Causes of changes in wheat prices

Since the summer of 2010, we have seen the price of wheat significantly increasing. In this essay I will outline the possible reasons why wheat prices have shot up in recent months and also introduce methods of intervention that can be used to try and contain the price rises.

This year has seen irregular weather patterns considerably affecting harvests in many major wheat producing countries. This has in fact manufactured the recent spike in wheat prices across the globe. Russia’s harvest has been the most significantly affected by the weather. During the summer, Russia and the Ukraine had been experiencing severe droughts and wildfires which have prevented the growth of crops, also destroying a third of their produced wheat. As a consequence, Russia announced a ban on all exports of their grain from the 15th August – end of December, which was then extended into 2011. After the failure of the Russian harvest alone wheat prices shot up by 20% alone, illustrating a restriction in supply of the grain. After this announcement the US Department of agriculture cut its projections for the next year’s world production of wheat by 15.3m tonnes to 645.7m tonnes. However, it is important to note that wheat stocks are higher still than crisis levels witnessed in 2007-08.

This projection and halted production have caused wheat prices to increase on the future markets to their highest levels since the last crisis. Canada, the 2nd largest wheat exporter in the world has been severely affected by heavy rains which have prevented farmers planting seeds and also destroying hectares of land, considerably damaging next year’s harvest. India, the 2nd largest wheat producer, was hit by severe monsoon rains in August which heavily affected their wheat storage. They had insufficient storage, causing around 10m tonnes of wheat to be at risk of rotting due to it being exposed to the rain. Also, Egypt, Serbia, Australia and Pakistan have been hit by major floods which have destroyed up to a fifth of the countries crops, reducing supply further and aiding the price increases. The combined effect of these weather disasters is shown in the diagram below:

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The diagram shows that supply has fallen from S1-S2. This has reduced output from Q1-Q2 and increased the price from P1-P2. Here you can see that the change in price is considerably larger than the change in output. This is due to the fact that wheat is a necessity and therefore is price inelastic, which is represented by the inelastic demand curve. This means that with a reduction in the supply of wheat, even if it is below crisis levels seen in 2007-08, there will be a large increase in price.

Another reason why prices have been rising lately is because of the rapidly increasing global population. The global population is rising so fast because emerging countries have the fastest increasing population rates. Many emerging countries are becoming wealthier meaning that demand for grains is increasing faster than the population. However, it may be argued that recent spike in wheat prices has been caused by uncertainty in the market and panic buying, as a result of export restrictions and a fall in supplies. It may also be argued that recent price rises have been exaggerated due to ‘Speculators’. These are investors who purchase wheat on the commodities markets expecting further price rises and are compressing supply whilst making profits from doing so. This results in short term increases in the price of wheat, which is what we have witnessed in recent months.

However, there are differences between the situation in 2007-08 and the situation we are in this year. Wheat prices rose consistently for many months in 2007-08, whereas recently, prices have been slightly more volatile. Price rises in the weeks of July this year were no larger, compared with a month previous to that, than those seen from May-October 2009. For the past 3 months, the price rises have been less than the ones seen for the last 3 months of 2009, indicating that the situation now isn’t anywhere near as bad as previously seen. One of the reasons for this is that this year we have seen excess production from the US and China; which has helped offset the problems faced by Russia and other countries previously mentioned. The surplus from the US and China suggest that these prices increases seen this year should only be temporary. Also wheat producers have rebuilt stocks again since the last crisis, predicted to be at approximately 646m tonnes for 2010 which should be sufficient to fill the hole left by countries like Russia.

When faced with increasing prices and falling supply for wheat the government have options on what actions can be taken to help in this particular situation. Firstly the government could provide producer subsidies. A producer subsidy is a payment from the government with the purpose of potentially lowering the input cost of production for farmers, thereby helping to increase the supply of wheat. This may involve subsidising the cost of a particular input used for the production process to help lower the farmer’s costs. The diagram below shows the result of a subsidy payment made to wheat producers:

Here you can see that the subsidy has helped reduce the cost of production, thereby increasing the supply of wheat from S1-S2. Also, output has increased slightly from Q1-Q2. The most important thing to note here is the price change. As you can see the price for wheat has fallen considerably from P1-P2. The reason why the price has fallen so much in comparison the small increase in output is that wheat is price inelastic. This means that output is less responsive to changes in price. However, this has helped to achieve and increase in supply of wheat to meet increasing demands but at the same time a much lower price for wheat making it more affordable on the market. It is also important to note that as price is inelastic, the consumer will benefit the most from this subsidy. This is indicated by the shaded area ‘P1.Q1.P2’ which shows the increase in consumer surplus as a result of the subsidy. Producers will also gain from this subsidy as they will receive higher net revenue leading to increased Producer surplus. Another benefit of this subsidy is that it can help control the price level as the government can use this to prevent the price of wheat soaring even further.

