Prices send signals.
Prices for copper and other mining and agricultural commodities are hitting record levels right now, at least if we don’t adjust for inflation. Such high prices signal consumers to buy less and producers to turn out more.
That is why economists often say high prices are the cure for high prices because they automatically motivate changes in decisions people and companies make that eventually push prices back down, although not necessarily to the starting point.
Such moderation occurs in the medium and long term. A generalized commodities price spike like the present one can be a wild ride in the short run and always provides myriad examples of basic economic principles.
Take the idea of “elasticity” of supply and demand. Why have wheat and copper prices roughly doubled in the past year or corn prices increased by 60 percent? Surely consumption of these products could not have increased so much.
That is true. Copper use has increased globally by only 10 percent over the past year. But demand for copper is very “inelastic,” meaning a large rise in price changes its consumption very little. And the supply of copper also is inelastic — it takes large increases in price to motivate producers to increase output very much. Combine those two factors, and relatively small changes in the quantities used or produced cause extreme price swings like we are seeing now.
Why don’t copper producers simply crank out more product? If there were slack capacity in mining, as there was 20 years ago, this is not difficult. When mines can increase output simply by adding workers or running existing machinery longer, supply is more elastic. In some cases, closed mines can be reopened in a relatively short time at low cost. So supply is not always as inelastic as now.
Once existing mines are running at capacity, though, increases in output can come only from opening new mines. Copper mining is highly “capital intensive,” it takes a great deal of money, currently at least $1 billion, to open a new open-pit mine. And it takes a lot of time, since much “overburden” soil and rock must be removed to get to the ore itself. And a large new mine usually needs its own concentrating or smelting plants with much custom-made machinery. In some cases, new railroads and port facilities are needed.
Paying off such an investment can take decades. Yes, with current prices near $4.60 per pound, many new mines would amortize such upfront investments more quickly. But mining companies know prices were as low as 76 cents for 2002 and averaged only $1.01 over the 15 years ended in 2004. They are hesitant to make enormous investments without some certainty that prices will remain high for a long time.
Agricultural commodity supply is similar. If the price of one product, say, soybeans, goes up while those of other crops stay constant, output the next season can rise substantially as acreage is switched from corn or even wheat to soybeans. But when prices of virtually all major crops increase, as they have now, it is hard to get more total land into production.
Yes, for fertilizer-responsive crops like corn and wheat, higher prices justify applying more fertilizer, especially nitrogen. But at some point, particularly in traditional wheat-growing areas, rainfall rather than nutrients becomes the limiting factor.
Yes, when high prices persist, some grazing land can be cropped. And as some Conservation Reserve Program contracts expire each year, high prices may induce landowners not to re-enroll their land and to plant crops instead. But land being grazed or in the CRP usually has lower-than-average productive capacity, so the boost to output is limited.
And yes, agricultural productivity grows year by year, both in output per acre and per hour worked. But this gradual increase over time, while powerful in the long run, is not big enough in any single year to offset the effects of drought or flooding in a major grain-producing area. So short-term price fluctuations can be extreme even if the long-term trend in inflation-adjusted prices is down.
Iron ore is an interesting case. Global production doubled from 2002 to 2009; the previous doubling took 42 years. U.S. production, largely from Minnesota, generally has oscillated in the 50 million- to 70 million-ton range since 1980. However, it fell by half from 53.6 million tons in 2008 to 26.7 million tons in 2009. (Consolidated 2010 data is not yet available.) That was the lowest tonnage since 1934. (The iron content of taconite pellets today is higher than that of the direct-shipping ores decades ago, however.) Despite this, international iron ore prices increased 25 percent from 2008 to 2009, when they reached three times what they had been five years earlier. And in February 2011 spot prices are now twice the annual average for 2009.
Such increases are hard to explain purely on the basis of Chinese demand given that world output doubled in only seven years. Some wonder if the extraordinary increases in monetary bases by the Federal Reserve and other central banks and increased speculation in commodities futures by hedge funds and investment banks has anything to do with the current commodities price boom. (The monetary base is the sum of bank reserves and currency that underlies the money supply itself.) Some economists claim not, but the question is a thorny one that merits a column by itself.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.