Supply response to sky-high prices
The steep ramp-up of grain and oilseed prices over a couple of years only to drop by one-half in a matter of a three or four months has been extremely confusing to lots of folks. Much has been written about the run-up but less has been said about the fall.
The fact that the 50% drop took place so quickly was a surprise -- it usually takes a couple or so production periods -- but otherwise such a drastic price drop is as predictable as night following day.
That is why, based on past events, we tell farmers that it is in their long-run best interest to hope for prices that fluctuate within a "normal" and reasonable -- but fairly wide -- band that covers production costs on average.
While winning the lottery has a nice ring to it, farmers should not want prices to triple and quadruple over a short period of time.
So, why is that?
In economics lingo, it is called supply response. In every day language it goes like this, "high prices cure high prices."
For crops, high prices of the triple and quadruple kind stimulate farmers to bring additional area into production, encourage investment in yield-enhancing technology, and drive customers to seek alternate suppliers.
In fact, it takes price increases of such a magnitude to get much of an aggregate response in the acreage used for major U.S. crops. Total acreage does not change much with "normal" variations in prices, either up or down. In the case of a drastic drop in prices, acreage does not decline quickly -- in contrast to the rush of incoming acreage when prices explode.
Following the price rise that began in the fall of 2006, we saw U.S. farmers switch crops and make use of every possible acre they could reasonably farm. As Conservation Reserve Program contracts came up for renewal, many farmers with acres suitable for cropping did not renew them. With increasing prices, every acre counted.
For the eight major crops in the U.S. (corn, soybeans, wheat, rice, barley, oats, sorghum, and cotton), harvested acreage increased from 217 million acres in 2006 to 231 million acres in 2008, the highest level since 1998.
Similarly, Brazilian acreage for the same eight crops also increased from 103 million acres in 2006 to 107 million acres in 2008. Farmers around the world see the same prices and respond just like U.S. farmers.
Part of the price increase resulted from unusually large wheat crop failures in several areas of the world. With the return of more normal circumstances, world wheat harvested area rose from 526 million acres in 2006 to 554 million acres in 2008. At the same time the yield increased from 41.6 bushels per acre in 2006 to 45.3 bushels per acre in 2008.
Those changes are a part of the normal pattern that we have come to expect.
With high prices, we were not surprised to hear seed companies talk about yield breakthroughs and numbers that seem like some pipe dream.
Just as acreage quickly comes into production when prices skyrocket but drains away slowly when prices tumble, yield-enhancing technology, once introduced, is here to stay no matter the price level. In fact at low prices individual farmers feel they need high yields to keep gross income from falling through the floor.