Reviews on the Instability of World Primary Product Markets and Stabilization Policies

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Reviews on the Instability of WorldPrimary Product Markets andStabilization PoliciesSeon LeePublished online: 19 Aug 2009.

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Reviews on the Instability of World Primary Product Markets and StabiIization Policies

Seon Lee

I. Introduction

The importance of primary product imports is increasingly felt among those countries which are poorly endowed with natural resources. This is part- ly because the world primary product market Ihas been- unstable in the past years, especially after the 1973 oil embargo imposed by OPEC countries. Korea is one of those countries which depend heavily on imports for essential raw materials. Along with the rapid pace of economic development in recent years, Korea’s imports have vastly expanded year after year. In 1977, the primary product imports amounted to $5,138.9 million accounting for some 48% of the total imports of $10,810.5 million. This represented an increase of 23.6% over the 1976 level of $4,156.9 million, a rise of 55.9% over the 1974 level of $3,297.4 million. Since Korea’s increasing dependence on imports for resource requirements is unavoidable, careful consideration must be given to its commodity import policy, especially in view of the current international market instability.

There exists a wide range of commodity policy problems Korea has to deal with as an importer. For example, there were two instances in which resources-importing countries proved to be vulnerable to a major commodity related international economic crisis. First, the economic impact of the 1973, oil embargo jolted both developed and non-oil developing countries. The ensuing “commodity boom” during the period 1973-1975 triggered rapid price rises for most primary commodities such as copper, tin, and bauxite. The high prices of commodities including oil caused world-wide economic recession during the period. Second, as the food and feed grain stock of the United States decreased sharply in 1975 due to the successive crop failures in the pre- ceding years, the food prices soared to the unprecedentedly high levels. In the political and economic quarters, there were wide-spread fears of a food-crisis. In response, FA0 attempted to work out world food reserves to prevent a vi- cious spiral of food price increases which would have a severe impact on poor -countries. Although the food crisis was not very severe and was only short- lived, it added a new dimension to the food policy for international organiza-

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tions as well as food-importing countries. Last year, prices of some agricultural commodities such as red pepper

and onions reached unprecdentedly high levels due to the poor harvests, which led to the formulation of some types of safeguard or stabilization policy. Furthermore, world market prices of major primary commodities such as tin and copper have risen since last year. Under the circumstances, the Korean government has adopted a buffer stock policy covering 32 commodities. These .are mostly primary products the market of which has been relatively volatile. The price band is to be set up for these commodities and the buffer stock operations are aimed at defending the price target. In addition, the government is to provide some $300 million in foreign exchange loans to private companies for the procurement of major primary commodities. This arrangement is also motivated by the recent price uncertainty of the world market. As the public .policy on the instability of the commodity market draws more attention than .ever, it is important to identify problems involved, to understand the theoretical and welfare aspects of the price stabilization policy and to define policy .alternatives.

The following article discusses some facts and issues of world primary product markets (SectionII), examines the welfare implications of the price stabilization policy (Section III), introduces stabilization policy alternatives a n the part of importing countries (Section IV), and finally presents conclu- .ding remarks (Section V).

II. World Commodity Trade: Facts and Issues

Major facts and issues of the world commodity trade are presented and adiscussed in this section. The problems of market instability especially in the context of developing countries are dealt with in part 11.1. The historical devel- apment and future prospect of the international commodity stabilkation me- .chanism is discussed in part 11.2 and the “Integrated Program for Commodi- ties” proposed by UNCTAD is analyzed in part 11.3.

lI.1 Tlie Probleiiis of Market Iiistability

Primary products have traditionally constituted an important commo- .dity group in world trade. Although their relative importance has declined some- what during the post-war period due to the rapid expansion of manufactured exports, the primary exports amounted to some USS 340 billion (S171 billion -excluding fuel) in 1975, which represented 38.9 % of total world exports (19.6% .excluding fuel), as shown in Table 11. Exports of agricultural commodities, largely food and beverages, registered S104.2 billion, 11.9% of the world total. Mineral exports amounted to $66.7 billion, 7.6 %, and fuels, largely petroleum,

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$168.6 billion, 19.3% of the world exports. i t is probable that primary commodities will continue to be of great importance in world trade in the future.

For developing countries, primary products provide a major source of export earnings. In 1975 exports of the developing countries totaled S210 billion (Table 1.1) including S124.6 billion worth of fuels. Exports of primary commodities, excluding oil, amounted to $49 billion, which consisted of S29.5 billion in agricultural products and S19.5 billion in minerals. Primary goods. thus represented 57.6% of the entire exports (excluding fuels) of developing countries. The importance to developing countries of their primary products exports is further highlighted by Table 1.2. Roughly 50 countries derived more than 28 % of their export earnings from ten commodities. When all primaries are included, 64 countries earned more than 50% of their export earnings from these commodities and 96 countries more than 20% (McNicol, p. 16).

