A note on food prices

An interesting article found on the Huffington Post website, originally published by Reuters, suggests that this year’s higher food prices are here to stay. (Click here for article). We don’t necessarily disagree with the article, but we do question some of their analysis.

First, there is a quote from a Chicago based commodities trader that says “Everything is set to the point where supply equals demand right now.” This seems to imply that at some point in the past, or there will be a time in the future when supply does not equal demand. Markets tend to adjust quickly to shortages and surpluses. This is especially true of actively traded markets such as the commodity markets. A surplus occurs when the amount supplied in the market exceeds the amount demanded. Markets react by reducing prices. When demand in the market exceeds supply, a shortage occurs and prices rise. Thus, the adjustment of prices always creates a situation where supply equals demand.

Extreme weather, droughts, and floods certainly have an effect on the supply of food and any of these events causes food prices to rise. Likewise an increase in fuel costs also reduces food supplies and raises prices. Also, as of January 1, 2011 all new tractors must meet Tier 4 emission standards which increases the price of these capital items. (Reported on Farms.com)

On the demand side, there are a couple of things to note. The demand for ethanol is high because the US government uses policy to support corn farmers. As anyone that has consumed liquor knows, ethanol can be produced from almost any crop: corn, rye, barley, sugar cane, rice, grapes, blueberries, elderberries, cactus, potatoes … the list goes on. Also on the demand side, governments keep stores of foodstuffs to protect against supply shocks. When crops are good, governments buy food and store it. When crop yields are low, governments can mitigate price rises by depleting inventories. In the year(s) after a poor harvest, governments replenish their reserves, temporarily increasing demand. This is not permanent.

China has a different problem. Their official policy of undervaluing the yuan makes their exports cheaper, but it also increases the price of their imports. India, and the remaining BRIC countries (Russia and Brazil) have been attempting to slow the appreciation of their currencies as money moves away from Europe and the US. This also causes import prices to rise.

Most food crops are seasonal in nature and producers can change output in a year or less. If food prices are expected to stay high, watch for an increase in the number of farmers producing the more expensive crops and reducing the production of the lesser expensive crops.

This is the ‘invisible hand’ that Adam Smith referred to and it is the way that markets work.

Nous ne l'avons pas vue venir

Greg Mankiw’s Principle #4 – People Respond to Incentives

An article from Bloomberg reports that the French government has required the electricity provider to pay above market rates in an effort to encourage more renewable energy. Surprisingly, to some, this has caused an increase in the number of solar energy producers. The situation is so bad, that farmers are building barns so they have a place to mount the solar panels. (Click here for article)

Profits are down at Electricite de France SA and this is hampering their ability to fund life-extending maintenance on its nuclear reactors. It is also restricting their investment in the U.K., China and Italy.

The problem is not unique to France. Elsewhere subsidies have increased the number of solar fields, to the point where, in Germany, customers are paying surcharges to fund the subsidy. This is a massive welfare transfer from users of electricity to solar power producers. Solar power producers are paid 546 euros per MWh while the spot price is 55 euros. At those prices, farmers can get rid of their cows and produce electricity instead.

It’s only week 5 of the new semester, but I’m pretty sure that 90% of my students can tell you that supply curves are upward sloping. The amount produced at 546 euros will be greater than at 55 euros. They haven’t learned that economic profits encourage firms to enter and industry, but they will by week 9. Unfortunately, politicians rarely take economics. A comment from French parliamentarian in response to the growth of the solar power industry … “We just didn’t see it coming” (Nous ne l'avons pas vue venir)

Why we write this blog.

Besides trying to educate and entertain, we are attempting to instil a culture of critical thinking in our students. Regular followers will know that not everything that is printed in the popular media is entirely accurate. It is our goal to explain some of the economic theory behind the articles that we bring to your attention, and use that theory to critically evaluate the articles.

We attempt to refrain from the use of “should” which implies a value judgement. Normative statements (value judgements) cannot be argued on the basis of fact or theory whereas positive statements can be. It is the latter that we wish to encourage. It is also the skill that allows one to separate fact from opinion, and the skill that we are supposed to be teaching in post-secondary education. An article on the McClatchy website looks at the findings of a study that followed students through university and found that our success in teaching critical thinking is not terribly successful. (Click here for article)

An example of the lack of critical thinking skills came up in class this week when I asked about the Hudson’s Bay Company’s sale of its Zeller’s division to Target. (Click here for article) A straw poll in all classes suggested that 2/3 of students had shopped at Target, while less than 25% had shopped at Zeller’s. There were a few in each class, however, that objected to the sale of a Canadian institution to American interests. This opinion is shared by commentators on several blogs.

