NS3040 Winter Term 2015

Price Theory Applications

Price Theory Applications

Papers that will be on the mid-term – illustrate various applications of microeconomic principles•Milan Brahmbhatt and Luc Christiaensen, The Run on Rice

• application of supply and demand, substitutes, problems of market interference

•Robert McNally and Michael Levi, A Crude Predicament: The Era of Volatile Oil Prices

• example of inelastic supply and demand, together with price stabilization schemes

•Donald Real, Saving Fisheries with Free Markets –

• example of Tragedy of the Commons

• where markets produce perverse results – but regulation does not work well either

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Run on Rice I

• The Run on Rice• Setting – rapid increase in dollar price of food

grains – doubled in two years

• What were the causes of this increase?

• What can be done about these increases?

• Possible causes –• Rising food demand in India and China due to

rapid economic growth – does not translate into consumption patterns.

• Upgrading of diets in Asia to more animal protein – rice not used much in animal feeds.

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Run on Rice II• Production shortfalls also not a good explanation• World production of rice in 2007 was at an all-time

high, with 2008 forecast expected to set another record

• Severe weather had a bigger role in the wheat market due to 2007/08 droughts in Australia

• Still weather unlikely to have resultied in a doubling of the price of wheat

• Other explanations:• Trade reforms – actually lowered the price of rice• Two other factors may have raised prices by one

third at most:

• Rising energy costs – increases prices of fertilizer and pesticides

• Commodities traded in dollars: Falling value of dollar – make prices cheaper in non-dollar currencies – increase demand but give farmers less for their crops – reduce supply 4

Run on Rice III

• Biggest single contributing factor to rise in grain prices:

• Government policy of encouraging/mandating biofuels

• Production most first generation biofuels in direct competition with use of land for food or feed production

• Almost all increase in global corn production 2004-2007 went to biofuel production

• Impact of biofuel use on rice less direct

• Rice not used for biofuel production

• Rice land not easily switched to other biofuel crops

• Surge in wheat prices with declining acreage planted encouraged consumers to substitute rice for wheat – helped push rice prices up

• Still, wheat prices can’t explain all of the increase in rice prices

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Run on Rice IV

• Unintended consequences of government policies in major rice exporting and importing countries

• Fear that sharp increase in corn and wheat prices in 2007 would spill into domestic rice markets

• Concerns about rising price of wheat imports and overall inflation led India to restrict own rice exports

• 3-4 million tons were taken off of thin world markets• Snowball effect – other countries followed, Egypt,

Vietnam and China also imposed export restrictions• Thin world markets – result major jump in price• Did not have intended effect on domestic prices due

to hoarding and speculation – shortages developed• Finally, forecasts of record harvests of rice and

Japan releasing 200,000 tons of rice stocks helped move prices back down

• Still, as long as biofuel programs are in place, always the danger of a reoccurrence. 6

Rice Prices, 2004-08 U.S. dollar/metric ton

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Run on Rice V

• Impact of high food prices

• Poor hurt the most – households in East Asia spending on average 30-50% of budgets on food

• Individual impact depends on whether household is a producer or consumer

• In Indonesia estimated 10 percent increase in rice prices reduces real value of expenditure of poorest tenth of population by 2%

• Policies to combat effects of high food prices

• Shield the most vulnerable through direct cash payments and other safety net measure

• Reduce domestic food prices by changing trade, tax and subsidy prices

• Encourage more efficient food production and

• Use international cooperation to get at the global sources of the problem

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Crude Predicament I

• Article deals with increased volatility in oil markets

• Textbook economics says prices rise and fall in order to balance supply and demand

• However in oil market supply and demand are slow to respond to price shifts

• Takes years to develop new resources

• Demand often inelastic

• When demand falls suddenly, takes time for suppliers to cut production

• Means prices undergo big swings before balance restored –

• Result: oil prices tend towards extremes

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Crude Predicament II

• Traditionally oil producers able to find new oil faster than demand grew – price bursts would wipe out profits and investments – followed by rises in demand then booms

• Producers thus sought to put floor on prices by holding oil off market

• Also sought to limit competition by placing caps on price and adding extra oil to markets during tight times

• 1930s – mainly Texas Railroad Commission

• After 1972 largely OPEC with Saudi Arabia the country with spare capacity

• After 2003 with Iraq out of market, little spare capacity

• Rapid world growth – prices up to $147/barrel in 2008

• Saudis less willing to develop spare capacity -- expensive

• No other producers can fill Saudi Arabia’s role – Russia unreliable 10

Crude Predicament III

• Policy Actions

• Governments can provide more and better information on supplies – avoids panic buying

• Assure good futures/hedging markets

• Don’t use strategic reserve to suppress oil prices

• Develop alternative supplies – shale Canadian Oil Sands

• Encourage the phasing out of subsidies – IMF, World Bank

• Encourage conservation, fuel efficiency

• Retrospect – many problems discussed may be lessening due to the rapid development of shale oil/gas supplies in U.S. and other parts of world

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Saving Fisheries I

• Pacific halibut fishing

• Problem of over-fishing – better technology, lack of restraint pushing fisheries to extension

• Initial regulation – basically cutting back the number of days in fishing season

• Unsuccessful – better boats/nets offset fewer days

• Result:

• Overcapacity

• Wastage – fishing season very short – fish dumped on market

• Other fish in danger – short season forces fisherman to turn to other varieties, red snapper, rockfish – may endanger these varities

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Saving Fisheries II

• Solution – quotas

• Creates more of a stake in the health of fisheries

• Fisherman willing to cut back when stocks are low because increases value of quotas – can sell quotas in secondary market

• Arguments against quotas –

• Local monopolies – destruction of way of life -- can be easily avoided

• Closing area more effective – fisherman can always fish on parameter

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