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 2

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. 3

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 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 5

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, U.S. dollar/metric ton 7

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 8

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 9

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 11

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 12

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 13