Apparently elementary economic analysis of stability turns out to be rather stupid, without care and attention to what is going on. For example, early scholars (Massell, Quarterly Journal of Economics, 1969, 284-298, who consolidated earlier articles by Waugh (QJE, 1944, 602-14; Oi Econometrica, 1961, 58 - 64), analysed the issue as follows.
Suppose, for simplicity, supply can either be S1 (a bad year) or S2 (a good year):
Conclusion: Producers gain from stabilisation of supply instability, consumers loose, but there is an overall social gain so stabilisation is a Ògood thingÓ, and can be done at no cost (except carrying charges and storage costs - which should be covered through a margin between buying and selling prices for the buffer stock - see below).
Alternatively, consider and instability in demand, where demand is either D1 (a strong year) or D2 (a weak year):
Conclusion: Consumers gain by more than the producers loss so again stabilisation a Ògood thingÓ, and again the buffer stock can operate on a break even basis given a sufficient margin between buying and selling prices to cover carrying and storgage costs.
BUT: all this analysis really says is that there is money to be made in storage - buying cheap and selling dear, and thus we would expect a market solution to store and thus stabilise. These diagrams ignore the storage markets:
The Storage Market: Essentially a market between the good and bad years, buying in good years and selling in bad. So we have an excess supply curve from the good year intersecting with an excess demand curve from the bad year. Thus, with no storage or carrying charges, the equilibrium price would be P*. More realistically, with storage and carrying charges, the market will balance when the difference between the buying price [Pg(s)] and the selling price [Pb(s)] covers the storage and carrying charges with the quantity stored (QS) equal to the amount bought into store in the good year (Qgs - Qdg) and to the amount sold from store in the bad year (Qdb - Qsb)
What about a trading economy faced with instability in world prices?
The conclusion (Waugh and Oi) is that it does not pay small countries to try and stabilise internal pries against world price instability
Large Countries: the conclusion holds (under this partial analysis) for large countries as well, while, if we consider the world as one country, we wind up back at the starting point of these notes!
So, what are the real questions?
Storage and Carrying Costs: Depend on:
Will the market store an optimal quantity? Why wouldnÕt it?
1. The consequences of uncertainty for the optimal allocation of resources rely on economic agents being non risk neutral. Risk-averse agents (the typical assumption) will tend to act more ÔconservativelyÕ in the face of uncertainty than otherwise, thus reducing the output and consumption levels and, in effect, using scarce resources to buffer potential outcomes to reduce risk, and avoiding otherwise profitable investments because of uncertain outcomes. It is thus argued that an ÔexternalÕ reduction in risk (uncertainty) will lead to a more ÔefficientÕ outcome, but only if people are risk-averse.
However, reduction is risk for one sector of the economy really means shifting the burden of the risk to someone else, some other sector - typically the government budget. Risk is like energy, it can only be transformed or shifted, it cannot be avoided or eliminated. It can be minimised by intelligent markets and sensible planning, and it can be spread out or concentrated. The real question is about who should bear the risks. The market solution will be to distribute the risks so that those most willing to take them are bearing most and those least willing to bear them bear the least - the principle of insurance.
2. Are insurance and risk markets complete? It is widely recognised (eg. Munk, 1994) that the Ôduality theoremÕ of perfectly competitive markets achieving a Pareto social optimum allocation of resources does not hold if particular markets are absent or incomplete.
