Tuesday, May 27, 2014

How Will Farmers and Farm Consumers Adapt to Drought?

Brad Plumer  has written a good piece about drought's consequences for California farming but he needs to think about general equilibrium effects.   As a California resident who moved here 8 years ago in large part to shop at organic farming markets, I understand that California produces some tasty stuff.  That said,  California does not have a monopoly on producing produce. If the marginal cost of growing stuff here soars then marginal crops such as alfalfa will no longer be grown and other international exporters will fill the void and will export to the U.S.  Such general equilibrium effects protect U.S consumers from the "hyper inflation" for food that Plumer fears.

In his piece he ignores the magnitude of the size of effects that he discusses. He warns that prices have risen .7% percent in a month for fruits and veggies.  That works out to a 8.4% increase in prices if this persists for a whole year.   Such a price rise of this magnitude would be unlikely because international exports would soon flow in when the "law of one price" for berries is violated (if Mexican farmers can export and sell in the U.S for $2.5 or sell to their own market for $1.2 they will figure out how to ship the goods North).

Suppose domestic fruit prices increase by 8.4%.  Where does this $ go?  This extra income would greatly enhance farmer profits and many farms hire less fortunate workers to work in the fields. They would receive  a raise.

Returning back to the demand side,  if prices go up by 8.4% for fruits and veggies, how much less fruits and veggies would parents buy for their children? What is the price elasticity of demand for these products?    According to this survey article, the best guess of the price elasticity is -.5.   So, the 8.4% price rise would reduce household consumption by 4.2%.  That's not a big number.   If adults are fully grown and worry about their kids' consumption, the adults in the household may cut back their consumption to provide these key nutrients to their kids.  So, this 4.2% reduction in household consumption may have no impact on the kids' consumption.

My point in this blog post is to highlight how behavioral effects work in the real world and how their existence affects the interpretation of the news that journalists write about.  General equilibrium shouldn't be ignored!

With regards to California's farmers and water,  farmers should be charged a higher price for water so that it reflects what urbanites are willing to pay for it.

In the efficient equilibrium, water should be allocated so that we achieve the same "bang per gallon consumed" across all users in California;

price of water is such that supply =   demand


$ benefits from using a gallon in sector 1 = $ benefits from using a gallon in sector j for j = 2....... N

Right now farmers treat water as if it is a free resource and this causes most of the "demand shortage" problems.