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.
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
unlikely to
to fall
fall much.
much. Therefore, PED is likely to be less than one, i.e. inelastic.
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;
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
theequilibrium
equilibriumprice
pricetoto P2.
raising the
So the reason why coffee prices rose to record levels was the combined effect of falling
Supply
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
‘normaalgoods with a positive income elasticity will rise, and demand for inferior
goods with negative income elasticity will fall. If we assume that coffee is a normal
good, 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
intervening in
in the
the market
market for
for commodities
commodities and
and causing
causing aa surplus.
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)
Buffer stocks are stocks of commodities like coffee and sugar that are stored and then
released
to stabilise
prices
eased to stabilise
prices
o 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 y
abad
very
bad harvest. When there is a good harvest, the price would fall too low, so buying
harvest
up the stock raises price. When there is a very bad harvest, the price would rise too
high, and releasing the stock reduces price back to an ‘average’ level. This can be seen
below:
below:
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
used
to regulate
prices,
but they
a number of weaknesses.
effectively
used to
regulate
price,have
but they
g.
Evaluate one other method of stabilising commodity prices. (12)
Another method of regulating commodity prices is using a ‘guaranteed price’ system,
where
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 above the long term
average,
average so that as well as stabilise prices, producer’s incomes can also be stabilised.
In the diagram, Pg is the guaranteed prices, 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
ealsticty 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
as insurance against inefficiency and over production.
the guarantee
g
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.