Systemic causes for the worldwide increases in food prices continue to be the subject of debate. Initial causes of the late 2006 price spikes included unseasonable droughts in grain-producing nations and rising oil prices. Oil prices further heightened the costs of fertilizers, food transport, and industrial agriculture.
Other causes may be the increasing use of biofuels in developed countries and an increasing demand for a more varied diet across the expanding middle-class populations of Asia. These factors, coupled with falling world-food stockpiles have all contributed to the dramatic worldwide rise in food prices. Long-term causes remain a topic of debate. These may include structural changes in trade and agricultural production, agricultural price supports and subsidies in developed nations, diversions of food commodities to high input foods and fuel, commodity market speculation, and climate change. As of 2009, food prices have fallen significantly from their earlier highs, although some observers believe this decrease may be temporary.
World population growth Growth in food production has been greater than population growth. Food per person increased during the 1961-2005 period. Although some commentators have argued that this food crisis stems from unprecedented global population growth, others point out that world population growth rates have dropped dramatically since the 1980s and grain availability has continued to outpace population. However, despite the small gains made in the last decades, when regarded on a whole the population increases far more rapidly than what the food production increases can make up for.
The actual annual growth in the number of humans fell from its peak of 87 million per annum in the late 1980s, to a low of 75 million per annum in 2002, at which it stabilised and has started to slowly rise again to 77 million per annum in 2007. The world’s population, on its current growth trajectory, is expected to reach nearly 9 billion by the year 2042.
Increased demand for more resource intensive food The head of the International Food Policy Research Institute stated in 2008 that the gradual change in diet among newly prosperous populations is the most important factor underpinning the rise in global food prices. Where food utilization has increased, it has largely been in processed (“value added”) foods, sold in developing and developed nations. Total grain utilization growth since 2006 (up three percent, over the 2000-2006 per annum average of two percent) has been greatest in non-food usage, especially in feed and biofuels. One kilogram of beef requires seven kilograms of feed grain. These reports, therefore, conclude that usage in industrial, feed, and input intensive foods, not population growth among poor consumers of simple grains, has contributed to the price increases.
Determinants of Supply Price
The profitability of goods in joint supply
Nature or random shocks and other unpredictable events
The aims of producers whether they are aiming for high profit margins of market penetration
Expectations of producers
Factors Several factors contributed to the rising food price. Analysts attributed the price rises to a “perfect storm” of poor harvests in various parts of the world, increasing biofuel usage, lower food reserves, growing consumer demand in Asia, oil price rises, and changes to the world economy. Agricultural subsidies in developed nations are another long-term factor contributing to high global food prices.
Change in input price
Change in technology
Change in organisation
Change in government policies
Costs for fertilizer raw materials other than oil, such as potash, have themselves been increasing as increased production of staples increases demand. This is causing a boom (with associated volatility) in agriculture stocks.
Crop shortfalls from natural disasters Several distinct weather- and climate-related incidents have caused disruptions in crop production.
Rice is the main crop grown during the rainy season, and under usual conditions, rainfall is adequate for rice production. However, if rain ceases to fall for several weeks to a month at a critical time in the rice growing cycle, yields will be significantly affected. Upland rice varieties, although adapted to a lower moisture requirement, are also affected by intermittent rains because farmers have no means of storing water in their fields.
Soil and productivity losses Large areas of croplands are lost year after year, due mainly to soil erosion, water depletion and urbanization. “60,000 km2/ year of land becomes so severely degraded that it loses its productive capacity and becomes wasteland”, and even more are affected to a lesser extent, adding to the crop supply problem.
Additionally, agricultural production is also lost due to water depletion. Northern China in particular has depleted much of its non-renewable aquifers, which now impacts negatively its crop production.
Urbanizations is another, smaller, difficult to estimate cause of annual cropland reduction.