It is further argued that the most obviously incomplete markets are those for insurance (contingent markets) and those concerned with future planning (risk and forward markets), since it is practically impossible to pre-specify and write contracts for every conceivable future outcome. This leads to the general notion that, because of uncertainty, we operate in a Ôsecond bestÕ world, where the general proposition of second best theory is that satisfying all but one of the conditions for a first best world (with prefect certainty) is not necessarily the optimal course. Intervention (in terms of breaking with the general free market rule) might be preferable in a second best world to offset the imperfection. Hence, it is often argued that there are strong reasons for government intervention in agriculture to offset the volatility of farm production and associated variability and uncertainty in prices and returns. Although, for example, Newberry and Stiglitz, 1981, find that there is likely to be limited static welfare gain from stabilisation, others have argued that the dynamic effects of stabilisation through encouraged investment in new technologies might be substantial (Crawford, 1988, Stiglitz, 1987, - referenced in Munk, 1994)
There is a counter-argument (eg. McKee and West, 1981). Comparing an uncertain world with a perfectly certain one is equivalent to wishing uncertainty away. Equivalently, we might argue that a world with cold-fusion nuclear power would be a more efficient world, but this is no reason to apply the theory of second best. In a similar fashion, recognition of information and transactions costs, and of the costs of decision making under uncertainty, should allow the competitive market to find appropriate and resource-efficient solutions to the problems of risk and uncertainty. Incomplete markets, in this perspective, are merely a reflection of the fact that the gains to be made from including new contracts or obtaining better information are not offset by the additional real costs of providing these ÔgoodsÕ. Thus Spriggs and Van Kooten, 1988: ÒAs argued by Arrow and Lind (1970) markets may not exist because of high transactions costs. In such cases there is no market failure, just no market. Secondly, recent research by Myers (1988) suggests that the actual cost of incomplete risk markets may not be very significantÓ (p8)
Gilbert, 1992, concludes that Òtheory does not provide any general presumption either for or against interventionÓ (p8). He goes on to point out that while Newberry and Stiglitz, 1981, do show that competitive markets are not pareto-superior, so that government intervention could be welfare-improving, they do not establish that any particular intervention would improve welfare. GilbertÕs general theoretical conclusions are worth quoting at length: ÒOf course, producers are fundamentally interested in their revenues being smoothed: this is not necessarily achieved through price stabilisation , and perhaps not best achieved in this way. Second, there exist market forces (notably private sector storage) which act to stabilise prices, and international prices may in any case be intermediated by governments in such a way as to stabilise producer prices. There is a clear danger that attempts to stabilise international (terminal) market prices will inhibit these tendencies. Third, it may be argued that commodity futures and options markets allow producers to stabilise their own revenues even given volatile (cash) price distributions. And finally, we shall see that calls for price stabilisation may disguise programmes which aim to raise primary prices through regulation of international tradeÓ.(p8 - 9)
The potential role of futures and options markets in providing necessary risk spreading and stabilisation facilities is clearly a critical part of the analysis of the case for governement intervention to stabilise markets and/or producer returns. Many analysts are convinced that, in the absence of government intervention, risk and insurance markts would be substantially more active for the agricultural sector than at present. Indeed such markets are already increasing in a variety of guises, including the land market where non-standard share and contract farming arrangements are becoming increasingly commonplace. Thus, Gemill, 1988, ÒWe conclude that the absence of suitable (futures and options) contracts is not a problem: intermediaries, such as merchants, will tailor them to suit the needs of farmers if there is sufficient demand.Ó (p458).
However, by their very nature, futures and options markets can provide no more information than is already contained in the current spot price, albeit in a condensed form. In effect, all futures and options markets provide is a means of spreading risks associated with price variations by substituting risks associated with market performance (in terms of price relationships or ÔspreadsÕ and ÔbasisÕ), Gilbert, 1992, p 15. Ultimately, the crucial problem of determining a Ôplanning priceÕ especially for the critical longer term investment or strategic managment decisions, is not particularly assisted by such markets. As Spriggs and Van Kooten, 1988, point out (p 6), following Newberry and Stiglitz, 1981 (p 238) ÒThe problem is that the generation and dissemination of information is costly and it has public good characteristics. this leads to an undersupply of information by the free marketÓ (no matter how complete are contingent and futures markets). ÒThe solution is for government either to improve the quality of information directly, to provide incentives to the private sector to do this or else to reduce the need for information. The introduction of a stabilisation programme is an attempt to reduce the need for informationÓ. These authors continue: ÒTo address the information problem, the stabilisation authority would be required to set the support price at the long-run expected level.Ó, where the crucial distinction is between random shocks (unnecessary price changes) and shifts in demand and supply of a fundamental nature (necessary price changes) - Tomek, 1969.