Table 1.1 World Exports by Commodity Class and Regions in 1975

World DCs* LDCs* CPCs* Total

Primary products: V a h Value % Valire % Value % Food, beverages and tobacco 104.2 66.3 63.6 29.5 28.3 8.4 8.1 Crude materials cxcluding fuel, 66.7 39.4 69.1 19.5 29.2 7.8 11.7 oils and fats Mineral fuels and related 168.6 29.3 17.4 124.6 73.9 14.7 8.7 materials Sub-total 339.5 135.0 39.8 173.6 51.1 30.9 9.2 Manufactured products 518.3 434.3 83.8 35.4 6.8 48.5 9.4 Total 872.5 578.0 66.2 210.0 24.1 84.6 9.7 * Unit: FOB Value in billion U.S. S * Developed countries @C), less developed countries (LDC) and centrally planned countries (CPQ Source: United Nations, Atiriirul Sfafisfics (1977).

For developed countries, primary products trade also raises important policy concerns. Since raw material supplies for the production of industria1 and consumer goods are largely derived from imports, a stable and continuous supply needs to be secured to protect domestic economic stability. For the European Economic Community and also for the U.S., which is relatively well endowed with natural resources, primary commodity imports have been a serious trade policy subject. The vulnerability of developed economies in this

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Tablc 1.2 The Average Percent of Total Export Earnings Obtained by LCDs from Export of Ten* Commodities, During 1970-1972

Earnings from Earnings from Country Commodities Country Commodities

Zambia Uganda Mauritius Rivanda Equatorial Guinea Zaire Sri Lanka Chile duba Columbia Dominican Republic Chad Ghana Sudan Bangladesh Togo Cameroon Bolivia Ethiopia Fiji Papua New Guinea Haiti Guadalupe Ivory coast Central Africa Republic Republic of Vietnam Kenya Egypt Guatemala Malaysia

94.1 % 92.6 88.7 80.7 78.1 76.6 75.4 72.0 72.0 66.7 65.0 62.5 61.4 60.6 59.8 57.2 57.0 56.8 55.5 55.5 55.5 54.8 52.7 52.2 52.1 52.1 48.1 48.0 46.8 46.5

Dahomey Brazil Nicaragua Tanzania Syrian Arab Republic Peru Angola Yemen Arab Republic Barbados Philippines Mali Malagasy Republic Ecuador Guyana Indonesia Belize Thailand Mozambique British West Indies Mexico Upper Volta Liberia El Salvadore Pakistan Honduras Nigeria India Afghanistan Khmer Republic Jamaica Burma

44.7 % 43.1 42.3 40.8 39.3 38.9 36.9 36.0 35.6 34.4 33.9 32.9 31.4 31.1 30.0 29.9 28.3 28.2 28.1 22.3 21.7 18.2 16.7 16.2 .16.0 14.3 14.2 13.9 12.9 11.0 6.3

* Cocoa, coffee, tea, sugar, cotton, jute, sisal, rubber, copper and tin Source: McNicol (1978)

respect was demonstrated during the oil embargo by OPEC countries. The rapid price increase for major primary commodities during the commodity boom- period 1972-75 also had a destabilizing impact on national e:onomies. Inflationary pressure created by high commodity prices has been identified as one of the major causes of world e-onomic recession during 1973-74.

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The instability of primary product market represented by wide fluctuations of market prices and export earnings of producer countries has been recognized and analyzed by international organizations as well as individual countries. The United Nations (1952) has initiated a number of commodity studies since its inception to organize international commodity agreements. A joint study by the World Bank and IMF (1969) stresses serious problems that can result from unstable commodity markets. Since its establishment in 1964, the United Nations Conference on Trade and Development (UNCTAD) has conducted a continuous study on these problems. Some of the results of this study will be reviewed in section 1.3.

The volatility of commodity markets can be explained by several factors. For agricultural products, stochastic yields caused by climate conditions, and inelastic supply and demand are primary causes of market instability. For minerals, the market instability is largely attributable to the demand side which varies along with the business cycle of importing countries (Brown 1975). In general, agricultural commodities are characterized by a supply-shift market, which minerals by a demand-shift market. In addition to these fundamental factors, the speculation by market intermediaries as well as rigid supply and demand may accentuate price fluctuations.

