Corn prices hit a 10-year high this week on news of the U.S. Department of Agriculture’s latest estimates of world supply and demand, specifically a 2006 crop that was somewhat smaller than 2004 and 2005, strong demand worldwide and burgeoning U.S. ethanol production.
These recent ag price increases illustrate the complexity of real-world markets. It is easy to see how a change affecting one factor alters the price or quantity of a single other product if you hold all other things equal. It is much harder to estimate the actual outcomes when all factors can vary at the same time.
Economists call the first approach “partial equilibrium” analysis, formalized by British economist Alfred Marshall in the late 1800s. Partial equilibrium can tell us a lot.
Higher corn prices, all other things being equal, should motivate farmers to plant more corn this spring than had they not risen. Higher prices motivate less use of corn for feed or other purposes, if that is not what is driving the demand. Those are familiar direct outcomes of supply and demand.
Higher corn prices also change prices of related goods. Soybean prices rise because acres that might have been planted to beans instead go into corn.
Higher corn prices can increase demand for fertilizer because they make it rational to use more fertilizer on corn. Rising fertilizer use in turn pushes up the price of natural gas, since natural gas is the key input for most nitrogen fertilizer. (This effect is small, however, since fertilizer production makes up only a small proportion of overall natural gas use.)
Rising corn prices also boost farmland prices and rental rates, at least a bit. Most land already is leased for the 2007 crop year, but there will be additional competition for any still available.
Higher input prices for high-fructose corn sweetener plants increase the cost of sweetener for beverages, canned fruit and bakery goods. That, in turn, marginally boosts demand for sugar.
High corn prices eventually pull up livestock prices. With higher feed costs, farmers will not raise as many cattle, hogs or chickens unless they can sell these animals for more. Higher livestock prices eventually translate into higher supermarket meat prices.
Corn prices are up over 20 cents per bushel since Jan. 1. This raises input costs for ethanol plants by about 7 cents per gallon of that fuel. But it is not a net increase because ethanol plants also will get more for the grain residue left over after the alcohol is distilled out. These distillers’ grains become animal feed and their price rises with the price of corn.
The point of all this is that economic interactions are complicated. The economics needed to predict the direction of each individual change is pretty simple. Estimating overall final effects on all related items — corn, soybeans, fertilizer, natural gas, corn sweetener, animal feed, ground beef, ethanol, land prices, etc. — is very complex.
Leon Walras, a French contemporary of Marshall’s, wanted to estimate a “general equilibrium” outcome. That is, what would happen to price and quantity for all related items in response to changes like a small corn crop or growing ethanol output.
Walras argued that, in theory, it should be possible to write a large set of equations specifying all the economic interactions. Then one could solve these equations simultaneously. He acknowledged that the necessary information would be enormous. Solving huge sets of simultaneous equations would require unimaginable computations. He did this work 70 years before the first primitive digital computers.
Modern econometric models try doing what Walras proposed. The USDA uses a model with many simultaneous equations to make predictions like those it came out with last week. But even with supercomputers and a century of advances in mathematics, Walras’ caution is still correct. You can make estimates for one sector, like agricultural products. But extending such estimates to the economy as a whole or over the longer run remains impossible.
Our current use of fossil fuels clearly imposes many costs on society that are not included in the price of gasoline or electricity. These include pollution and a reliance on oil imports that skews our foreign policy. It also is clear that there are significant advantages in renewable energy sources like ethanol and wind power.
We cannot estimate, however, just what would happen to the prices of grains, fuels, land, fertilizer, livestock, soda pop and chicken nuggets if we increased ethanol production to 25 percent or 50 percent of vehicle fuel use.
Nor can we tell what electricity would cost if wind generated 25 percent or 50 percent of Minnesota’s consumption.
That is not an argument against public policies favoring greater use of renewable energy. However, it does suggest prudence in moving toward that goal.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.