Spriggs and Van Kooten (amongst others) are highly critical of theoretical arguments supporting the view that governments ought or need to intervene to stabilise anything in agricuulture, over and above the stabilisation and insurance offered by the market place. Such market adjustments include the often forgotten stabilising influences of rational economic decisions and contracts in the land and investment markets - such as varying land tenure agreements and timing new (and often moveable) investment decisions to coincide with the ÔgoodÕ years.
However, there remains the critical ÔinformationÕ problem referred to above. It is far from clear that this can be adequately solved through either direct production of more information by governments or by appropriate incentives to the private sector to generate such information. Certainly there are few practical examples of such action, though the apparent success of ÒSituation and OutlookÓ conferences and associated publically funded commodity market forecasts in market-oriented countries (US, Canada, Australia) is an example of the percieved benefit of additional information coupled with an established forum in which the value of such information can be openly discussed. Add the very substantial transactions costs associated with such risk and insurance markets, and the real possibilities of major economies of scale in covering these if ÔmanagedÕ by the public sector, and the pragmatic conclusion is that there is a logical case for some publicly assisted insurance/stabilisation provision to an important and highly atomisitic industry such as agriculture. Furthermore, stability continues to be a major element of publicly stated objectives for the sector and is unlikely to be ignored on the arguments of pure economic theory.
3. Private versus Public Discount Rates (interest charges) (The following is an incomplete introduction to a particularly messy and controversial area of economics!)
There are essentially two perspectives on interest rates - two purposes or functions fulfilled by interest rates:
a) interest rates reflect the opportunity cost of capital - the revenue foregone by investing in the stock rather than in some other investment alternative, or (equivalently in a perfect capital market) the cost of borrowing the capital from the banks or other investors - how much do we have to pay people to invest in stock-holding rather than some other form of investment? - the CAPITAL ALLOCATION FUNCTION which should ensure that the limited capital available (see (b) below) is used in its most productive uses;
b) interest rates reflect the cost of waiting - the preference for consumption now rather than later (otherwise known as the time-preference rate) - how much do we have to offer people to save (i.e. forego consumption) in order that we might use these savings to invest in something? - The INTER-TEMPORAL WEIGHTING (WAITING) FUNCTION - which effectively implies some comparison between the utility of now (the present generation) versus the utility of the future (including the next generation).
In addition, in practice interest rates reflect the risk associated with waiting or investing, arising from the uncertainty about the future, including the future value of money (inflation) Rm (nominal market interest rate on an asset) = R* +RP + I where R* is the Òrisk-freeÓ interest rate (approximated by the return on long term government securities such as consols (perpetual or undated government secturities which pay a fixed nominal amount (the yield) per year indefinitely or for ever - so the rate of return is the consol yield (C) divided by the market price of the consol (P); RP is the premium required to cover the risk of the investment (or foregone consumption); I is the (expected) inflation rate (which accounts for the potential decline in the value of the money) - so that ÒrealÓ interest rates equal the nominal market rate less the (expected) rate of inflation. Note, the Capital Asset Pricing Model (CAPM) assesses the risk of a single asset versus the risk (variability) of the whole market in variable assets, and allows computation of the systematic risk through ÒßÓ coefficients - measuring the correlation between the returns to a portfolio of assets throughout the market and the returns to the asset under consideration)
In the world of perfectly competitive general equilibrium economics, the time preference rate and opportunity cost of capital is brought to equilibrium (equality) through the savings/investment decisions, with interest rates adjusting so that, at the margin, people and firms are willing to give up current consumption (i.e. save) at the same interest rate as other people and firms are willing to invest for the future rather than produce now (the marginal productivity of capital investment, or equivalently the marginal productivity of the current capital stock). Furthermore, this market determined interest rate will provide the correct incentive to allocate capital between alternative investment projects (including storage) efficiently.