Rising levels of ozone One possible environmental factor in the food price crisis is raising background levels of ozone in the atmosphere. Plants have been shown to have a high sensitivity to ozone levels, and lower yields of important food crops, such as wheat and soybeans, may have be a result of ozone levels. Ozone levels in the Yangtze Delta were studied for their effect on oilseed rape, a member of the cabbage family that produces one-third of the vegetable oil used in China. Plants grown in chambers that controlled ozone levels exhibited a 10%-20 % reduction in size and weight (biomass) when exposed to elevated ozone. Production of seeds and oil was also reduced.
Price Control (Price Floor and Price Ceiling) Price Floor In certain instances, the government may intervene in the market to control prices, In such cases, the market will not be in equilibrium. This is called a minimum price/ price floor.
On April 30, 2008 Thailand announced the creation of the Organization of Rice Exporting Countries (OREC) with the potential to develop a price-fixing cartel for rice.
The purpose would be to control production and set prices similar to the OPEC cartel that controls production of oil
Rational for setting a price floor
To protect producers’ income
To create a surplus of the good
In case of minimum wage, to protect workers’ income from falling below certain level
Impact of price floor
Excess supply that went into production will be wasted. This can be seen as a misallocation of resources which could otherwise be used to produce other goods
Firms with surplus output may try evading price control and cutting their prices.
High prices remove the incentive for firms to be more efficient in the use of the resources.
Methods government can use to deal with surplus
Buy surplus and store it, destroy it, or sell it
Restricting producers to production quotas
Raise demands by advertising
Find alternative use for the goods
Cut down on the consumption of substitute goods by imposing taxes.
Price Ceiling Rational for setting price ceiling
To protect the consumers and to ensure ‘fair’ price for essential goods.
In times of war and famine, the government set price ceiling for basic goods so that
everyone can afford including the poor.
Impact of a price ceiling Will result in shortage, and government will need to intervene to allocate basing on;
1st come 1st serve basis
Criteria for purchase
Deciding which customers should buy 1st.
Leads to emergence of black markets, where customers, unable to but enough in the legal market may pay higher price for the products in the illegal / black market.
Methods government can use to deal with the shortage
Government may draws on stocks to reduce shortage
Government may produce the goods
May give tax relief or subsidies to firms to encourage them to produce more
May attempt to reduce demand and by encourage production of substitutes
Here are 2 examples of Supply and Demand curve.
Demand Curve An outward or rightward shift in demand increases both equilibrium price and quantity.
Supply Curve The price P of a product is determined by a balance between productions at each price (supply S)
and the desires of those with purchasing power at each price (demand D). Along with a consequent increase in price (P) and quantity sold (Q) of the product.
Qns 2. Prior to mid 2008, the price of oil shot up to US$145 per barrel. Then it fell drastically to as low as US$40 per barrel by the end of 2008. How do you explain these 2 phenomenons? Phase 1: Why US$142? With oil prices approaching US$100 a barrel, the world is headed towards its third energy shock in a generation. But today’s surge is different from previous oil crises, with broad and longer-lasting global implications. Just as in the energy crises of the 1970s and 1980s, today’s high prices are causing anxiety and pain for consumers, and igniting wider fears about the impact on the economy.
But unlike past oil shocks, which were caused by sudden interruptions in exports from the Middle East, this time prices have been raising steadily as demand for petrol grows in developed countries, as hundreds of millions of Chinese and Indians climb out of poverty, and as other developing economies grow at a sizzling pace.
At the root of the stunning rise in the price of oil, up 56% this year and 365% in a decade, is a positive development: an unprecedented boom in the world economy. Demand from China and India alone is expected to double in the next two decades as their economies continue to expand, with people there buying more cars and moving to cities to seek a way of life long taken for granted in the West.
More than any other country, China represents the scope of that challenge. As it turned into a global economic behemoth over the last decade, China also became a major energy user. Its economy has grown at a furious pace of about 10% a year since the 1990s, lifting nearly 300 million people out of poverty. But rapid industrialization has come at a price: Oil demand has more than tripled since 1980, turning a country that was once self-sufficient into a net oil importer.
India and China are home to about a third of humanity. People there are demanding access to electricity, cars and consumer goods and can increasingly afford to compete with the West for access to resources. In doing so, the two Asian giants are profoundly transforming the world’s energy balance.