However, there are some drawbacks when using subsidises. For example, it can distort market prices possibly creating uncertainty in the market which can increase prices one again but also cause a misallocation of resources. Also if a subsidy was given to the agricultural industry it might create huge controversy especially after coming out of a recession and many industries in decline, for example the car industry, greatly in need of such finance. Also a subsidy can synthetically support farmers who are unproductive and require structural change which can lead to higher costs for the government and higher costs for the consumers in the long run. Another drawback is that subsidies are very expensive and are funded by the taxpayer’s money which comes from long term increases in taxation. Therefore it can be argued that subsidies provide partially false benefits to consumers. Also increased government spending involves an opportunity cost as the money could have been spent elsewhere on for example, education. Subsidies may also lead to a fall in productivity on production as a result of a lack of competition from other farmers or a reduced incentive to increase wheat production as they are protected by the subsidy.

Another option the government have is setting a maximum price for wheat. This involves the government legally imposing a price limit on the market in order to restrict the price exceeding that particular level and becoming too high. However, it can only be effective when set beneath the free market equilibrium price. The diagrams below show the process of a maximum price:

The diagram on the left shows the original market prior to an imposed maximum price. Here you can see that where demand equals supply, we have a price (P*) and output (Q*) equilibrium also with an equal amount of consumer and producer surplus. The diagram on the right shows a maximum price being introduced into the market, indicated by ‘Pmax’. As you can see, as a result of the maximum price quantity supplied contracts to Q2 and quantity demanded extends to Q1, creating excess demand at that price. Excess demand is created here because the price has now been held beneath the original equilibrium price P*. From a maximum price being introduced consumers gain from a lower price sold for wheat; however, consumer welfare has still fallen due to the contraction of quantity supplied. Also, as you can see, as a result of the maximum price the levels of consumer and producer surplus have changed. The new area for consumer surplus equates to the trapezium C.B.D.Pmax, indicating an increase in consumer surplus due to the lower price for wheat. However, producer surplus has fallen and equates to E.C.Pmax. Also there has been a loss of economic welfare indicated by the triangle ABC.

However, the situation of contracted supply and excess demand can cause problems. If the government simply introduced a maximum price without further intervention, wheat would be sold at a first come first serve basis which could mean that the people who appreciate and demand it the most may not acquire it. Firms may also sell their wheat stocks to their preferred customers and other people would be neglected and their access would be restricted. All of this would prove unfair for the general public, therefore, rationing the wheat stocks would have to be adopted to try and overcome these problems. Another problem with the use of maximum prices is that it can lead to the manifestation of underground markets. This is when consumers are unable to buy sufficient amounts of wheat in a legal market and are therefore prepared to wheat at very high prices, even above the normal free market price P*. Also maximum prices reduce the amount of wheat that is produced thereby reducing food supplies. As a result, farmers will earn less income and may decide to move away from wheat farming all together and switch to dairy farming, for example. This will reduce the supply of wheat even further, creating a multiplier effect. Here the government may then have to try and encourage supply further or carry out direct government production or giving tax reliefs for farmers. The government may attempt to reduce the demand for wheat by promoting the production for other grains in order to minimise the excess demand.

Overall, I believe that there is no perfect solution in order to try and offset the situation of increasing wheat prices and restricting supply for wheat. In order for intervention to be effective and achieve maximum economic efficiency, I believe the government should use a variety of policies in order to achieve lower prices and also to promote increased supply of wheat. Another option that government have is to use the Buffer Stocks’ scheme. This would involve the government purchasing wheat and storing it during good harvests and then setting it free during bad harvests. This will help to balance demand and supply in the long run, also providing a fixed stabilised price. This will prevent situations of excess demand and contracting supply, along with souring prices for wheat. I also believe that the recent jumps in wheat prices are only a short term shock to the sudden contractions in supply. Surpluses in the US and China should help fill the hole left by other countries over the next few years. Also, many of the affected countries mentioned are now experiencing more favourable weather conditions, meaning supply should return to normal within the next year or so. Finally, there is no reason why supply should stay contracting within the next year. Even if wheat prices remain as they are or continue to rise slightly, farmers will be attracted to this and devote more land to wheat farming, using this as an opportunity to increase their incomes but at the same type help return wheat stocks to a normal level.