Managing Mechanisms of Agricultural Prices - Essay Example

? Global Economy: Market Structures and Trade Theory GLOBAL ECONOMY: MARKET STRUCTURES AND TRADE THEORY Agricultural prices andmechanisms for their management The last eight years, the price of agricultural commodities has doubled. However, the possibility of a fresh international recession and sovereign debt issues for the developed world has seen a shift in attention from the escalating prices of agricultural commodities (Atkin, 2009: p6). The current high food prices, according to analysts, are expected to last for a while. The analysts concur that the cause of the current price volatility is associated with both long and short-term factors. The short-term factors involve; government interventions, high oil prices, and financial speculation. Housing value depreciation and stock market declines have aided in the heightening of commodity futures appeal as assets. The higher petroleum prices on the input side have seen an increase in agricultural commodity production while government actions to mitigate the impact of global prices on their domestic market prices have also aided this volatility (Atkin, 2009: p7). Against a high volatility background, the price of soy bean was 10% higher in July 2012 compared to July 2008 prior to the global crisis with maize being 4.4% higher than it was in the month of April 2011 (United States Department of Agriculture, USDA, 2012: p1). The drought experienced in the US drove these record prices as it destroyed crops significantly. The lower output and yield also resulted in a decrease in the narrow stock/consumption ratio, which had been narrow. This was especially so in the case of maize that was used in the industrial production of ethanol. The graph below shows the evolution in price for major agricultural commodities. (United States Department of Agriculture, USDA, 2012: p1) Financial speculation has had an especially significant impact on the prices of agricultural commodities. For one, the exchange rate volatility has affected the volatility of these commodities. The prices that producers receive on deflation into the domestic producer currency may play a significant role in the prices at which the producers are willing to sell their commodities (Cooke & Robles, 2010: p32). This factor also extends to the stockholders. Volatile rates of currency exchange may play a role in significantly increasing the risk that is inherent in the returns. Therefore, it is expected that a positive volatility in the exchange rate transmission could lead to volatility in price for agricultural commodities. Another mode of financial speculation that could lead to volatility of agricultural prices is the interest rate volatility. Interest rate volatility is a vital macroeconomic factor that could result in a direct effect on agricultural commodity prices since they are representative of cost to stock holding (Cooke & Robles, 2010: p57). They also, however, act as an important indicator of the economic conditions. Thus, the volatility of interest rates could also act as an indicator of uncertainty in economic conditions and, therefore, affect commodity demand. Another short term factor has to do with oil price volatility, which has seen the most significant shifts in the last decade. This shift is expected to continue, at least in the short term, especially with the recent move towards the bio-fuel use (FAO, 2009: p22). Recent studies have shown that there is a transmission between the price of sugar and that of oil. There is a likely link between the costs of input commodities and output. Costs of freight, use of mechanized agriculture, and the price of fertilizer are interlinked with the price of oil and are transmitted to the overall cost of agricultural commodities. In light of the last decade’s unprecedented oil price volatility, there is every chance that it has spilled over into the agricultural commodity market. Government intervention has also led to volatility in the agricultural commodity market. One of the methods used by governments to lower prices, export concentration, has had a major effect on the prices (Lines, 2011: p34). A decline in the number of countries that export agricultural commodities could expose the international agricultural commodity market to variability in exportable supplies, domestic occurrences such as policy changes, and shocks from weather changes. Lower export concentration could lead to a higher potential volatility while increased concentration could see a lower potential for volatility. Trade tariffs are short term factor that affect the prices of agricultural commodities. These are customs duties that are charged on imported merchandise. They afford a price advantage for goods produced by local farmers and producers over goods of a similar nature that are exported while also raising revenues for the government (Lines, 2011: p40). Recent developments have looked towards cutting them in order to prevent them from affecting the prices of agricultural commodities. More important, however, are the long and medium term factors that lie under the volatility of agricultural commodity prices. On the side of demand, the two elements that are considered are the evolving patterns of development of bio-fuels and the changing and rising patterns of agricultural commodity consumption in developing nations (Munier, 2012: p42). On the side of supply, climate change and its impact on the productivity of agricultural land could have a crucial role to play in the coming years. The rise of developing countries economically is creating an increasing demand for commodities and raw materials. The Chinese consumption of meat has grown from approximately nine kg of meat in 1970 to nearly fifty-five kg in 2011 (Piot-Lepetit, 2011: p61). The country now accounts for half the consumption of pork in the world and approximately a fifth of poultry consumption. This could explain the increase in demand for feedstock crops in China. Other countries like Brazil have also seen an increase in their proportion of meat consumption to the rest of the world. Looking at these changes in global demographics and the changing income distribution patterns, the result, has been increased food demand and altered food consumption patterns (Piot-Lepetit, 2011: p62). The global demand of meat is even expected to rise by double in the next fifty years as will the demand for cereal. The rise in demand for global energy coupled with efforts to reverse climate change has given rise to increased interest and emphasis on bio-fuels as a replacement for