Today, China consumes only a third as much oil as the United States, which burns a quarter of the world’s oil each day. By 2030, India and China together will import as much oil as the United States and Japan do today. During the first eight months of the year, China’s net imports of crude oil rose 18.1% over the same period last year. Chinese demand has been identified as at least partly responsible for currently high oil prices. Demand for energy in China, the world’s second-largest oil importer, has rocketed as a result of explosive economic growth that has been in double digits for 4 consecutive years. Imports last year accounted for 47% of the country’s overall consumption, and industry observers have warned imports might make up more than 50 percent of its petroleum needs in a year or two.
In a market more concerned about the supply of crude oil in the coming years than any immediate shortage of refined fuels, news of another 500,000 bpd of refining capacity starting up in China from later this year may give the bears reason to pause.
More realistically, global demand is expected to rise to about 115 million barrels a day by 2030, a level that is likely to tax the world’s ability to pump more oil out of the ground.
With government subsidies keeping fuel prices artificially low, gas stations is either running out of supplies or are shutting operations hoping for a state-approved rise.
Phase 2: Why US$40? With major new refineries being started towards the end of this year, China crude oil import growth should accelerate but its massive products stockpiling will slow, cutting fuel imports.
With oil prices having fallen more than 20% from their mid-July peak above $147, traders are searching for direction beyond the dollar gyrations, weakening US fuel demand, the Iran-West faceoff and this week Russia-Georgia conflict.
The government hiked fuel prices by about 11% but had kept them frozen at that level, seeking to avoid fuelling inflation.
People are travelling less, manufacturers are slashing production and there are job cuts across almost every sector of the economy, leading to a severe drop-off in energy use.
Gas now costs a dime more per gallon than it did just a month ago even as crude prices fall. Gasoline bottomed out at $1.61 a gallon on Dec. 30 and prices have yet to catch up with the latest drop in crude.
Crude has closed lower every day with dire economic news overshadowing armed conflict in the oil-rich Middle East, a dispute that has shut off or disrupted natural gas supplies to more than a dozen European nations, and diminished crude exports from the Organization of Petroleum Exporting Countries, which accounts for about 40 per cent of global supply.
Oil analysts said oil price sentiment remained weak although the Organization of Oil Exporting Countries (OPEC) that commands 40% of global crude oil production has just announced a production cut of 2.2 million barrels per day
Inflation In February 2008, Reuters reported that global inflation was at historic levels, and that domestic inflation was at 10-20 year highs for many nations. “Excess money supply around the globe, monetary easing by the Fed to tame financial crisis, growth surge supported by easy monetary policy in Asia, speculation in commodities, agricultural failure, rising cost of imports from China and rising demand of food and commodities in the fast growing emerging markets,” have been named as possible reasons for the inflation.
Other Claimed cause.
1) Caused by excess monetary expansion;
(2) Prolonged by an inability to evaluate counter-party (risk due to opaque financial statements; and (3) worsened by the unpredictable nature of government’s response to the crisis.
It has also been debated that the root cause of the crisis is overproduction of goods caused by globalization (and especially vast investments in countries such as China and India by western multinational companies over the past 15-20 years, which greatly increased global industrial output at a reduced cost). Overproduction tends to cause deflation and signs of deflation were evident in October and November 2008, as commodity prices tumbled and the Federal Reserve was lowering its target rate to an all-time-low 0.25%. On the other hand, Professor Herman Daly suggests that it is not actually an economic crisis, but rather a crisis of overgrowth beyond sustainable ecological limits.
The importance of opportunity cost in decision making
It is vital to discourse prudently the opportunity cost and its importance in the practical life by discussing in detail the concept of opportunity cost in the light of different economists and authors and its value in the decision making of everyday life. In this discussion, a broader meaning of the opportunity cost will be given and its relevance with scarcity and choice. Moreover, the significance of opportunity cost will be shown in the context of decision making pitfall, exchange and opportunity cost, the relation of opportunity cost and specialisation with respect to the principle of comparative advantage and it relevance to trade. Furthermore, its importance in the business decision making, objective of maximising the profit, its relevance to the cost of capital, difference in economists and accounting point of view regarding opportunity cost will be considered with relevant explanation. In addition to this, the affiliation of opportunity cost and markets, opportunity cost of political decisions, opportunity cost for society and the opportunity cost of holding money will be analysed to manifest the meaning and significance of opportunity cost.