For the record: Zellers was formed in 1931 when Walter Zeller purchased 14 locations from an American retailer. Zeller's was sold to the Hudson’s Bay Company in 1981. The Hudson’s Bay Company was incorporated in 1670, 197 years before Confederation. Hudson’s Bay was a British company. In 2008 HBC was acquired by a US based private equity firm – an American firm buying a British firm. The sale of Zeller’s to Target is really a sale from one US company to another.

And yes, an American company sold us those lovely red Olympic mittens.

Lingerie or boxer shorts?

An article in Bloomberg Businessweek tells the story of a clothing manufacturer in India that produces lingerie, but refuses to produce boxer shorts. The article presents two entirely different concepts that we thought we might discuss today. (Click here for article)

One reason that Mr. Bhagwat chooses to produce lingerie instead of boxers has to do with the amount of profit that he earns per unit produced. His profit depends on his cost of production and the price at which he can sell his products. While he has some control over his costs, the amount that he receives depends on how much people are willing to pay for the goods he produces. This, in turn, depends on the elasticity of demand, a measure of consumers’ response to a change in price. The more responsive they are, that is the more they react to price changes, the more elastic the demand. The demand for boxer shorts is more elastic than the demand for lingerie because men, in general, don’t usual care what they wear while women do care what they wear. Look around you for evidence to that. One implication of profit maximization is that the gross margin (price minus marginal cost all divided by price) is inversely proportional to elasticity. The less elastic is the demand for the product, the greater the gross margin. Production of lingerie maximizes profits.

The second reason has to do with Indian labour law. When a firm employs more than 100 workers, they are not permitted to reduce their workforce without the permission of the government. Cost minimization dictates that firms do not cross the 100 employee threshold. Mr. Bhagwat has 98 employees. This policy prevents firms from capturing economies of scale that may be available to larger firms, and the large number of relatively small firms is impeding economic growth in India. China, where no such labour law exists, is able to capture the economies of scale in production and thus able to grow faster.

Policy makers in India can do nothing about the elasticity of demand, but they can do something about the labour laws. Until then, we appreciate the efforts of the 98 workers making lingerie.

Who maximizes what?

When attempting to teach economic principles we always try and determine the objective functions of market participants. In this way, we can predict what individuals are likely to do in certain circumstances.

For example, we assume that firms will attempt to maximize profits, or equivalently minimize costs. From this we can predict how they will behave when faced with rising input prices, rising output prices, the imposition of taxes and government regulations.

Individuals, on the other hand, are assumed to maximize utility, an abstract measure of happiness or satisfaction. From this we can predict how they will behave to changing incomes, prices, tastes and information.

What then, do governments maximize? We would like to believe that they maximize social welfare or economic growth or employment or something along that line. However, evidence seems to suggest that our politicians are actually vote maximizers. They tend to do or say whatever is required to get elected or re-elected. We offer some recent evidence from the state of Kentucky where, in a matter of a few days, they introduced a series of bills that will leave you shaking your head.

The first article (click here) relates to a proposal to make it illegal to smoke in a car where a minor (person under 17) is present.

A second article (click here) reports that Republican representative Lonnie Napier wants all recipients of state funding, including welfare, to be subjected to random drug testing. Those found testing positive for illicit drugs would lose their state benefits. One can't help wondering if this applies to the elected representatives as well. At the same time another bill being introduced reduces the severity of punishment for the possession of illegal drugs (click here). A cynical person would suggest that both measures are simply designed to save money and have nothing to do with the question of illegal drugs.

The third article (click here) relates to a proposal to “exempt Kentucky-made guns and ammunition from federal background checks, dealer licenses and other national regulations if the items remain in the state.” From http://www.lcav.org: “Kentucky does not impose criminal liability for negligent storage of a firearm, even if a child gains access to the firearm and causes an injury or death.” Clearly, at least in Kentucky, cigarettes and welfare recipients on drugs are more dangerous than firearms.

In no way are we critical of the citizens of the fine state of Kentucky. Their politicians are doing exactly what they think the citizens want. The only reason this blog is specific to Kentucky is because all of the articles came out in the same week.

Debt Loads and Low Interest Rates

There have been several articles appearing in the papers raising alarm at the increasing amount of consumer debt in Canada and other industrialized countries. There is a concern that if, and when, interest rates begin to rise, the cost of servicing the debt will cause hardship among a large percentage of the population. We cannot help but wonder why the growing debt load is a surprise to anyone, except for the Keynesians (or maybe it’s the Kenyans – still working on that one). (See previous blog)

In the Keynesian consumption model, a reduction in disposable income is accompanied by a reduction in both consumer spending and savings. Aggregate spending in the economy decreases and leads us down the path to depression unless the government stimulates the economy with expansionary fiscal policy. Only large decreases in income are expected to cause large increases in debt load.

