In the simple spatial equilibrium diagram (ignoring marketing costs) the trade of commodities between countries or regions equalises the price in both countries/regions. This leads economists to speak of the law of one price. In the absence of transport and marketing costs, trade leads to the establishment of a single world price.
In practice, markets establish a whole set of inter-related prices for the same commodity at different stages and places in the marketing chain. Each price is related to the next by the costs of moving, marketing and transforming the product. The world grain market is characterised by a whole series of prices for each grain and grade, some fob (free on board - i.e paid for but not yet moved, the export price), some cif, (cost of goods, plus insurance and freight charges - the import price) at different locations. Two of the more important of these prices are: (i) the Chicago spot price, referring to the current price of wheat (of a specific grade) fob, export position in the US, typically the Bay Ports - New Orleans; (ii) the Rotterdam cif wheat price.
Figure 1 shows an illustration of the chain or web of prices one might expect to observe in the marketing chain from Kansas to (for example) Poznan, Poland for milling wheat. This shows three important things. First, as a grain trader, it is vitally important to know what the prices are supposed to include. Contracting to sell to Poznan millers at the Rotterdam cif price means that you must make sure the millers know that they have to pay the onward (downstream) costs from Rotterdam. If your contract is badly worded or misunderstood, you may well find they thought they were being offered an acquisition price, not a cif, Rotterdam price.
Second, the marketing costs associated with finding buyers or sellers, assembling information, making decisions and organising the movements of products are overhead costs associated with all the physical handling and transportation costs shown here. These jobs also carry considerable risks of contracting for purchase or delivery of products at prices which do not leave sufficient margins to cover these costs. Mistakes will be made, and the average margins should be enough to offset the occasional mistake. The point is, these jobs cannot be done for nothing. Traders have to be able to make a living too.
Third, the world price for wheat can be expressed in a number of different ways. Any, or all, of these illustrated prices could qualify as the world price. How can this be true, and what, if anything does the world price mean? The answer involves an understanding of the effects of competition on market price differences.
Competition and market price differences
The logic of the competitive market place makes sure that price differences between places are close reflections of the real costs of marketing the commodity. Suppose you are a trader and you find that you can buy cheap and sell at a high price, and make more than enough money to fully cover the costs of transport, marketing and storage, including your own salary. You (or your firm) would then be making a lot of money (pure profit). If you are lucky enough to find yourself in this position, you should expect others to want to imitate you and make money themselves. As they do, the price in the cheap market will be bid upwards, and the price in the expensive market will be depressed, until these extra profits are eliminated. You and your competitors will still be making a living, provided you are competitively efficient - as efficeint as the next guy - otherwise profitable price spreads will open up again. However, the competitive market place should ensure that you cannot regularly make a killing! If you can, treasure it; you should not rely on it.
By the same token, if the margins are too small to cover all the costs of providing the marketing service, then traders will go bankrupt and trade will fall. As this happens, so margins (gaps between buying and selling prices) will improve until they are high enough to provide acceptable livings (salaries and returns) for the people doing the job and providing the capital (loans, investments and physical plant and equipment) to provide the service.
This process of competitive trading is known as arbitrage - trade to take advantage of profit opportunities between different markets or market positions. Commodity traders, therefore, perform the useful social function of ensuring that we pay as little as possible to move products between different places and different time periods. The competitive market place provides a continual incentive to encourage people to do a good and as cheap a job as possible. It penalises inefficiency by paying the inefficient firms and individuals too little to provide acceptable incomes.
The example used here is the world grain market. But, the same analysis and the same market mechanisms also apply to other commodities. However, costs of transport and storage often result in more substantial differences between prices at different locations and in different time periods for less storable commodities. Sometimes (as for fresh fruit and vegetables, or fresh milk) these costs are sufficiently high to prevent trade between places (or storage between time periods). In these cases, processed substitutes (dried, frozen, tinned) form the major traded and stored commodities rather than their fresh counterparts.
The Analytics of Marketing Margins (start at top right of the diagram and work down!) (summary and re-statement of Ritson, chapter 3)
This analysis assumes that the supplies of raw materials and of marketing and processing services are competitive, and that the retailers are also competitive. In the event that there is either Monopoly - single sellers of either raw materials or marketing and processing services - or Monopsony - single buyers (a monopsonist retailer outlet), then the analysis must take account of the behaviour of these imperfectly competitive firms.
Marketing Margins under Monopolist/Monopsonist Marketing/processing firm:
So, compared with the competitive marketing position, the quantities marketed are reduced, the price paid to farmers is reduced, the price paid by consumers is increased, and the monopolist/monopsonist makes pure profits (of PmÕ - Cm) over and above the actual and opportunity costs of supplying the marketing and processing service in the marketing chain link - in effect, ripping off both producers and consumers.
In the typical story of the market mechanism, such pure (or super-normal) profits are expected to rapidly attract other marketing/processing firms into the business, and increase competition, eventually returning the system to the previous figure - increasing trade and marketings, increasing the price to producers, and reducing the prices to final consumers. However, in the event that the marketing services inputs (such as transport etc.) are limited, then a monopolist might be able to prevent entry into the market by monopolising the available supplies of transport, and retain their competitive advantage. But, under these conditions, if farmers can be persuaded to band together and withhold supplies, acting as countervailing monopolists, then they could drive up the farm price to capture some (or possibly all) of the monopsonistÕs pure profits. The eventual share of the profits then depends on the market/negotiating power of the farmers versus the marketing/processing firm, especially the farmers cohesion and solidarity in restricting supplies in the face of higher returns, and their ability to prevent individual farms from undermining the solidarity of the group in delivering more at a slightly lower price.
