greater technical/allocative efficiency, decreased transaction costs, and differential investments in environmental sustainability.

Identification of domains for reform with respect to existing policy incentives in the dairy sector to make it more competitive and policy options to address SHE objectives more broadly through impacts on the scale of operations and organization of the dairy sector.

1.3 Testable Hypotheses

The following hypotheses, are empirically tested in this study:

If this statement is supported, it suggests that, in the absence of action, small-scale producers will eventually be put out of business by competition from large-scale producers, especially since the better producers will scale up. Note that lower financial profitability as perceived by market actors does not take into account interfarm differences in uncounted costs, such as transaction costs and environmental externalities.

· Small-scale producers are not less efficient in the use of productive resources if family labor is not costed and environmental externalities are taken into account.

If this statement is supported, it implies that the displacement of smallholders from livestock production in the areas studied is not some inevitable process driven by technologically based economies of scale in production but is more a matter of a lack of supporting institutions to overcome transaction cost barriers to market participation and other noncosted costs, such as environmental externalities.

· The profits per unit of output of small-scale producers are more sensitive to differences in transaction costs across farms, other things equal, than is the case for large-scale production systems.

If this statement is supported, it implies that dealing with transaction costs (through institutions) is critical to improving the ability of smallholders to compete with large-scale producers. The analysis will also yield insights as to the relative importance of different kinds of transaction costs faced by producers.

· Small-scale producers in densely settled areas generate a lower negative environmental externality per animal than large-scale producers in the same areas, and smallholders expend a higher amount of effort/investment in pollution abatement per unit of output than large farmers, which creates a lower capture of environmental externalities per unit of output by small farms.

This is an open question, since the reverse could well be true, but since enforcement of regulations is not scale-neutral, the answer to whether large-scale or small-scale producers pollute more is relevant to policy, as discussed above. Why would small farmers invest more (less) effort/money in pollution abatement (production activity, animals kept, herd size, sales, regulations, location, density of animal production in the immediate region) than large farmers?

1.4 Structure of the Report

The study begins with a review of changes in the policy environment (national and international) of the Indian dairy sector and the impetus for those changes (Chapter 2). Chapter 3 discusses the conceptual framework and econometric estimations of efficiency measures and determinants of inefficiency. Sampling procedures, sample design and composition, and data description are given in Chapter 4. Chapter 5 discusses the socioeconomic and demographic characteristics of households, asset composition and ownership patterns, milk production and marketing practices, provision of animal health and breeding services, and constraints faced by dairy farmers. Mass balance estimation procedures and results are given in Chapter 6. The issues of relative efficiency and profitability of dairy farming and farm sizes are examined through profit frontier and inefficiency models in Chapter 7. Conclusions and policy implications of the study are given in Chapter 8.

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