fossil fuels. This has already had a significant effect on food supply and is expected to rise in significance in the next fifty years (Sarris, 2011: p42). Certain food crops including sugar cane and food crops have found use in the production of bio-fuels. Another factor that has seen bio-fuels have an adversarial effect on the price of agricultural prices is competition for land resources, which are to be devoted to bio-fuel production instead of production of food. However, all is not gloomy with this as there are some mitigating factors like substantial spikes in food production and increased efficiency in the production of ethanol (Sarris, 2011: p43). However, in the long term, it could have an adversarial effect on the production of food and supply of food globally. Another long term factor that affects agricultural commodity prices has to do with the super-cycle. Raw agricultural materials have been involved in a super-cycle since the year 2001 with the average length of every phase beginning in the late 1700s lasting approximately twenty one years. Developing economies and emerging economies are set to grow by 5.3% compared to 3.3% around the globe. There is set to be a 7.8% growth this year for china and a further 8.25 next year (Sarris, 2011: p70). According to measurements by S&P GSCI, raw materials have been rising for the last ten years and have been making advances over the last eleven of the past thirteen years. Agricultural commodity prices, as seen, tend to fluctuate more than those of manufactured services do and products do. Therefore, businesses and governments have sought to manage these prices using various mechanisms to mitigate its adverse effects. One mechanism is by use of buffer stocks (Winters & Sapsford, 2010: p57). These schemes aim at making market prices for agricultural commodities stable via buying product supplies during surplus production and selling them to the market on lowering of supply. A large supply rise, results in a shift out of market supply that puts a downward pressure on the market equilibrium price. The intervention agency, in this case, intervenes and buys, out the surplus stock, to avoid a dramatic fall in price (Winters & Sapsford, 2010: p58). Therefore, a faster rise market supply compared to demand will see growth in storage supplies being sold when supplies are running low. Another mechanism is intervention price. This can be defined as the price at which intervention agencies are obliged to buy any amount of an agricultural commodity that is offered without regard to the market price levels, making the assumption that the commodities meet the specifications designated, as well as quality standards (Winters & Sapsford, 2010: p59). Therefore, the intervention price acts as a market price floor. They have made up one of the fundamental policy mechanisms that act to regulate markets in the European Union, markets for products such as milk powder and cereals. Several studies have also suggested that alterations to futures prices for particular commodities could also lead to changes in spot prices. Spot prices are normally to be discovered in the futures prices (Winters & Sapsford, 2010: p59). Evidently, alterations in futures prices could lead to spot changes more often than not. Thus, from a perspective of policy, the implementation of virtual reserves globally could carry viability in the address of excessive spikes and dips, in commodity prices, through futures markets signals and, where needed, maintain favorable economic conditions and commodity demand. References List Atkin, M., 2009. Agricultural Commodity Markets: A Guide to Futures Trading. London: Routledge. Cooke, B. & Robles, M., 2010. Recent food prices movements: A time series analysis. Washington: Intl Food Policy Res Inst. FAO., 2009. The State of agricultural commodity markets . Rome:Food and agricultural organization of the United Nations. Lines, T., 2011. Agricultural commodities, trade and sustainable development. London : International Institute for Environment and Development. Munier, B., 2012. Global uncertainity and the volatility of agricultural commodities prices. Amsterdam : IOS Press. Piot-Lepetit, I., 2011. Methods to Analyse Agricultural Commodity Price Volatility. New York : Springer. Sarris, A., 2011. Agricultural commodity markets and trade : new approaches to analyzing market structure and instability. Cheltenham : Elgar. United States Department of Agriculture, USDA. World Agricultural Supply and Demand Estimates (WASDE). August 2012. http://usda.mannlib.cornell.edu/MannUsda/viewDocumentInfo.do?documentID=1194 (accessed January 12, 2012). Winters, A. & Sapsford, D., 2010. Primary commodity prices : economic models and policy. Cambridge : Cambridge University Press. 2. Trade theory: Application to inter-industry and intra-industry trade According to the Ricardian model, countries will specialize in the production. In the Heckscher-Ohlin model supposes that domestic economies that are capital abundant will specialize in the production of capital intensive products, for instance cloth that is imported by foreign economies (Freinkman et al, 2010: p49). In turn, labor abundant economies will specialize in production of labor-intensive products like food that is imported by domestic economies. For intra-industry trade, we could suppose that a monopolistic competition model can define the international cloth industry. Because of product differentiation, we could suppose that each country is involved in production of different types of cloth. Large markets become desirable given the economies of scale with foreign countries exporting cloth and domestic countries exporting cloth. Therefore, intra-industry trade will occur within the cloth industry (Freinkman et al, 2010: p50). If the domestic country is abundant in capital, it will still have an advantage comparatively with regards to cloth. Therefore, it should import less cloth than it exports. Inter-industry trade gains are reflective of comparative advantage with the home capital abundant country being a net exporter of cloth that is capital intensive. Intra-industry trade gains are reflective of economies of scale and wider choices by the consumers, rather than comparative advantage (Grimwade, 2012: p38). The model of monopolistic competition is not predictive of the country in which the firm is located; rather a comparative advantage in production of differentiated goods could most likely lead to the country importing fewer goods than it exports. The importance, relatively, of intra-industry trade is dependent on the similarity