Data on price fluctuations by commodities are shown in Table 1.3. The

Table 1.3 Variations in Commodity Price During 1950-1975

Price Range* Coeficient of t High Low Variation

Coffee 288.2 100.0 .25 Cocoa 190.7 54.9 .29 Tea 274.2 100.0 -26 Sugar 128.7 16.9 -61 Cotton 227.1 100.0 .22 Rubber 531.6 100.0 .38 Jute 166.7 77.4 .21 Sisal 144.5 41.4 .38 Copper 285.3 100.0 .33 Tin 129.0 100.0 .20 Wheat 125.6 72.9 .14 Rice 153.5 69.2 .21 Banana 214.1 100.0 .18 Beef 129.4 26.8 .55 wooj 324.7 100.0 .29

* Index with 1975 as the base year. 7 Computed by the deviation from the estimated trend.

Source: McNicol(l978)

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coefficient of variation for price ranges from a low of .14 for wheat to a high of .61 for sugar. Among 15 commodities shown, 10 have an instabillity index greater than .25. In the case of some individual commodities, cocoa prices vary between 54.9 and 190.7, copper between 100.0 and 285.3, and rice between 26.8 and 153.5. The economic consequences of price instability will be reviewed in the next section.

. The export revenue instability is another important policy issue of the international commodity trade. The exports of developing countries have con- centrated on primary commodities, as shown in Table 1.2, and these countries have experienced substantial changes in their export earnings. The coef- fieient of variation for export revenue varies from a low of 5.5 for tea and to a high of 28.6 for wheat as shown in Table 4.

Table 1.4 Export Revenue of LDCs Derived from Primary Comniodities in 1975

LDC Exporf * Export Coeficient of Earnings Share (%) Variation

Coffee 3 .O 96.8 9.2 Cocoa .7 99.2 12.6 Ten .6 82.8 6.0 Sugar 2.2 69.7 7.5 Cotton 1.8 57.9 7.9 Rubber .9 97.7 14.4 Jute .7 95.6 14.1 Sisal . I 97.7 28.6 Copper 2.4 54.5 l7.5 Tin .6 85.5 18.4 Wheat .2 4.0 31.1 Rice .4 33.0 14.8 Banana .6 93.3 7.2 Beef 1.4 30.0 15.1 \Vool .2 37.9 12.5

* Unit: Billion U.S. S Source: Behrman (1977) and McNicol (1978)

11.2 Iiiteriiatioiial Coimnodity Coiitrol Mecliaiiisin

The problems caused by market instability and the ensuing coordinated commodity control in the world market has been a major policy concern a- mong trade partners, as well as in international organizations such as UNCT- AD, FA0 and IMF. The instruments of commodity control that have been suggested range from national policy tools such as production control, deficiency payments, buffer funds, export quotas and national buffer stocks to various forms of international arrangements, for example, international buffer stocks,

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compensatory financing scheme, and bilateral agreements. Since the early part of this century, a number of commodity arrange-

ments or agreements have been set up for a variety of primary commodities. The exact nature of such agreements has varied quite widely. The international tin control scheme, which is the oldest in continuous operation, employing export quotas and buffer stocks, dates back to the early 1930s. Supply control, either through export quotas or production restriction, had been exerci- sed for rubber, coffee, sugar, tea and wheat. Informal arrangements, involving no market intervention, and designed to facilitate the exchange of market information, have existed for copper, cocoa, bauxite, jute, tungsten, and many other products as well (Law, p. 69).

In recent years, the movement toward forming international commodity agreenents has revived. The International Cocoa Agreement has been renewed, although it has not been fuctioning at all. The third International Coffee Agre- ement has been in effect. The International Tin Agreement has been succes- sively renewed and the U.S. joined it from the Fifth Agreement. The Interna- tion Sugar Agreement which collapsed in 1973 has been now under negotiation to be reorganized. Besides, the inter-governmental negotiation has been seriously considered to reah agreements for such commodities as wheat, rubber, tea, cotton and copper. The most significant development of international commodity arrangement is the “Integrated Program for Commodities” (IPC), which has been initiated by UNCTAD since 1974. The historical background and major features of IPC will be discussed in the next section.

The compensatory financing scheme constitutes another important international commodity arrangement. It was established to stabilize export earnings of developing countries and to relieve their balance-of-payment difficulties. The lnternational Monetary Fund (IMF) adopted the scheme in 1963 which had been operated on a loan-basis. Its operational procedure was quite strict and the utilization of the fund had been inactive until 1975 when the access to the scheme was made easier. In 1975, EEC established a similar compensatory financing scheme, called “STABEX,” in the 1975 Rome Convention. The scheme now covers 52 African, Caribbean and Pacific countries (Goreux 1977).