Opportunity cost is a simple and one of the most significant concepts of microeconomics (Frank: 2003). McDowell et al. (2009) describes, opportunity cost of engaging in an activity is the cost of the next most desirable alternative activity that a person have to give up in order to engage in that activity. Giving a simple example of opportunity cost, McDowell et al. (2009) suppose that a person is indifferent in choosing the amount of time to spent on either studying for a very important test or watching a favourite programme on television. In this case the opportunity cost of watching the television is the value of the study for the test that must be sacrificed, which is very high, and the person is very highly unlikely to watch television and is more likely to decide against watching television. Sloman (2006) illustrate that as there are scarce resources in the world, so people have to make choices among scarce resources, which involves sacrifice of alternative goods or services. Spending more money on food involves sacrifice of other goods and services. This sacrifice of other goods and services is known as its opportunity cost. Sloman (2006) called opportunity cost as a ‘threshold concept’. Once people become aware of its vitality, they start thinking like economists and it affects the way of dealing with economic problems. However, the way of thinking like economists and dealing with economic problems is different from accountants thinking and dealing, which will be discussed later in detail. Sloman (2006) claim that people start recognising that they face trade-offs, when they begin looking at the opportunity cost. That means engaging more in one action involves doing less of other activities. Nations face trade-offs and is widely known as ‘Gun versus butter’ trade-off. The more a country will spend on its defence, the less it will be left to spend on the welfare of its people and basic consumer necessities.
McDowell et al. (2009) and Frank (2006) both claim and agree that decision makers quite often ignore opportunity cost and do not take it into consideration while making a decision and this behaviour is one of the most common decision making pitfall. Rational people always apply the cost-benefit analysis to their decision making process, that is an action has to be taken if and only if its extra benefit is greater than its extra cost, but the common problem amongst many of the decision makers is that they ignore the implicit costs. However, taking forgone opportunities into account is vital for a prudent and intelligent decision making. Economists suggests that problem of overlooking opportunity costs can be avoided by translating questions such as ‘Should I watch the television programme?’ into ones like ‘Should I watch television programme or should I study for my test?’. Frank (2006) in an example of a similar type of question illustrates the significance of opportunity cost. A person faced with a question ‘Should I go skiing today or work as a research assistant?’. Going skiing and spending that day on the slopes worth £60 to that person and the explicit cost for that the day is £40. However, it is important to take into account the implicit cost, which is the value of the next most desirable activity forgone by going skiing because the explicit cost is not the only cost of going skiing. If that person did not go skiing, he/she can work as a research assistant with his professor and get a pay of £45 for that day. Here the cost of going skiing is not only the explicit cost of £40 but also the opportunity cost of £45 of working with professor, so the total cost of going skiing is £85. Making a decision in terms of the cost-benefit analysis, the cost of going skiing £85 is greater than the benefit of £60. Thus, that person should work as a research assistant and anybody who would ignore the opportunity cost will make a wrong decision and go skiing.