In the real world, life is not so simple! First, consider the private sector: the rate of time preference is likely to be lower than the opportunity cost of capital simply because there are normally a) costs associated with financial/capital transactions which make lending rates lower than borrowing rates and b) taxes on returns to capital which makes observed interest rates (to borrowers) geater than the time preference rates for lenders. This, of course, leads to problems in an appropriate allocation between consumption and investment which can be resolved in practice through personal/firm investment from existing income or wealth - illustrated by the ususal phenomenon that the rates of return obtained from ÔownÕ capital are typically lower than those available on the capital market or the cost of borrowing (eg farmers returns on equity capital versus borrowing or investment rates).
Now, a question becomes: is the social time preference/opportunity cost of capital higher or lower than the private (market) opportunity cost of capital?
i) Social Time Preference rates might be different from Private Time Preference rates (if they are lower, then the appropriate public decision to invest for the future should take the social time preference rate as the discount or interest rate):
ii. Social Opportunity costs of capital might be different from private opportunity costs of capital:
But, Markets may (not necessarily will) store sub-optimal levels of stocks - because they use market rather than social discount rates. Once public sector [international - from conclusion (i)] interference is accepted, it is likely that the private sector will not undertake any storage, so the public sector will replace or crowd-out private sector inter-annual storage. Hence, the logic says, subsidise private storage by the difference between the private and social discount rate, whatever that is.
But, Insurance markets may be incomplete because of private (atomised) transaction costs being substantially in excess of public (concentrated and organised) transaction costs - the transactions themselves are a sort of public good. Hence, organise insurance (including margin stabilisation - e.g. Canada) at a public level.
See a recent discussion paper prepared for DEFRA (UK) on Risk Management in Agriculture for further discussion of the risk management options and strategies. The full report can be found on the DEFRA web site.
But, even with subsidised market storage (i.e. greater levels of stock carry-over than otherwise), and with publically-organised insurance schemes, including social security, it may be that in some developing country situations, there is still a dnager of some insecurity in times of improbably bad harvests. The difficulty with improbabilities is that they happen sometime. As and when they do, there will be catastrophic local food shortages. Democratic governments will always find it difficult to live with this possibility and will be tempted and encouraged to protect against such possibilities. While international lines of credit and emergency supply could provide such protection, countries with a history of either isolation or antagonism with major powers (also the major suppliers) will find it difficult to rely on such emergency agreements and dependence on others. The implication seems to be that some form of internationally guaranteed emergency supply will be necessary, which will also require guranteed emergency delivery systems. This is, in effect, what the UN World Food Agency seeks to provide, though there remains considerable doubt in some vulnerable LDCs that the Agency's command over stocks or available supplies elsewhere in the world is too small.
In the end, the world's experience with a more liberalised agricultural and food trading system should provide for more stable (less volatile) world prices than in the past. On the other hand, if global warming means more variable and less reliable climate, the world's food supplies will be more volatile in the future that during the particularly benign climatic patterns (by long term hsitoric standards) of the 1950s to 1980s.
Food security and world market volatility (and hence the democratic
demands for stabilisation) will, on this logic, continue to be major issues
for the WTO and other international organisations. Similarly, the World
Bank, the IMF and the major developed country powers may well continue
to accept the market as the best (if not the only) way of organising food
production and consumption. But local democracies all round the world (both
developed and developing) will continue to raise questions about the reliablity
and justice of the market mechanism, especially when these seem to be dominated
by multinational companies with no national or social allegiances. As they
do so, they will seek to invent systems of protection and intervention,
and to demand sanction for these from the international community.
Further reading
Newbery, D. and Stiglitz, J., 1981: The Theory of Commidty Price Stabilisation: a study in the economics of risk, Oxford, Clarendon Press - the "definitive guide"
Other references available from DRH on request.
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