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April 6, 2001

Total Crop Demand Increases Very Little When Prices Decline Contributing Little to Market Self-Correction

When technology, weather and/or released acreage expand crop supply faster than the rate of demand growth, crop prices plummet as they most certainly have in recent years. But in contrast to other sectors, crop agriculture tends not to recover in a reasonable time—the last three years being a case in point.

In a market economy, bloated product inventories (grain stocks in the case of agriculture) should be worked down automatically as consumers purchase more and producers produce less of the product in response to the depressed prices. This self-correction causes inventories to rebalance and prices and incomes to recover. To the dismay of all, no such correction has occurred in crop agriculture despite prices that have plummeted by 40 percent. This column considers why a market-driven recovery has not occurred through expansion of the quantity demanded.

The lack of a significant increase in the quantity of agricultural commodities purchased, especially by importing nations, is in marked contrast with the rhetoric of the past. The conventional wisdom in the 1980s was that we were pricing our crops out of the export market. A lower U.S. price, it was said, would cause a surge in demand by crop importers and cause our export competitors to reduce their exports. Then, as our exports greatly expanded, revenues would increase, inventories would decline and prices would improve.

Yet, when given a chance¾especially since the adoption of Freedom to Farm in 1996¾the market has not reacted as expected. Compared to early 1980s, crop prices are down by half while exports are virtually unchanged. It has taken us twenty years to relearn what we had known for decades: Crop demand is relatively unresponsive to price changes.

The overarching idea is that since food is essential for life, price is of little consequence. Food comes first. We will pay whatever is required to obtain it. But once we have enough, we will not buy significantly more total food, no matter how far the collective price of food has dropped.

Is this true for other products? Of course not. Typically, a price drop greatly expands the quantity of an industry’s product purchased by consumers.

It is also likely that feed demand, the major use of grains and soybean meal, is becoming less rather than more responsive to low prices. With the increased use of large, high-fixed-cost buildings in livestock production and fewer producers who come “in and out” of the market, there are fewer opportunities for adjusting feed use in response to price changes.

And as the last four years have shown us in spades, export demand responds very little to lower prices, even after four years. Importing countries have no more tendency to import more because of a general drop in grain prices in a given year than we have a tendency to eat more total food because prices have dropped. As a result, the total world export pie expands very little in response to lower prices.

And since our export competitors tend to export almost all their production in excess of their domestic use in a given year, the U.S. tends to be the residual supplier. We tend to be the residual suppler whether prices are “low” or “high” and regardless of the rate that the dollar exchanges with other currencies.

Likewise, importers do not produce significantly less even when prices remain low for a number of years. Although, as a result of a drop in world price, it may be significantly cheaper to import food than to produce it locally, food security and other politically important considerations often override price.

As an economist, I would like to think that relative costs or comparative advantage among countries is the driving force behind international trade. And I believe it is for many or most internationally traded products. However, it is delusional to think that comparative advantage is in the driver’s seat in the case of raw agricultural commodities.

Export competitors react to lower prices much the same as our producers, they produce anyway. It is important to note that with the loan deficiency payment program, our export competitors have experienced the full force of the low prices in recent years. Yet, Brazil has increased soybean acreage by thirteen percent since 1996 despite a 40 percent drop in soybean prices and an increase in U.S. soybean area of over 13 million acres.

At the same time, lower wheat prices have not brought the “EU to its knees” as was so commonly heard during the policy debates of the mid-1980s. After years of receiving price-depressed wheat export revenue and experiencing the continued erosion of our share of world wheat exports, not only were we unsuccessful in reducing wheat exports from the EU over the years, it now appears that the EU is capable of exporting wheat without the export subsidies that we were so sure they needed to be competitive.

It is astounding to think of how much money we have spent on deficiency payments and other direct payments convinced that by driving the price well below our full cost of production, we could regain the export share we enjoyed during the late 1970s.

Obviously, this hasn’t worked! Are we going to learn from that policy failure or are we going to continue to stay the course, producing more than can be sold at profitable prices so we can be competitive in the export market but receive successively less from the sale of crop exports?

Daryll E. Ray holds the Blasingame Chair of Excellence in Agricultural Policy, Institute of Agriculture, University of Tennessee, and is the Director of the UT’s Agricultural Policy Analysis Center. (865) 974-7407; Fax: (865) 974-7298; dray@utk.edu; http://apacweb.ag.utk.edu/.

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