Grain prices, especially for corn, spiked by some 20 percent in recent days. University of Chicago finance professor Eugene Fama’s theory of efficient markets helps provides a starting point for examining just why this spike took place. And more basic economics tells us something about what this news means for ordinary families.
First, the facts: The price of corn, the most important feed grain used by meat producers, especially those raising chickens and hogs, and feedstock for ethanol production, jumped by some 20 percent in a little over a week. (At a cash price of $4.86 per bushel Wednesday — or $5.6925 for December delivery — it remains well below levels hit in 2008. And like most other farm products, if one adjusts for inflation, the price is only a fraction of levels hit 50 or 100 years ago.)
Such a jump is not unprecedented, but it still is an enormous price increase in a very short time. It was initiated by a U.S. Department of Agriculture monthly report predicting that the 2010 U.S. corn harvest, already well under way across southern and central Minnesota, would produce 4 percent fewer bushels than previously estimated. Four percent may not sound like much, but it was the largest drop from one month to the next in all the years the USDA has made such estimates.
A 20 percent price jump in response to a 4 percent quantity drop illustrates that the short-run demand for corn is extremely inelastic. That is, quantities don’t change much in relation to any given change in prices. This inelasticity is common for foods or food production inputs, especially those grown seasonally — it is hard to adjust production levels in less than a year.
Fama’s insights relate new information to prices. People have known for centuries that new information about factors of supply or demand causes prices to change. But Fama went further, arguing that at any point, the market price of a traded asset, be it corn or a bond, incorporates all the known information that might have any effect on price.
This does not mean that everyone who might buy or sell the product has exactly the same estimate of its value. Nor does it mean that when the price is for future delivery, say a sale in October of corn to be handed over in December, that the going cash price in December will match what was contracted two months earlier.
However, it does imply that, overall, there are no unexploited opportunities to make money. Yes, someone who had contracted, before the recent USDA report, to buy corn at a lower price would come out well. And someone who had agreed to sell at a low price would lose out. But these variations from what had been the expected price for the market as a whole are random and cancel one another out. And variations between expected price in one period and some later one cannot be predicted in advance.
The idea that market prices fully incorporate all available information was a powerful one that shaped finance theory over the past 40 years. Financial firms built sophisticated mathematical models to guide trading based on this idea.
But events of the past few years have battered the theory. Did housing prices in Boca Raton, Fla., or Las Vegas or Maple Plain really reflect the rational evaluation of all available information? Did the value of complex mortgage-backed bonds really depend on all available information?
One also wonders why corn prices jumped more than 20 percent. The new information was not about a crop-destroying tsunami or a sudden attack by UFOs. The raw information about the weather and its impact had been out there for weeks. Since there is such potential profit in pre-guessing the USDA, why didn’t traders put more resources into gathering such information themselves? And why doesn’t such private production of information result in buying in anticipation of higher prices that would have reduced the eventual jump when authoritative government numbers were released?
Efficient markets adherents would say that this is just an ordinary example of a random error in expectations that, over time, will be offset by other errors in the other direction. But over time the sum of such errors will be zero. Perhaps.
For most people, this debate matters little compared to the question of food prices. Here basic economics is clear: Food will get more expensive. In the United States, only a small fraction of the corn crop is directly consumed by people. But it is one of the most expensive inputs in producing meat, milk and eggs. Introductory microeconomics, week five, explains how supply, the willingness to sell different quantities of a good at different prices, depends on the cost of producing one more unit of the product.
If corn is 20 percent more costly to livestock producers, the marginal cost of another dozen eggs or gallon of milk or pound of chicken, beef or pork will rise at the farm level and at the supermarket. In the long run, it is consumers who will bear the brunt of a smaller-than-expected crop.
But in the short run, livestock producers will take a pounding. In cases like this, input prices rise much faster than product prices. Farmers for whom cash crops are a principal activity will realize stronger profits from 2010. But livestock producers just got a setback.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.