Are low prices the cure for low prices?

May 2010

Dr Kobus Laubscher, Hoofbestuurder/CEO

Prices are signals and if an economy operates properly and competitively, prices guide decision-making with regard to consumption and production. Low and decreasing prices promote consumption and the reverse is also true. Any reaction to price changes is a function of inter alia the time involved. The longer the consumer and/or the producer have to guide decisions on the grounds of price changes, the more variable the decision-making and reaction to price fluctuations.

The market is in balance when demand equals supply and a market clearing price is established. The equilibrium of the market is disturbed when prices decrease as the result of for example a decreasing demand and an increase in supply or a combination of variations in the demand and supply. The economy of demand and supply holds that low prices are the best cure for low prices. In the simplest terms, low and decreasing prices encourage consumption while at the same time discouraging production and in doing so an over-supply (that made prices decline) is reduced (by higher consumption) because less is produced at low and decreasing prices. A large number of other factors also affect this dynamic.

Decreasing producer prices likewise have an interesting passage. Producers increase production when prices increase with reasonable expectations that prices will stabilise at higher levels. In the case of agriculture this entails the mobilisation of production factors whose mobility depend inter alia on the time involved in decision-making. Furthermore agriculture has a tendency to over-react in such a commitment to higher production levels.

On the one hand the reaction of the committed resources is unpredictable (because nobody can really correctly predict the crop yield) and on the other hand consumer reaction to lower prices is equally unpredictable but usually of a shorter positive time frame. When the market therefore depresses prices, producers react slower and producer prices can remain under pressure for a longer time. Lower producer prices are slow in being passed on to the consumer. Eventually producers react and production is decreased after which prices can increase if the reaction on the demand side complements this decision. The reality, however, is that these adaptations are slow with considerable negative impact on especially production capacity, because production stimulating prices must through increases persuade producers of sustainability to once again revive confidence.

Because of the typical inelastic nature of decision-making, the market can not in all instances act as a remedy and on occasion it becomes necessary to intervene. The current over-supply situation with resulting low producer prices in the maize industry is an excellent example.  Should prices be allowed to remain at the current low levels, they will in time lead to decreased production, but that could go hand in hand with significant disinvestment and consequent restructuring. The appropriate would be to facilitate surplus removal by way of consensus to reduce the supply pressure on price. Normal demand and supply changes will not be able to make re-adjustments without permanent economic scars. The proposed export pool for a portion of the current maize supply represents the start of a strategic road map that must restructure the grain industry for the sake of sustainable food production over the long term.

For this purpose the market must be relieved of a part of the supply by isolating it for export exclusively. Two different markets will allow price discrimination and local prices will hopefully recover to levels that will re-establish confidence.

Publication: May 2010

Section: Editorial