Friday, April 25, 2008

The second law of supply, or, food's too important to leave to government 

The same people who wanted you to use biofuels now are telling you they are bad. The worldwide shortage of food because of demand for a substitute leads to rising prices and, because in the short run you can't grow more rice, runs on rice supplies here and abroad.

I make part of my lecture on supply and demand a "second law of supply". Big shifts in supply or demand will lead to large initial changes in price. Elasticities are always greater in the long-run than the short, as some fixed prices become variable and some investment opportunities take time to build. When Ed Morrissey says,
Perhaps turning food into transportation fuel would make sense if massive amounts of grain spoiled every year from a lack of demand...
he's only half right. All surpluses are eliminated by falling prices, and all shortages are eliminated by rising prices, in a free market. The grain will spoil for one year, and then we grow less grain.

'Tis from this logic that the theory of cobweb cycles grew in the 1940s. Cobweb cycles make sense as a theory for the movement of corn prices if two conditions apply: There's a significant lag between the decision to produce and the delivery of the product (true for most agricultural products) and supply decisions are based on current prices. Of course, corn has a futures market. At the time of this writing, the spot price for corn was $5.77 but the price for delivery in December 08 is $6.07. That price is driving the decision to plant X acres as corn, valued in comparison to the prices of soybeans, wheat, and whatever else you might grow on that land. What happens after about June 15 to that market doesn't matter so much, as most corn is already in the ground by then in the Northern Hemisphere.

It is also interesting to note that, while the price of corn futures rises steadily, the price of ethanol futures declines as we go to more distant dates on the contract. The rising price of corn induces more corn into the market, which creates more ethanol and reduces its price. Prices adjust in the long run back towards the initial price. Far better than the Terror for allocating goods and services.

Ed continues:
Farmers love the higher prices that come from the new demand to fill gas tanks, but higher prices have consequences for poorer nations that have just begun to be felt. Morally speaking, shouldn�t we feed people before we feed cars?
Esther Duflo is also arguing that we need price insurance for the world's poor.
The traditional method used by developing country governments � maintaining large stockpiles of grain by buying when the price is low and selling when the price is high � has its share of problems. In India, it was said that at some point that there were enough bags of rice in those storage facilities to go to the moon and back. The losses in storage and to corruption were important. Alternatively, the governments can manipulate prices using taxes and subsidies. Or perhaps it is time to be creative and make the international financial services actually work for the poor: governments could provide price insurance for the poor (in the form of transfers to some when price are high, and others when price are low). Countries that are neither net sellers nor net buyers could do this internally, and countries that are either net sellers or net buyers should be able to sell this insurance on the world market.
But isn't this what speculators do? We have seen what public insurance in financial markets does: We get too-big-to-fail. We get political pressure overriding contracts and even the law, letting banks and brokerage houses skirt financial regulation because it would be too disruptive to let them fail. Should we trust those same mechanisms with our food?

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