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Prices and the Global Economy

All of us are affected by changes in the price of food and other agricultural products. Farmers are affected not only by changes in the price of their products, but also by changes in the price of their inputs – seed, fertiliser, pesticide and so on – which affect their profits. The reasons for these changes are not always obvious, so we asked economist, Julian Morris, to explain

why prices of inputs and outputs change and how these changes impact on farmers and consumers?

Julian is a Visiting Professor at the University of Buckingham, Executive Director of International Policy Network  and co-editor of the Electronic Journal of Sustainable Development

In the past few years, prices of both farm inputs and outputs have changed dramatically – and this has had an impact on my profits. Why do prices of inputs and outputs change? Why were the changes in recent years so dramatic?

Markets comprise basically two types of people: buyers and sellers. Buyers demand products and sellers supply them.

The price at which a product trades is affected many factors. Some of these factors affect the supply of the product. Others affect demand for it.

In an agricultural market, the total amount of any product supplied will vary according to decisions made by the farmer and environmental conditions. Most important are the decisions made by farmers about what to produce and the amount of inputs; such as which seed to plant, and which fertiliser, water and pesticide to apply. For crops, other important factors which affect the total quantity supplied, include

  • the type of plant being grown;
  • how much sun and rain there has been; whether
  • the crop has been affected by frost; and the
  • incidence of disease.

The amount purchased of any specific product will depend in part on

  • that product’s availability; and in part on
  • the availability of other products that are alternatives or “substitutes”; and
  • the preferences of consumers.

If there is abundant supply of a product, many substitutes for it, and demand is low, then the price will be low. But if there is very limited supply, no substitutes, and demand is high, the prices will be high. Thus the relative availability of and demand for these substitutes impacts on the price of each product.

To understand this better, think about the supply and demand for maize and cassava – two agricultural products which can be substituted for each other as foods. If farmers have produced a large amount of cassava and only a small amount of maize but consumers prefer maize to cassava, then maize will be relatively more expensive than cassava.

Why Prices Change

Seeing that the price of maize is higher than cassava, many farmers will respond by planting more maize and less cassava the next season. If other conditions remain mostly the same (constant), the supply of maize will increase and the supply of cassava will fall.

Assuming that consumers (buyers) still prefer maize to cassava, the impact of the change in the amounts of the two products supplied is to reduce the price of maize and increase the price of cassava.

In a bit more detail for the interested or skip this:
The relationships between price, quantity supplied and quantity demanded is shown in the diagram below: “Supply 1” represents the supply of maize in season 1. “Supply 2” represents the supply of maize in season 2. The quantity actually supplied is given at the point at which the Supply line and the Demand line cross. The resultant shift in the supply curve, from Supply 1 to Supply 2, results in a fall in the price, from P1 to P2, and an increase in the quantity produced, from Q1 to Q2.

Graph illustrating the relationships between price, quantity supplied and quantity demanded. (22Kb JPEG)

How Governments influence price

There are many other reasons why prices change, one important factor is government action. For example, some governments buy agricultural outputs at a price higher than private buyers would pay. These above-market prices benefit landowners. If the land is owned by farmers, then they benefit. If the land is rented from landowners by farmers, then the farmers pay higher rental prices reflecting the subsidy.

These “price supports” also affect the type of crop which is produced. Since the subsidised price is determined by politicians or bureaucrats rather than by the interactions of willing buyers and willing sellers, the relative price of each crop will usually be very different from the relative price that would result from purely voluntary transactions. As a result, such subsidies affect both the total amount of crops that are produced and the relative amount of each crop produced.

Some governments provide subsidies to inputs, which makes those inputs cheaper than they would otherwise be. Input subsidies alter the pattern of inputs demanded, as farmers use more of the subsidised inputs than they would otherwise and less of other unsubsidised inputs. Input subsidies also impact on the type of crops produced, since farmers will make decisions regarding which crop to produce based on expected profitability. So, if the input subsidies increase the profitability of maize relative to cassava, then farmers will increase maize production and reduce cassava production.

Governments also impose restrictions on international trade. Export restrictions prevent producers from selling to the highest bidder if that bidder is overseas. This has the effect of increasing the quantity supplied to the domestic market and thus reducing the price paid to farmers.

