NS3040 Winter Term 2013 Price Theory Applications

1. NS3040 Winter Term 2013Price Theory Applications

2. 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

3. 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.

4. 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

5. 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

6. 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, Egype, 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.

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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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