Food price volatility

Why may food prices start rising again raising fresh fears of high food price inflation? The key is to understand the reactions of farmers to changes in prices and the decisions they make about whether to plant new crops on marginally productive land.

"If inflation comes roaring back, the first place many people feel the pinch may be in food prices. The cost of corn, soya and wheat has fallen sharply from the levels they reached last summer at the height of the commodity boom. But lower prices mean lower returns per acre, so farmers are cutting plantings of marginally productive land to maximise profits.

European farmers cut plantings of winter wheat 2 per cent this year. In the US, which supplies half the world’s corn and a fifth of its wheat, officials expect plantings of those crops to decline 1.2 per cent and 7 per cent respectively. The US Department of Agriculture says aggregate 2009 plantings of the eight biggest grains could fall the largest amount in 20 years.

This is precisely the set-up investors who worry about a rapid return of inflation fear: low prices lead to underinvestment and cuts in productive capacity. When the economy picks up, prices soar because suppliers – in this case, farms – cannot keep up with renewed demand.

Food prices might rise even in the absence of an economic recovery. Export stockpiles are tight. That has not been a big problem in recent years thanks to an unusually long spate of good weather. At some point, that lucky streak will end.

Such concerns help explain why food prices have not fallen as far as those of other commodities. Prices for corn, wheat, soya and rice have dropped nearly half from their 2008 peaks, but they are still trading at about double their average prices of the past 10 years. Corn, at $4 a bushel, costs the same as it did in 2007. Aluminium, by contrast, is trading at levels not seen since 2003. Natural gas prices have not been so low since 2002. Food prices are unlikely to fall into line with those of other commodities. Indeed, they may not have anywhere to go but up."

(1) How could you illustrate the process described above with supply and demand diagrams?

(2) Explain why price elasticity of demand and price elasticity of supply is relevant in explaining food price volatility

(3) What do you understand by the term ‘marginally productive land’?