Opportunity cost also helps in explaining the fact that people should focus on those activities in which they perform better relative to others (McDowell: 2009). In other words, it helps to explain the far more productivity of the economic systems based on specialisation and the exchange of goods and services relative to less specialised economic systems. The nature of specialisation being so productive is due to an economic principle called ‘Comparative advantage’; that is in carrying out an activity, a person has comparative advantage over another person, if his opportunity cost is lower than the other person’s opportunity cost in performing that activity. In the same way, if two nations have different opportunity costs, exchange or trading of goods and services between the nations will help to increase the value of available goods and services by properly utilising the scarce resources (ibid). Mankiw (2006) posing a question that ‘whether United States should trade with other countries or not?’. As discussed, that nations can also benefit from specialisation and trade as individuals do. Many of the products used my Americans are imported products, whereas many of products exported from America are used abroad. In order to see the benefit countries get from specialisation and trade, suppose two countries America and Japan and two goods cars and food. Let us suppose further that both the countries are equally efficient and well in producing cars. A Japanese and American worker, both produces one car in a month. However, in case of food, as America has more and better fertile land than Japan, its workers are better in producing food than Japanese workers, and assume American worker produce 2 tons of food per month as compared to a Japanese worker, who can produce only 1 ton of food in a month. Now according to the principle of comparative advantage, the country should produce that commodity in which its opportunity cost is lower compared to the other good. So, as the opportunity cost of Japan is 1 ton of food for producing a car per month, whereas the opportunity cost of America is 2 tons of food. Clearly, Japan’s opportunity cost is lower in terms of the production of cars and it has a comparative advantage in producing cars. America should produce food more than its personal consumption and export it to Japan, whereas Japan should produce more cars than its personal use and export it to America. In this way, both countries can produce more of both goods through specialisation and can have more food and cars through trade.
Samuelson and Nordhaus (2004) are of the view that the opportunity cost is also involved in the business decisions. Generally, the business accounts do not show the opportunity costs on their profit and loss statement and includes only those transactions in which tangible money is involved (Meigs et al.: 1999). However, the economists include all costs whether they reflect the monetary costs or not. Mankiw (2006) claims, the most important implicit cost in every business decision making is the cost of the financial capital that the owner invest in the business. For instance, a person has invested a capital of £300,000 to buy a new factory. Alternatively, this capital amount of £300,000 could be deposited in a saving account and the owner could earn £15,000 at an annual interest rate of 5 percent. To buy the factory, the person has actually forgone an annual amount of £15,000, which is the implicit or opportunity cost of investing in the business. Pacillo (2010) gave an equation for the calculation of the overall economic cost by simply adding up the explicit financial cost and the opportunity cost. The equation is as follows:
Total Economic Cost = Total financial cost Total opportunity cost
This illustration of difference in measurement of economics cost and accountants cost is significant for the fact that it leads us to a more important objective of a firm’s economic profit. Similar to the difference in cost, the accountants and economists also differ in the measurement of profit (Mankiw: 2006). In analysing the firm’s profit, the economists subtract from revenue all the opportunity costs (implicit and explicit both) to measure firm’s economic profit, whereas the accountants just subtract the firm’s explicit costs to calculate firm’s accounting profit, that is why the accounting profit is usually larger than the economic profit. From economist’s point of view, for a firm to be profitable its economics profit should be positive and must cover all explicit and opportunity costs. The concept of economic profit is of great significance because a firm making positive economic profit will remain in business (ibid).
Furthermore, it is also very important to know the opportunity cost of holding money or in other words, hoarding. The opportunity cost of holding money is the sacrifice of the interest that a person must incur by not depositing the money into interest bearing account or investing in another business (Samuelson and Nordhaus: 2004). Suppose that a person deposit £1000 into a saving account at the start of a year and earn 5 percent annual interest. By the end of the year he/she would have £1050 in the account. By contrast, if a person does not deposit the money into saving account and hold it as currency, he/she would end up with the same amount of £1000. In this case, the opportunity cost of holding money would be £50.
Hence, from the above discussion the concept of the opportunity cost has been explained along with its importance in daily life. It is important to take opportunity cost into account in every kind of decision making. It is not only important for the economists but also for the common rational people to take opportunity cost into account to increase utility and to make better choices amongst scarce resources, which is the basic theme of studying the subject of economics. The importance of opportunity cost for the poor countries is also evident through the explanation of comparative advantage, that poor countries should focus on those activities in which their opportunity cost is lower as compared to other countries to increase the standard of living by trade. Moreover, for businesses to make better profits, it is important to consider economics costs and profits. However, the explicit costs can always be measured and estimated but it is sometimes very difficult to estimate the implicit costs, where the businesses needs to rely on accounting costs for the sake of book keeping. At the end, the simple and most relevant to common people is the opportunity cost of holding money. People think that by holding money in terms of cash, they do not incur any cost but they are usually unaware of the forgone opportunities that could have increased their wealth and made their life better-off.