The following key features are known about the wheat industry:
- Wheat prices, expressed in constant dollars, have exhibited a downward trend over the last 100 years – see figure Since wheat is traded globally and market outcomes are determined by world-wide supply and demand, a similar trend in prices has occurred in all countries, including Canada.
- Wheat prices are quite volatile, with sharp rises in price every so often.
- This volatility is unique – prices tend to “bounce” along a “floor” (albeit one that is down-ward sloping), spiking every so often (again, see figure 1). Expect for the spikes that occur infrequently, price increases are short-lived and are followed by a return to the “floor.”
- The demand for wheat is inelastic at prices that are above the minimum marginal cost of production. An inelastic demand curve is one that is steep.
- At prices near the minimum marginal cost of production, the demand for wheat is relatively elastic as traders buy grain to put in storage in anticipation of the price rising at some point in the future. An elastic demand curve is one that is fairly flat (but still downward sloping).
- The world supply of wheat is very inelastic at any given point in time (it takes 4-5 months to grow a wheat crop) at the output level corresponding to the then-current production (which is determined by acreage seeded and yield). An inelastic supply curve is one that is steep.
- At output levels below the current production level, the supply curve is relatively elastic at a price roughly equal to the minimum marginal cost of production. An elastic supply curve is one that is fairly flat.
- The yearly supply of wheat fluctuates from year to year because of weather and disease
- Incomes have grown significantly over the last 100 years
- Wheat is a normal good with respect to income, with an income elasticity positive but less than one
- Yields have, on average, grown substantially over time – see figure 2 – as a result of agricul-tural R&D (e.g., development of new varieties that yield better, new production techniques that better use moisture, and so on.)
Question: Based on the information provided above, use appropriately drawn supply and demand curves (and shifts in these curves) to tell a story that would provide an explanation for three things:
- The long-term downward trend
- The sometimes sharp year-to-year fluctuations off of a “floor”
- The cause of the dramatic spike in prices in the early 1970s.
Please answer each of the questions using a separate demand and supply model, and without considering the issues raised in the other two questions.
Figure 1: U.S. Wheat Prices, 1913-2013
Figure 2: U.S. Wheat Yield, 1913-2013
Point E* represents the equilibrium point. At any other price that is higher or lower than the equilibrium price, the supply and demand forces will come into play and bring the price back to the equilibrium market price, P*. At any price that is higher than the equilibrium price, producers would increase the quantity supplied, and the consumers would decrease the quantity demanded. It would result in a surplus since quantity supplied is higher than the quantity demand. The downward trend in wheat prices over the years has been due to improvement in biotechnology, farmers, as well as plant breeders, have developed and adopted new crop varieties with high yields. Also, the number of suppliers of the inputs of the modern biotechnology has increased hence, making the prices of wheat decrease since the raw materials are readily available. This leads to an increase in numbers of farmers growing wheat and other consumers have substituted wheat with other grains. From the figure below the technological improvement in other grain production will shift the demand curve to the left. The price and output of wheat fall from p* to p1 and Q*to Q1 respectively.
Sharp prices year to year has been due to excess production and extreme tight supplies, causing price variability in the world grain prices. Also, the domestic policies of importing and exporting grains have led to the destabilization of the grain price. Wheat yield varies year to year due to weather and other natural conditions; market structures vary, financial and economic conditions change, input and product prices vary. All of these factors lead to variability in farm income. For example, the sharp costs in 1971-82 are partially related to the higher average level of prices.
The causes of spikes in price in the seventies were due to several factors. Firstly, international monetary conditions, grain price variability resulted from changes in global demand for grain. It was prompted by changing world economic conditions, shifts in foreign currency exchange rates. The absence of adequate buffer stocks lead to devaluation of the dollar in 1972, and the adoption of floating exchange rates by the world monetary system (Miller et al., 1985). Us farmers found themselves exposed not only to changes in the world crop production and trade policies but also to variations in the strength of the dollar compared with other in major grain-importing countries. The devaluation of the dollar in 1972 and 1973 caused lower grain prices in countries buying us grain products. Wheat exchange rate-the value of the dollar compared to with currencies of countries buying us wheat declined by 7 percent in 1973(Wright 2011).
Secondly, trade policy, trade policies for both exporting and importing played a significant role in the dramatic spike in price during 1972-74and the fluctuations in the world grain markets (Wright, B. D. 2011). The principal exporting countries reduced their stocks in the early seventies, through production controls in the United States and stock disposal in Canada. Also, the soviet union entered the world market as a significant union, an effect which is emphasized by evidence of actively destabilizing response to world price fluctuations, Trade policies of both exporting and importing countries to stabilize prices were a significant factor in increasing the world grain market fluctuations in the seventies.
Miller, T. A., Sharpies, J. A., House, R. M., & Moore, C. V. (1985). Increasing World Grain Market Fluctuations: Implications for US Agriculture. Economic Research, 703, 487-4780.
Wright, B. D. (2011). The economics of grain price volatility. Applied Economic Perspectives and Policy, 33(1), 32-58.