Monday, March 07, 2011

Assessing the Risk of More Food Price Increases

In the Wall Street Journal, Scott Kilman tells a "triple witching" hour tale about the prospects of even higher food prices.  Soaring world demand is one fundamental trend. On the supply side, he talks of ethanol subsidies attracting U.S corn production and weather shocks disrupting production.

He is aware that if he knows that these trends exist, then there should be some profit opportunities for farmers who actually grow some agricultural yield. Here he writes a strange conjecture; "Farmers have long responded to high prices by planting more land and then producing price-depressing gluts. But this cycle appears to be breaking down, which means high food prices could stick much longer than in the past."

So, what is Mr. Kilman's evidence for this pessimistic claim that supply curves do not slope up?  Why is this "cycle" breaking down?   Economists know the classic "cob-web" model of expectations and that if farmers are myopic and choose agricultural investment today as a function of last year's price then they will not like the results. They will "over plant" when prices are high and the next year prices will fall due to the bumper yield.

So, it appears that this agricultural case offers us a sharp test of both rational expectations and induced innovation.  Why?

1.  Rational Expectations:  I recognize that climate change makes the probability of extreme weather events (both temperature and rainfall) higher.  If farmers recognize this fact, then this should affect their investment choices today over a range of options.   For example, the adoption of heat resistant seeds or having access to more irrigation are just two examples.

2. Induced innovation;  if we expect that agricultural prices will rise -- then this should focus our nerds' attention on developing potential solutions.  As agriculture faces more extreme weather scenarios, has anyone around the world figured out how to deal with them? How can these "best practices" be diffused around the world?  I do not know the exact details about how to grow grains under different climate conditions but how can human capital and physical capital substitute for resources that Mother Nature is now randomly choosing not to supply?

In a nutshell, if we anticipate that we face a challenge --- what is the "small ball" of how farmers will figure out how to respond?  What are the short run adaptation strategies? and what are the medium term adaptation strategies that investments in new ideas and capital will make possible over the next 5 to 10 years?