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ACE 2006: AGRICULTURAL ECONOMICS

WORLD TRADE, WORLD MARKETS & POLICY.

NOTE: The previous notes on the gains from trade emphasised:

Trade is a 2-way street - we only export so as to be able to import something else - there is nothing inherently bad about imports or good about exports, and if we try to import more than we export (practically equivalent to consuming more than we produce, or spending more than we earn), we will have to finance this deficit somehow - by running an overdraft, borrowing funds, or persuading someone to invest in us, or give us some funds.
Trade depends on differences - there can be no gains from trade if all potential trading communities or partners are indentical - comparative advantage arises because of different resource endowments, asset mixes and balances, differing technologies and preferences. Without these differences, there will be no trade
Trade is ubiquitous- although most textbooks (and even these notes) tend to treat trade as if it only applied to inter-country trade, the principles on which trade happens are universal, and apply from the household level up to international trade.

It is important to keep these fundamental points in mind as we turn to the more practical application of trade principles to the single markets - a "partial" equilibrium analysis. Remember, too, that the logic of the previous arguments on the gains from trade identify the 'fundamental physics' of the nature of economic transactions and behaviours. Any trite dismissal of this framework as 'just theory' or 'only theoretical' is equivalent to dismissing the laws of gravity as only theoretical.

THE MIRCOECONOMICS OF TRADE - SPATIAL (PARTIAL) EQUILIBRIUM.

Trade happens when someone discovers that market prices for the same goods are different in different places - high prices in one place and low in another. Common business sense then takes over - BUY CHEAP AND SELL DEAR - for example, wheat in North America versus wheat in Europe:

Imports reduce the price of the good in the importing country (or region or locality), by adding to the local supplies, and increase the quantity which is purchased.
Exports raise the price in the exporting region or location, by adding to the deamnd for the local production and reduce the quantity consumed (purchased)

So, where will the process of Trade reach equilibrium? Think, before you read on:

Trade will be in equilibrium when it no longer pays to buy cheap and sell dear - in the limit, when the prices in the two markets are the SAME (apart from transport and marketing costs between the two locations). The process of trade can be represented through:

Excess Demand (XD): equivalent to the Demand for Imports - the difference between the quantity demanded and the quantity supplied in the local market at each and every price - which equals zero at the local equilibrium price (Pe in the diagram above), and increases as price is reduced below Pe - so XD is Downward sloping.
Excess Supply (XS): equivalent to the Supply of Exports - the difference between the quantity supplied and the quantity demanded in the local market at each and every price - which is zero at the local equilibrium price (Pu above), and increases as price is increased above this level - so XS is Upward sloping.

With NO transport and marketing costs, the trading equilibrium will be at the point of intersection of XD and XS - the same price in each market, with quantities exported equalling quantities imported. This is sometimes called the "Law of One Price"

In practice, there are costs of moving goods between different markets (especially over international borders), so prices of the same goods are not the same in different markets - they will generally be higher in importing markets and lower in exporting markets.
The Importing price is often referred to in the statistics and trade press as the "cif" price - meaning that the cost of the good, insurance and freight charges are all included in the price.
The Exporting price is often referred to as the "fob" price - meaning the price of the good free on board the exporting ship, having been paid for, but not yet moved.
The difference between these two prices therefore reflects the costs of moving the good (more generally, moving and marketing it), which can be applied in the analysis as a 'wedge' between the Import demand (excess demand) and export supply (excess supply) curves.
Although this illustration is in terms of international markets, EXACTLY THE SAME PRINCIPLES APPLY to separated regional or local markets.

It is usually pretty simple to get current data on domestic and world consumption and production, and prices. With these basic data, and some educated guesses about elasticities of supplies and demands, you should be able to estimate/approximate the consequences of market developments using this framework.

The Effects of Policy Intervention - the EU case

In the 'old CAP', this insulation and protection was achieved through taxing imports (the tax called a variable levy - WHY??). The import tax depresses the world price and increases the domestic EU price, and generates the shaded area as the revenues to the EU budget from the levy or import tax.

Over time, though EU supply curves shifted to the right faster than domestic demand, as structural and technical change have improved the 'competitiveness' of EU supplies (more produced at lower total costs), leading to the EU changing from a net-import position to a net export position

Here, the exports from the EU are shown as negative excess demand (i.e. = excess supply), and imports by the rest of the world are shown as negative export (excess) supply in the RoW (i.e. as import (excess) demand). Now, the EU has to apply an export subsidy to remove the surplus from the domestic EU market to maintain the internal EU price. The shaded area shows the costs to the European Budget of doing this.

Can you identify the costs to the consumers and the gains to the producers of this policy?