between the countries. Countries that possess similar relative factors of production can be predicted to possess intra-industry trade. In turn, countries that have different relative factors of production can be predicted to have inter-industry trade. Unlike the Heckscher-Ohlin model prediction of inter-industry trade, effects of income distribution are not predictable in intra-industry trade. Approximately 25% of global trade is intra-industry trade (Grimwade, 2012: p39). However, some industries possess more intra-industry trade compared to others with industries that require labor that is more skilled, physical capital, and technology exhibiting intra-industry trade. Countries that have similar amounts of skilled labor, physical capital, and technology engage in relatively more intra-industry trade. To explain the pattern followed by international trade, different trade theories offer relatively complementary explanations. While no one theory can explain the pattern of global trade, the new trade theory, Porter’s theory, product life-cycle theory, the Heckscher-Ohlin theory, and the theory of comparative advantage are suggestive of the factors that are most important (Handjiski, 2010: p71). The theory of comparative advantage contends that differences in productivity are vital. The Heckscher-Ohlin theory contends that factors endowments are important. The product life-cycle theory contends that the introduction of a new product is vital. The new trade theory contends that first mover advantage and increasing specialization, returns matter while Porter’s theory says that all the factors could be vital as long as they affect the national diamond’s four components (Handjiski, 2010: p72). The absolute advantage theory suggests that countries have differing abilities in efficient production of goods. This theory is suggestive of the fact that a country specializes in the production of products, in areas, which it possesses an absolute advantage and, in turn, imports goods where other countries possess absolute advantage (Marjit & Eden, 2008: p22). The comparative advantage theory suggests that it is sensible for a country to specialize in the production of goods that it possesses the ability to produce best while purchasing products that are relatively less efficient for it to produce, even when it means purchasing goods that it can efficiently produce itself. It suggests that free and unrestricted trade leads to an increase in world production with trade becoming a positive sum game (Marjit & Eden, 2008: p23). It also suggests that by allowing free trade in a country, economic growth, is stimulated and creates dynamic trade gains. The Heckscher-Ohlin theory contends that international trade’s patterns are determined by factor endowment differences. It contends that countries will be more likely to export goods that intensively make use of factors that are in abundance, in the country, and import those goods that require intensive use of locally scarce factors (Pomfret, 2009: p65). The theory of product life-cycle is suggestive of the fact that patterns of trade are influenced by the area where new products are introduced. In a global economy that is increasingly integrated, this theory is relatively less predictive than it was when it was used between the years 1945 and 1975. The new trade theory contends that countries may predominate in exportation of particular products because it possesses a firm that acted as the first mover in industries that profitably supported only a few companies due to significant economies of scale (Rivera-Batiz, 2009: p41). New trade theorists have promoted an idea concerning strategic trade policies. The argument has to do with the fact that government via the use of subsidies could increase the probability of domestic firms acting as first movers in industries that are emerging. Porter’s theory suggests that trade patterns are influenced by domestic conditions, factor endowments, firm rivalry, structure, and strategy, as well as supporting and relating industries. International trade theories are vital to individual firms because they help the company decide on the location of various activities of production (Rivera-Batiz, 2009: p42). Firms that are involved in international trade have a strong influence on the policy of the government to trade. Via the lobbying of government bodies, firms could aid in the promotion of trade restrictions and free trade. The H-O model can be defined as an international trade general equilibrium model that builds on the comparative advantage theory via the prediction of commerce and production patterns with its basis on endowment factors of a region of trade ((Freinkman et al, 2010: p70). This model contends that states export products, which utilize their cheap and abundant production factors while importing products that require it to use scarce resources. Relative endowment of capital, labor, and land are great determinants of a country’s comparative advantage. Countries possess competitive advantages in products whose required production factors are locally abundant. This results from the fact that profitability is determined by the cost of inputs. Goods whose inputs are abundant at the local level are relatively cheaper to produce compared to those that require scarce inputs (Freinkman et al, 2010: p71). For instance, a country with abundant land and capital, but scarce labor, will possess a comparative advantage for products that are land and capital intensive, which do not need a lot of labor. Prices are expected to be low if there is an abundance land and capital. For grain, the price will be low and will be attractive for export and domestic consumption (Freinkman et al, 2010: p71). Goods that are labor intensive should be expensive since there is scarcity of labor and high prices. The country, therefore, will gain more for the importation of goods. References List Freinkman, L. Evgeny P. & Carolina R., 2010. Trade performance and regional integration of the CIS countries. Washington: World bank. Grimwade, N., 2012. International Trade: New Patterns of Trade, Production, and Investment. London: Routledge. Handjiski, B., 2010. Enhancing regional trade integration in Southeast Europe. Washington: World Bank. Marjit, S. & Eden, Yu., 2008. Contemporary and emerging issues in trade theory and policy. Bingley : Emerald. Pomfret, T., 2009. Lecture notes on international trade theory and policy. Hackensack: World Scientific. Rivera-Batiz, A. & Maria-A O., 2011. International trade : theory, strategies, and evidence. Oxford : Oxford Univ. Press. Read More