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Data response on coffee and sugar

In May 2009 it was reported that world coffee and sugar prices were expected to rise sharply because of poor crop levels and rising demand. Rising commodity prices have been largely unexpected because it was widely predicted that the global recession would reduce rather than increase prices. In a recession, real national incomes fall, and this has an effect on personal disposable income and spending.

International coffee prices hit a 6 month high of $1.28 per pound, a rise of nearly 25% in the last 6 months. The spot price reached a 12 month high at $2.20 a pound. It was reported that the Columbian crop was particularly affected by very heavy rains. Rising coffee prices forced some manufacturers to raise the price of their retail brands by around 20%. Although prices are on the rise analysts predict that demand is unlikely to fall very much in the short term.

Sugar prices also rose, to their highest levels in around 3 years, up to $450 a tonne. Analysts believe that the main reason for this rise was a crop failure in India and, as the world’s biggest consumer of sugar, it increased its imports from the rest of the world. Changes in India’s output, which is very volatile, are a main cause of unstable sugar prices worldwide.

Unstable commodity prices are often regarded as a market failure because markets fail to bring about a stable equilibrium. The main reasons for the instability is that next year’s output is based on this year’s prices, which creates a time lag during which unexpected supply shocks can dramatically alter the actual amount produced. Others argue that unstable prices are simply a sign of the price mechanism at work, sending out signals to consumers and producers, and providing incentives for them. Other economists see government intervention as ‘government failure’ which leads to over-production and surpluses.

a. With reference to the data, comment on the likely price elasticity of demand for coffee. (3)

	Price elasticity of demand (PED) indicates the responsiveness of quantity demanded to a change in price. The formula to calculate it is:
	% change in quantity demanded % change in price The article states that, although coffee prices are rising analysts predict that demand is unlikely to fall much. Therefore, PED is likely to be less than one, i.e. inelastic. For example, if prices have risen by 25%, but demand has not fallen much, by less than 25%, PED is <1.

 

 b. Using a diagram, explain why coffee prices have reached a 6 month high.
(5)

 

	The article states that rising coffee prices, up 25% in six months, was due to two factors:
	Poor crop levels, caused by bad weather, especially in Columbia, and rising demand.
	Poor crop levels will reduce supply, causing the supply curve to shift to the left, as shown below:
	The result is that equilibrium price rises from P to P1. Secondly, rising demand will shift the demand curve to the right, as shown above, raising the equilibrium price to P2
	So the reason why coffee prices rose to record levels was the combined effect of falling supply and rising demand. If either PED or PES is inelastic, the effect of a shift in the other curve will cause the greatest price rise.

 c. 
Explain why analysts predicted that the global
recession would cause commodity prices to fall? (5)

 

	A global recession means that real national incomes around the world are falling.  This means that, on average, individuals have less disposable income and demand for normal goods with a positive income elasticity will fall, and demand for inferior goods with negative income elasticity will rise. If we assume that coffee is a normal good, then demand is likely to fall, ceteris paribus. This means that, when world incomes fall, demand for coffee would also fall, causing a shift in the demand curve to the left, and causing prices to fall, as shown below: The result is that equilibrium price falls from P to P1.

 d.  
Apart from unstable prices, outline three other ‘market
failures’. (3)

	A market failure is a situation when free markets fail to allocate resources efficiently. Three other examples are: Information failure, which occurs when information is not available to all participants in a market transaction. Failure to provide public goods, which are goods which when supplied to one consumer are freely available to others – hence the ‘free rider problem’ Failure to provide enough merit goods, like education and healthcare, because markets do not take into account positive consumption externalities.

 e.  
What is meant by the term ‘government failure’? (2)

 

	This is a situation where government fails to allocate resources efficiently, such as intervening in the market for commodities and causing a surplus.

 f.  
Using a diagram, explain and evaluate the use of
buffer stocks by some
associations of commodity producers as a method of stabilising prices.
(10)

 

The result is that equilibrium price of P is established
from year to year.

However, in evaluating buffer stocks it is argued
that they cannot be used for all types of commodity.
For example, perishable commodities like fruit cannot be stored.
However, coffee and sugar can be stored, so buffer
stocks can be used effectively.

Secondly, the system needs to start with a good
harvest, so that the stock can be built up. Buffer
stocks could not be used in a situation of several years of a
bad harvest.

Thirdly, the intervention of buffer stock managers
may create a ‘moral hazard’ where producers do not
bother to behave efficiently because the buffer stock is a kind
of insurance.

 Fourthly, buffer stocks cost money to
set up and manage.

In
conclusion, the instability of many commodity prices means that
buffer stocks can be effectively used to regulate price, but they have
a number of weaknesses.

	Buffer stocks are stocks of commodities like coffee and sugar that are stored and then released to stabilise prices from year to year. Buffer stock managers will buy up excess stocks when there is a very good harvest, and then release them from stock when there is a very bad harvest. When there is a good harvest, the price would fall too low, so buying up the stock raises price. When there is a very bad harvest, prices would rise too high, and releasing stock reduces price back to an ‘average’ level. This can be seen below:

g.   
Evaluate one other method of
stabilising commodity prices. (12)

 

	Another method of regulating commodity prices is using a ‘guaranteed price’ system, where producers are guaranteed a price, usually guaranteed by the government, irrespective of the amount they produce. The guaranteed price can be set to the long term average of prices, or more usually above the long term average, so that as well as stabilise prices, producer’s incomes can also be stabilised. In the diagram, Pg is the guaranteed price, and the effect is for producers to expand their output to Q1, and consumers to contract their demand to Q2. In evaluating guaranteed prices, it can be seen that there is a danger that they lead to a large surplus of production. The price mechanism sends out conflicting signals – for producers to increase their output, but for consumers to reduce their demand. This causes a surplus, which can be regarded as a waste of scarce resources. The bigger the elasticity of demand and supply the bigger the surplus. Secondly, the use of a guarantee costs the government money, and this creates an opportunity cost, where the money could have been spent on another worthy cause, such as education or healthcare. Thirdly, the excess output will need to be stored, and this creates an extra cost in terms of storage and insurance. Finally, a guaranteed price can also create ‘moral hazard’ where inefficient producers see the guarantee as insurance against inefficiency and over production. Guaranteed prices were a common method of protecting European farmer’s incomes up until the 1990s, but because of the huge cost of dealing with vast surpluses, they were gradually withdrawn, and farmers were given direct subsidies not related to output.