[Note - area E refers to the whole of the stippled rectangle]

Taxpayers Cost (export subsidy, or surplus removal and disposal):	[b + c + d + E]
Consumer Cost (relative to Free Trade)	[A + b]
Producer Gain (relative to Free Trade)	[A + b + c]
Net Cost	[b + d + E]

[Remember that we can interpret the Supply curve as the cost of supplying succesive units of the product, and the Demand curve as the consumers' willingness to pay for succesive units of the product, hence defining the 'benefits' and 'costs' of the policy intervention]

[Note, in this case, the PSE would be estimated as [A + b + c + d + E + (Pe - Pa)*Qd], as a % of Pd*Qs
An offsetting CSE (consumer tax, in this case) would be estimated as [A + (Pe - Pa)*Qd], as % of Pd*Qd,
The Taxpayer cost (budget expenditure) in the OECDs estimates of the effects of policy would include the administrative costs which are not identified in this diagram]

Implication: Once the EU moved into a net export position for its major commodities (beginning with Dairy in the 1970s, and then in cereals in the 1980s) the CAP began to be increasingly expensive for the EU, and prompted a succession of reforms to the policy:

1984:   Dairy Quotas
1992:   MacSharry Reforms - substituting area payments for reduced (eliminated) export subsidies
1996:   Agreement to the GATT Uruguay Round negotiating agenda, to include agricultural products for the 1st time.
2003:   "Agenda 2000", extending the area payments concept to livestock through headage payments
2005:   Single farm payments - incorporating previous area and headage payments into a single de-coupled payment per farm, subject to 'modulation' - the progressive reductioin in these payments in favour of more general rural development assistance.

SPATIAL EQUILIBRIUM MECHANICS OF THE WORLD MARKET

The effects of one country's policies on the world market depend on the elasticity of the world market excess demand (or supply) curve facing the country in question. To see how elastic or inelastic this excess demand is likely to be, we need to consider the basic defintions and relationships more formally - using some elementary algebra. THIS WILL LOOK COMPLICATED WHEN YOU FIRST SEE IT - BUT IT IS STRAIGHTFORWARD - JUST TAKE IT SLOWLY AND CAREFULLY AND YOU WILL BE ABLE TO FOLLOW IT, I PROMISE (JUST SWITCH YOUR BRAINS ON!!).

Excess demand in the rest of the world equals demand in the rest of the world minus supply in the rest of the world, by definition: XDR = DR - SR, by definition

So: ¶XDR /¶P = ¶DR/¶P - ¶SR/¶P; as the response of each side to a change (¶) in the (world) price P, - effectively just multiplying each part of the first equation by ¶/¶P [where ¶XDR simply means "a small change in XDR", ¶P means "a small change in P" so the whole expression ¶XDR /¶P simply means "the small change in XDR per unit small change in P" and so on through the rest of the expression];

Then, multiplying the LHS by P/XDR to turn it into an elasticity - of RoW excess demand with respect to a change in world price -, which in turn means multiplying each term on the RHS by the same term, to preserve the equality, gives:

¶XDR/¶P * P/XDR = ¶DR/¶P *P/XDR - ¶SR/¶P * P/XDR;

Now multiply the first RHS term by DR/DR (ie 1) and the second term by SR/SR (again = 1), and re-arrange terms: gives an expression in terms of elasticities on the RHS as well: So:

EXD = [¶DR/¶P * P/DR] *DR/XDR - [¶SR/¶P * P/SR] * SR/XDR;

= [ED(row)] * DR/XDR - [ES(row)] * SR/XDR

What this expression means is that the elasticity of the Excess Demand curve for the rest of the world (EXD) is the weighted sum of the elasticities of demand (ED(row)) and supply (ES(row)) with respect to the world price, in the rest of the world, the weights being the ratios of demand and supply (i.e. consumption and production) in the rest of the world to EEC exports respectively.

" Guestimates" of these elasticities and knowledge of production and disappearance data for the world and for the EEC now allow some reasonable estimates to be made about the elasticity of excess demand facing the EEC.

eg for cereals,

let ED(row) be -0.5; ES(row) be +0.75;

XD(Row) has to equal XS(EC) for equilibrium in the world market - that is, for markets to clear with no unsatisfied buyers or sellers,

so XDR = XS(EC) = 30m.tonnes approx.;

DR = approx 450m tonnes for cereal grains (check this),

so SR = 420m tonnes.

So: EXD (for the EC) = -0.5 * (450/30) -0.75 * (420/30) = -0.5 * 15 -0.75 * 14 = -7.5 - 10.5 = -18 i.e. highly elastic.