Import tariffs have the converse effect on crops being imported; they raise the price of imported crops, reducing the amount imported and driving up the price paid to domestic producers.  

Why Prices Changed so Dramatically in the past Decade

Underpinning many of the economic problems experienced in the past few years was a massive oversupply of credit during 2000-2006. Put simply, too much money was chasing too few investments. This drove up demand for assets, such as land, houses, stocks and commodities. And this, in turn, drove up demand for raw materials such as iron ore, bauxite, coal, oil, gas, copper, zinc, cadmium and lithium.

But because production of these raw materials is a huge undertaking, requiring significant investment over periods of years, the supply of such materials increases only slowly, regardless of the rate of increase in demand.  Moreover, for one very important raw material - oil - supply actually fell in some of the main producer countries (including Iran, Iraq, Russia, Venezuela, Nigeria, and Mexico) as a result of various political factors. So, with demand increasing rapidly and supply increasing only slowly, if at all, prices of all these raw materials rose quickly.

The rising price of raw materials then drove up the price of many agricultural inputs. For example, most nitrogen (N) fertiliser is made using natural gas (methane).  As prices of natural gas rose, so the price of N rose as shown in the graph below.

Prices of fertiliser and natural gas 1990 - 2009 (25Kb JPEG)

The costs of most other inputs, from pesticides to machine parts, are affected by the price of oil, as are planting, spraying and harvesting operations using petrol-powered machines. As oil prices rose, so did the prices of all these inputs.

While the cost of agricultural inputs rose, demand for agricultural output also rose, driving up prices. This increase in demand was partly driven by population growth and partly driven by rising incomes, especially in countries such as India and China. As people became wealthier, they began to eat more meat, driving up demand for it. The diagram below, shows that meat production has more than quadrupled since 1961, or approximately twice the rate of population growth.

As it takes more inputs to produce meat with a certain energy value than it does to produce grain of the same energy value, the increase in demand for meat led to a more than proportional increase in demand for agricultural inputs driving up the prices of agricultural products.

Graph of global meat production 1961 - 2008 (28Kb GIF)

Governments also responded to the increase in oil prices by intervening in highly distorting ways. In particular, many wealthy country governments introduced additional mandates and subsidies for the production of ethanol as a gasoline substitute. This resulted in increased demand for sugar (cane and beet), maize and other crops that can be converted into ethanol. The increase in demand for these commodities increased their price and their diversion towards the production of ethanol reduced their availability for other purposes. Moreover, by diverting more land to the production of such commodities, the ethanol mandates and subsidies reduced the supply of other agricultural products, resulting in reduced supply and increased prices.

In many cases, the increase in price of agricultural products more than compensated for the increase in price of inputs, leading to an increase in farm profitability.

In the past few years, adverse weather conditions and disease have negatively impacted on harvests, reducing outputs across the world. This has driven up the price of agricultural products. For some farmers, this rise in price may compensate for reduced output, or even result in increased profitability. But these price effects are temporary, so it is important that farmers be aware of the cause of price increases and make planting and other decisions accordingly.

The high prices of agricultural products – caused by a combination of demand and supply effects discussed above – resulted in demonstrations around the world, from Argentina to Bangladesh. Many governments responded by intervening in the market. In particular, several countries introduced temporary restrictions on exports. These had the effect of reducing prices inside the country, thereby harming local farmers and reducing the incentives to increase output. At the same time, as more product remained within the borders of those countries with export restrictions, the amount supplied internationally was reduced. This had the effect of increasing  prices internationally.

Some countries introduced price controls on foods, which had similar results to the export ban: farmers (and downstream processors such as millers and bakers) had less incentive to produce, so total output of those foods was reduced. The reason for this is quite simple: where the cost of production, distribution, and storage of a food item was greater than the controlled price, it no longer made sense to produce and stock the food item.  The price controls also had a knock on effect on supply, since there is less incentive to produce goods where prices are capped. 

Price controls may also have led to an increase in exports for those goods produced locally as farmers and downstream producers tried to get better prices in the international market. The increase in quantity supplied internationally would have reduced world market prices.

What are the prospects for agriculture in the long term?