Many Americans would not even know wheat prices had increased were it not for news stories.
Wheat prices hit record highs a week ago, at least if you don’t factor in inflation. This week they fell back again on news the U.S. crop was better than some had thought. High prices are good news for many farmers. They hurt consumers, at least in a minor way, since prices of foods containing wheat will increase at least marginally. Wheat price fluctuations are wonderful for econ professors like me, since they provide examples to illustrate many different economic concepts.
Nominal versus real prices: “Nominal prices” are those paid at the time of sale, without any correction for inflation. If you correct for inflation, you have “real prices.” Wheat futures over $7.50 a bushel set records in nominal terms. But $7.50 in 2007 buys no more for a household than $1.02 did in 1957. Adjusted for inflation, current “record” wheat prices are just a bump in a decades-long downward trend.
Exogenous shocks: Economists distinguish between changes that happen because of something inside an economic system and those caused by external forces. Such external forces are called “exogenous shocks.” Today’s high wheat prices largely result from bad weather in many different countries that grow wheat. Weather is an “act of God,” outside the economic system.
Starting with British economist John Maynard Keynes in 1936, economists have long studied how governments could control the fluctuations in employment and prices that we call the business cycle.
Twenty years ago, a group of economists, including Edward Prescott, the 2004 Nobel laureate who taught for many years at the University of Minnesota and is still affiliated with the Minneapolis Federal Reserve Bank, decided to examine a more basic question: What causes business cycles in the first place? The group concluded that exogenous shocks are one of the most important factors. This doesn’t mean current high wheat prices will trigger recession or inflation, but they do exemplify an exogenous shock.
Supply shifters: Market prices derive from supply and demand, but factors other than the price of the good itself can change supply or demand. One important factor for both is “the price of related goods.”
For wheat, the prices of substitutes – other crops that can be produced with the same resources – are an important supply shifter. Bad weather has been a big reason for the recent spikes in wheat prices. But high corn prices play a role. Corn prices have increased because of growing demand for corn to produce ethanol as a motor fuel. Higher corn prices motivate farmers to plant somewhat less wheat and somewhat more corn. That pushes up wheat prices even if demand for wheat itself does not change.
Expectations: Both consumers and producers don’t just look at the prices they face today. They also take into account all the things they expect in the future. If farmers expect the price of wheat to be higher in a few months, they are less willing to sell today. Wheat processors, conversely, are willing to pay more today.
Technological change: Until recently, farmers’ ability to substitute wheat for corn and vice versa was limited. There was a Corn Belt and there was a Wheat Belt, without much overlap. But plant breeding has created corn varieties that are more tolerant of the dry conditions common in traditional wheat areas and that still produce well with these areas’ short growing seasons. So there is more room to substitute corn for wheat and vice versa than even 30 years ago.
Elasticity of demand: For centuries, poor harvests and high grain prices implied human suffering and starvation. Buying wheat or other grains consumed a large proportion of many household budgets. It still does in poor nations. But many Americans would not even know wheat prices had increased if not for news stories.
We still eat a lot of wheat, but the cost of the wheat itself constitutes a small and declining proportion of the total cost of food. For some products, the costs of packaging or advertising exceed the cost of wheat itself.
Since wheat makes up a much smaller faction of our spending, we don’t vary the quantity of wheat we eat much as the price increases or decreases. We say demand for wheat is “inelastic” for contemporary Americans.
Income elasticity of demand: This refers to how people vary their purchases of things as their income changes, even as the price of the products themselves stays constant. People tend to eat fewer peas and beans as they get richer. They tend to eat more meat. They tend to go bowling less and go skiing more. They ride the bus less and fly more frequently. In comparison to protein sources like beans, eggs, cheese and meat, people don’t vary wheat consumption much with income, at least in the United States. In Asia, as incomes have risen, people eat more wheat and less rice.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.