But the general perception is that excess demand curves are typically quite inelastic (so that relatively small changes in EC exports would have significant effects on world prices - for most applications, the flexibility of world prices with respect to EEC exports (the reciprocal of the elasticity) is likely to be more useful). So what has gone wrong here? - THINK BEFORE YOU READ ON!

Answer

The elasticities are with respect to the world price, not to the ruling domestic prices in the rest of the world. Many countries protect and insulate their domestic agricultural industries from the effects of world prices.

If domestic prices do not change as world prices change, i.e the domestic policies insulate the domestic markets, then the elasticities of domestic supply and demand w.r.t. world price changes in the above expression are zero and the elasticity of excess demand will also be zero, i.e. the flexibility will be infinite (any increase in EEC exports will depress world prices to zero).

However, few countries can afford to totally INSULATE their domestic markets from the world price (e.g., the bigger the gap between domestic and world prices, the more costly in one way or another are domestic polices) hence there is some logic for movements in world prices to be translated, at least partially, into movements in domestic prices. There is also some empirical evidence of this, through correlations of world and domestic price changes.

Protection, i.e. a "wedge" between the domestic price and the world price, with domestic and world prices tending to move together, will make the elasticities more inelastic, cet. par. but will not reduce them to zero.

The more insulative and protective are domestic support policies around the world with respect to the world price, the more inelastic (the less flexible) the XD facing the home country, with obvious consequences for domestic policies at home.

We can see this as follows: go back to the expression for the EXD:

EXD = ED(row) * DR/XDR - ES(row) * SR/XDR

= ¶DR/¶P * P/DR *DR/XDR - ¶SR/¶P * P/SR * SR/XDR;

The "true" domestic elasticities (with which we usually feel fairly comfortable and confident) are with respect to domestic prices: ED(row) = ¶DR/¶Pd * Pd/DR, where Pd is the domestic price in the RoW, rather than the world price. Similarly: ES(row) = ¶SR/¶Pd * Pd/SR

Now, to retrieve the expression for the EXD, we need to "transform" these domestic elasticities so that they reflect responses to the world price.

We need the elasticities of domestic prices with respect to world prices - E(Pd/P) = [(¶Pd/¶P) * (P/Pd)]

Now multiply each term in the RHS by this elasticity:

¶DR/¶P * P/DR * [(¶Pd/¶P) * (P/Pd)] *DR/XDR - ¶SR/¶P * [(¶Pd/¶P) * (P/Pd)] * P/SR * SR/XDR {The terms in Pd cancel out, leaving the expression as before, try for yourself, so we have not changed the expression, merely expanded it.}

Now we have the complete expression:

EXD = ED(row) *E(Pd/P) * DR/XDR - ES(row) * E(Pd/P) * SR/XDR.

where E(Pd/P) = [(¶Pd/¶P) * (P/Pd)] is the 'Price Transmission' elasticity - measuring the extent to which domestic prices (Pd) respond to world prices (P).

<>and the first term in the RHS of E(Pd/P) is: (¶Pd/¶P) - the "insulation" of the policies in the rest of the world, since this measures the rate of change of domestic prices in reponse to world price changes. Note, in principle, the Old CAP set domestic prices which did not alter whatever the world price was, through variable import levies and export refunds, so this term might be thought to be zero for the EC under the old CAP, making the EXD of the EC, which the rest of the world faces, zero - i.e, the effective excess demand curve for the EU, which is the relevant one for the rest of the world, was, potentially, vertical. However, the consequences of world price changes showed up in the EC budget, which got bigger as world prices fall, and hence exerted some downward pressure in turn on domestic (EC) support prices, so (¶Pd/¶P) was not zero for the EC, and has been estimated as about 0.5. under the old CAP. Given fully decoupled support now, this term should be 1 under current policy.

The second term (P/Pd) measures the extent to which domestic prices are different from world prices (usually above in developed economies), ie the "protection" offered by the EC policy - actually the inverse of protection as normally measured ((Pd-P)/P) - , so that Pd > P and P/Pd < 1 (in the EC, for cereals, about 0.5 under the old CAP)

So, for the EC cereals market, E(Pd/P) =0.5*0.5 = 0.25. If the Rest of the world behaves as does the EC, then this would reduce the EXD facing the EC to: - 1.875 - 2.625 = - 4.5, that is rather more inelastic than the first attempt above. In fact, many countries (especially the old USSR, China, non EC European countries etc. hav been even more protective and insulative than is the EC, so EXD for the EC may well be even more inelastic than this.

SO, WHAT CAUSED THE 2007/8 WORLD FOOD PRICE SPIKE?

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