A severe problem in commodity markets concerns the wild fluctuation of prices. Commodities include raw materials like metals (copper), minerals (oil) and agricultural output (wheat, sugar, tea and bananas).
Causes of Price Fluctuations Many factors cause commodity prices to fluctuate wildly including:
1) Price Inelastic Supply.
Agricultural output has a long time lag because it takes time to plant, grow and harvest crops. Raw materials like oil also have a long production lag because it takes time to find and extract from the land. If supply is inelastic and there is a demand shock, the demand curve shifts and price changes a lot.
2) Unpredictable Supply Shocks.
Agricultural output suffers from unpredictable supply shocks. A bumper harvest will result if weather conditions are favourable. A bad harvest will result if there is a drought, too much rainfall, a tsunami, a hurricane, a tornado, an insect plague or rabbit infestation. A good harvest causes supply to shift right and price to fall whilst a bad harvest causes supply to shift left and price to rise.
3) Price Inelastic Demand.
Agricultural output like food and raw materials like oil are necessities so they have an inelastic demand. If demand is inelastic and there is a supply shock, the supply curve shifts and price changes a lot.
4) Income Inelastic Demand.
Agricultural output like food is income inelastic because people have a limit to how much food they can consume, so demand for agricultural goods rises only a little bit as world income rises. If supply keeps increasing because of technological innovations like genetically modified crops (drought and pest resistant) but demand rises only a little bit then agricultural prices will fall over time.
Consequences of Price Fluctuations There are many consequences of commodity price fluctuations:
1) Farm Revenue/Income.
A bumper harvest means price falls and, because demand is inelastic, revenue falls for farmers. Although, a bad harvest means price rises and, because demand is inelastic, revenue rises for farmers.
2) Lower Investment.
Because supply shocks are unpredictable farmers do not know if harvests will be good or bad so farmers cannot plan, they cannot invest and the development of farming may be restricted.
3) Consumer Surplus.
A bad harvest means price rises, consumers pay more for agricultural goods so consumer surplus falls. Although, a bumper harvest means price falls, consumers pay lower prices for agricultural goods so consumer surplus rises.Buffer Stock Scheme A buffer stock scheme is used by the government to reduce commodity price fluctuations. The government sets a band within which price is allowed to fluctuate between a maximum price and a minimum price, the government then buys/sells the commodity to ensure price remains within the band.