There is a number of riders to these arguments. First, it is possible that a monopoly marketing firm might have sufficient economies of scale (associated with cost-minimising sizes of processing plants or storage facilities etc.), especially in a small market where exploiting such economies quickly exhausts (i.e. supplies) the total market demand, that the monopolists cost curves (Sm and Mcm) are actually much lower than an apparently more competitive and fragmented marketing system would provide. Thus, MCm might actually be lower than Sm would be under more competitive conditions. In this case, neither consumers nor producers would suffer relative to more competition, even though both would be denied any benefit from the economies of scale in the marketing process - which would still accrue to the marketing firm as pure profits.
Second, it is seldom the case that marketing chains are characterised by 100% monopolies, with only one single firm responsible for all marketing and processing. Even under the various Marketing boards around the world, marketing happens outside the boards control, and typically these boards are subject to some competition from foreign markets and suppliers. In fact, to obtain a true monopoly, Marketing boards need to either have control of imports or have them controlled by the government.
Discussion of Marketing Boards lead to the third caveat on the economic analysis of monopolistic marketing. The figure above assumes that the monopolist is purely interested in maximising profits, which, if a marketing board were to follow, would necessitate restricting production of the raw material. An objective of maximising returns to producers of the raw material would result in a different strategy, which could still mean restricting production levels from their competitive levels. Such restrictions pose problems - persuading the producers to submit to such controls and policing the controls - the costs of which would need to be included in an analysis of whether such controls were actually more beneficial to producers than the competitive alternative. In practice, most marketing boards act to sell any and all the producers produce at the best possible price, and in that sense are acting no differently from an equivalent private firm - though they may organise deliveries and payments in different (and possibly less economically efficient) ways - e.g. the CWB.
Such single desk sellers may also be able to differentially price their products into different markets, according to the elasticities of demand in the separate markets - which depends on the single desk seller having sole control over the supplies. This would only make economic sense if some markets are willing to pay a significant premium for (e.g. Canadian wheat) even though there are alternatives available (e.g. US wheat) - that is that some markets exhibit an inelastic demand for Canadian wheat. As far as competitors are concerned, the question then becomes whether such differential pricing is damaging to their interests. How would it be? Is such a practice any different from Cargill, say, discovering that some markets are willing to pay a premium for Cargill's grain over and above the competition and pricing their product accordingly? The answer seems to be no. The losers of such practices are the consumers, not the potentially competitive suppliers. Thus the current anxiety being expressed (frequently by the US) over single desk selling agencies seems duplicitous - it is really about the control over markets denying private firms the rights to capture the markets, although, so long as the private firms are competitive, the only real losers from such control are the final consumers (who already have the remedy in their own hands - simply refuse to pay the premium and turn to alternative supplies).
In private (non board or government controlled markets), the competitive conditions are typically not purely monopolistic, but exhibit somewhat limited competition (a few major multiples or major processing firms). Here there are questions about how such firms operate - if they take account of the likely responses of their competitors to their own pricing and supply (marketing) decisions, then the analysis becomes more complicated (and is dealt with under the phrase oligopolistic competition and monopolistic competition in the economics text books). In addition, the literatures on structure, conduct and performance and contestable markets also become relevant.
Concluding remarks
Monopolists may not always or even generally raise prices - because to do so attracts potential competitors. If markets are contestable (entry is easy and costless) even apparent monopolists may well be subject to contest, and thus be forced to behave competitively - in the long run at least.
But, for markets to be contestable, firms must be able to avoid large sunk costs. With no large sunk costs, entry offers a potential competitor a one-way bet - winning of the profits turn out to be good, and losing nothing (no sunk costs) if the profits turn out not to be there. But what of advertsing, of purchase/lease of shop space or factory capacity or airline capacity etc.? The greater the sunk (or start-up) costs, the less the incentives for new (potential) entrants.
Static games (under game-theory - the typical method of analysing non-competitive beahviours), played only once, typically give the reuslt of non collusive or strictly competitive behaviour - the market competition result. However, repreated versions give the optimal strategy of collusion - cooperation, since defecting becomes identifiable and subject to retaliation (by a variety of different means). As Adam Smith was aware, capitalists, if left to their own devices, would much rather collude than compete.
Competition regulators and their armies of lawyers are very busy trying to devise means and rules of preventing such activity. But the logic of the market ensures that they will always be one step at least behind the capitalists. Perhaps the answer lies simply in using the market place to expose these activities and leaving it to the buyers to decide whether or not to go on supporting such activities, or whether to resist and complain about these apparent rip-offs. In short, Ann Robinson's Consumer Watchdog TV programmes, and the equivalent in the popular press, might be very much more effective and efficient counteractions to such behaviours than armies of lawyers and impenetratable legal rules. If you don't like what Bill Gates and Microsoft are doing, make their life a misery by complaining and colluding as consumers (and investors) to make it clear that their activities and behavours are unacceptable. Government action would then simply be to provide assistance to genuine consumer or buyer power through provision of communication and information systems. Shame is possibly much more effective than prisons or puny financial penalties.