According to Milton Friedman’s Permanent Income Hypothesis, however, consumption will only be affected to the extent that individuals consider the reduction in incomes to be permanent. If the recession is expected to be temporary, then savings decreases dramatically (or debt increases) to maintain the level of consumption. When the economy rebounds, consumption does not rise. Instead, savings increases and debts are repaid. This is likely what is happening in Canada where we escaped most of the banking crisis. The story in the US is very different where projections suggest that the labour market may not recover for ten years.

There is also a microeconomic model that helps. Here, the basic premise is that a pizza today is worth more than a pizza in the future. For each individual, the difference between the two is known as the rate of time preference. When the interest rate is below the rate of time preference, we are better off by borrowing and consuming now. If the interest rate is higher, then we tend to save. Interest rates are at historically low levels and so we would expect individuals with stable incomes to be borrowing now and repaying later.

Articles:

Bank of Canada comment in Financial Post

Bloomberg report on Canadian debt relative to US debt

Ottawa Business Journal reporting on comments by the Superintendent of Bankruptcy

A World Without Borders

The New York Times published an article that tells of the pending demise of Borders, the US bookseller. (Click here for article) Regular readers of this blog will not be surprised. Last September we told the story of the downfall of Blockbusters, the bricks and mortar rental outlets for movie rentals. (Click here for blog) Blockbusters failed to respect the competition presented by the likes of RedBox and Netfile.
Borders, and other booksellers, failed to respond quickly enough to the introduction of the various e-readers and the electronic delivery of books. Another NY Times article published before the holidays predicted that the number of e-readers could reach 10.3 million by the end of 2010. We are still waiting on Christmas sales numbers. (Click here for article)

The problem for bricks and mortar stores is the opportunity cost of shopping there. I went to 3 different bookstores looking for a particular trade paperback, to no avail. That took 3 hours of my time which, at my tutoring rate, was over $100. That is too much to pay for a paperback. Yesterday, I ordered it from Amazon. $7.99 plus tax and 1 minute of my time. Much cheaper.

News from the electronic trade show in Las Vegas tells us to expect more tablets capable of displaying e-books. Due to increasing returns to scale and new entry, the cost of these devices will fall throughout 2011 and as they do, more people will buy them and the demand for e-books will increase. Barnes and Noble may be next in the US, and we will likely see some restructuring in Canada where Indigo dominates the market through Indigo/Chapters/Coles.

One bookstore that I’m sure will survive however, is Powell’s in Portland Oregon. If you’ve ever been there, you know what I mean. If you haven’t, you don’t know what you’re missing.

A New Year. For Estonia, a new currency.

Yesterday, Estonia became the 17th country to adopt the euro as its currency. Given all the recent turmoil, they may regret the decision before this year is over. We have previously written about the troubles facing the EU and its common currency and since it was one of the biggest stories of 2010 we decided to start this year with an update. (click here for previous post) A Reuters article discusses the reasons why Estonia joined and why other Eastern European countries have not joined. (Click here for article)

Meanwhile, in Slovakia, some are regretting adopting the euro and the Associated Press is reporting that leaders in that country are exploring their options with respect to leaving the common currency. The advantages of the euro once outweighed the disadvantages, but if member countries are forced into bailouts of fiscally irresponsible countries the costs may exceed the benefits. (Click here for article)

We have expressed our thoughts on the future of the euro, and now, a UK based think tank has given the euro a 1 in 5 chance of surviving in its current form in 2020. The prediction is based on the unwillingness of the PIIGS to curtail spending and raise taxes to get their fiscal houses in order. The FANGs (my new acronym for France, Austria, Netherlands and Germany) may not be willing to undertake anymore bailouts for fear of putting their own budgets at risk. (Click here for article)

Of course, German Chancellor Angela Merkel and French President Nicolas Sarkozy in separate New Year's addresses have reiterated their support for the euro. (Click here for German article, and click here for French article). This is to be expected. If either of the two leaders even hinted that they may pull out of the euro and revert to the franc and deutschemark or to a northern european currency, the value of the euro would plummet as speculator sold the currency en masse. The demise of the euro will occur with no warning. One morning we will wake up and it will be a fait accompli.

It will be an interesting year, and a story we will continue to follow.