Tuesday, February 27, 2007

Bad economics drives out good...

I have been fielding comments on post previous posts about basic economic scenarios. One of the most frustrating of these strange theories for me has been the agrarian absurdity that low prices force higher production:
But computer chips and crops work differently. Say you're an Iowa corn farmer and the price of corn futures drops after you've planted the spring crop. Unlike Intel, you can't slash production any time soon; you have to wait until the next season's planting.

Worse still, when the time comes to put the next season's crops into the field, you're faced with a harsh fact. If you decide to plant less corn, there's no guarantee that the corn price will rise. Why? Because unlike Intel -- which essentially shares the chip market with AMD -- you have thousands of competitors. Unless you can figure a way to organize a significant portion of them to join you in cutting production, you're not going to succeed in pushing prices up.

Since no mechanism exists to coordinate farmers in their planting decisions, they tend to respond to price drops in a way that would be alien to an Intel exec: they plant more corn. The calculation: If they're going to hold their income steady while prices fall, they'll have to bring more product onto the market. But since thousands of other farmers are making the same decision, the market just gets flooded with corn and prices fall further. [More unadulterated drivel]

OK - it all sounds so down-to-earth reasonable, doesn't it? Followed to its extreme, if nobody offered to pay for corn, we farmers would cover the planet with it. What is wrong with this logic chain?

First, let's look at the flip side.
Prices are rising for corn and farmers are planting more of it. Ask seed or fertilizer salesman. It seems if you can make more money with a crop you choose to do so. Gosh - if only I had thought of this earlier! I have heard no hints of "holding back" to keep income level. So I think it is safe to say if prices for corn go up, farmers plant more corn.

But wait, according to the above, when prices go down, farmers plant more corn. So it would seem no matter what prices do we plant more corn. Obviously not.

One of the key ideas in the agrarian economic explanation is we farmers can increase our production at any time by doing things like plowing up pastures, polluting, and applying more chemicals - in short, fair prices keep us from doing bad things that will raise production. And our only goal in life is to keep our income steady.

Oddly my experience has seen no economic return to erosion, in fact it is a really bad production idea. Similarly when corn was $1.80 I was skimping on fertilizer, cutting spray rates, and lowering population to cut costs. As prices drop, we have to lower costs to make money, we can't just command the field to have higher yields. Now with $4 corn, I'm going to try some fungicide I never could quite afford. According to the salesman, this will increase my yields and profits. (Yeah- well, we see about that - but only with high prices would this idea be feasible)

If I can increase my income at any time as suggested by agrarians by magically increasing my yields, or planting some apparently unused acres, why don't I? Is the income I am making right now "just right"? "Oh, no thanks, I've got all the money I can handle, thanks."

Producers try for
the highest yield (income) they can afford every year, not just in down years.

As corn prices drop, producers switch to other crops to see if they will make more money. This cuts supply, as well. Check out soybean acreage this year, for example.

Finally, we really don't have that many idle acres around that we can bring into production cheaply, as agrarians would suggest.

The supply curve slopes up, not down. And the proof is the explosion of corn acres as $4 corn continues.

The other danger of such pseudo-economics is the perpetuation of the idea producers are helpless to control their business. This Is debilitating dogma.

On the other hand, believers in such clap-trap are not competitors I have to worry about.


Anonymous said...

What if higher prices cause the demand curve to shift to the left?

Bill Harshaw said...

I should know better than to argue economics, but it seems to me beneath all the rhetoric your position and that of the "agrarian" (link no longer works) are closer than they might appear. If we were talking, I suspect you'd both agree that the production curve is inelastic (i.e., you didn't cut your corn yields when corn was $1.80), and not very responsive to price signals. Where do you differ? You are farming in today's world: where soybeans are a real alternative to corn, where seed, fuel, fertilizer, etc. are inputs that have to be paid for, where you can gather information from all over and hedge part of your crop at a keystroke, where land is mostly farmed or in CRP, where many agricultural products are grown under contract. The "agrarian" is stating the theory as it applied in the 1930's: inputs were land, labor, and equipment, with little out-of-pocket expenses; soybeans were an odd specialty crop, information was limited, hedging unlikely, vertical integration limited to industry, and the mass of farmers had gotten their education following the rear of a horse, not a college professor. So, yes, the individual farmer has many more tools than his great grandfather in the 1930's. (It would be interesting to know if economists have done serious studies of the issue of how much more elasticity there is now than in the 1930's.)

But the bottom line, as the Congressional Research Service says (http://www.nationalaglawcenter.org/assets/crs/RL33204.pdf )is: " In general, the demand and supply of farm products, particularly basic grains and oilseeds, are relatively price-inelastic (i.e., quantities demanded and supplied change proportionally less than prices). This implies that even small changes in supply can result in large price movements. As a result, unexpected market news can produce potentially large swings in farm prices and incomes. This price dynamic has long been a characteristic of the agricultural sector and a farm policy concern."
And at the end of the day, the individual farmer is still at the mercy of the weather gods and the market makers. Intel can close factories and slow production lines, not so the individual farmer. It's much the same logic as the "tragedy of the commons"--what's good for the individual is counterproductive for the industry.

I'll bet that today's $4 corn lasts about as long as the $3 corn of 1974, 1983/4, and 1996.

John Phipps said...


Thanks for your thoughtful comments. I will reply when I get home, but I did repair the link.