The performance of the past commodity agreements has not been satis- factory except in the case of tin. In general failures can be explained by many reasons: geographically wide dispersion of producers and consumers, con- tradicting interests between exporters and importers, and technical problems relating to, for example, setting export quotas, storage and the price policy. McNicol(l978) ascribed the failure of agreements during the pre- and post-war period to the disputes among sellers and buyers (sugar, wheat, coffee), the overshipping (coffee), disputes on market-share (sugar) and the market disruption due to the entrance of non-member countries (rubber, sugar, coffee).

The unsatisfactory performance of international commodity agreements

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over the past years has cast doubt on the viability of commodity control measures. Critics argue that agreements mainly protect the interests of producers through arbitrary increases of market prices, and further assert that commodity agreements are an inferior means of providing foreign aid to developing nations (Kravis 1968). This reaction can be interpreted as a response to the early ex- perience of supply control through producer cartels such as the Bandeung Pool (tin), Stevenson Plan (rubber), Chadbourne Plan (sugar) and the Latin American Coffee Agreement, all of which. were short-lived.

Another criticism of the international commodity control is reflected by the U.S. attitude over the past few years. Traditionally, the U.S. commodity policy has been based on the philosophy of competitive free-market system which advocates the role of market price in attaining an efficient allocation of resources. This view precludes intervention or control. The U.S. has supported free trade by private entrepreneurs rather than attempting to solve problems through intcr-governmental agreements ( U S Congress 1975).

A review on the performance of the past commodity arrangements indicates that failures were caused by mismanagement such as overshipping, disputes between member countries and, most importantly, the inadequate price policy which were set up higher than the long-run trend, as previously noted. This implies that the good management of control schemes is the key to success, as evidenced by the performance of the International Tin Agreement (ITC). ITC has successfully worked out buffer stock management as well as export quotas.

Another lesson is that commodity agreements should have very specific objectives. There are many potential policy objectives and many policy instruments to achieve them. Policy instruments should be carefully evaluated depending on policy goals to be pursued. If the objective is to stabilize short- run price fluctuations, buffer stock and supply control are efficient policy instruments. If the policy goal is to improve export earnings, compensatory financing seems to be preferable, If resource transfer is needed, direct aid or development loan is a superior ‘policy tool.

11.3 Integrated Prograin for Coinniodities

With the independence of many developing countries from colonialism and their admission to the United Nations, the LDC voice has grown stronger in international politics since the early 1960s. UNCTAD was organized to meet the needs of this group with respect to development and trade problems, and held its first meeting in Geneva in 1964. The “Group of 77’ which now has more than 110 member countries, was formed as an international pressure group .to advocate LDC interests. At UNCTAD’s second 1968 meeting in New Delhi and the third 1972 meeting in Sandiago, they envisaged stronger and more positive actions to close the gap between rich and poor countries. In 1974, “A Declaration and Action Program for the Establishment of A New

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International Economic Order” was adopted at the Sixth Special Session of the United Nations, and the idea was further discussed at the Seventh Session in 1975. On the basis of the “Manila Declaration” which was drafted in 1976 by the Group of 77, UNCTAD prepared for its fourth meeting at Nairobi, Kenya. The “Integrated Program for Commodities” (IPC) was the product of this meeting. It represented an action program to improve market structurcs and LDC export earnings from primary commodities.

IPC comprises four major components: price indexation, compensatory financing, the common fund and a general development package. The price indexation scheme is to ensure that the price of LDC commodity exports kecps up with the world inflationary trend and, if possible, improving the long-run terms of trade for LDCs. A compensatory financing scheme is suggested to stabilize fluctuations in export earnings. This is similar to the existing IMF’s scheme and EEC’s STABEX. The general commodity development package includes loans for diversification, market promotion, research and development, and commodity processing.

The central and most controversial subject of IPCis the idea of establishing series of international buffer stocks to be financed by a “Common Fund.” Ten core commodities (cocoa, coffee, tea, cotton, hardfibers, jute, rubber, sugar, copper, tin) have been selected as suitable for international stockpiling and eight more commodities (beef, iron-ore, bananas, bauxite, manganese, pho- sphates, tropical timbers, vegetable oil and oil-seeds) would also be included jn the IPC. The financing of buffer stock will be effected through loans to individual commodity agreements or through direct intervention by UNCTAD for commodities having no international agreement. UNCTAD suggested that, of the total S6 billion, S5 billion would be used for buffer-stocks and S1 billion for diversification and other commodity development schemes. The fund would be financed by contributions of $2 billion and borrowing of $4 billion. UNCTAD expects that financial needs would be reduced by 18-25 % by pooling.

Reactions among economists to the idea of IPC vary. Virtually they all agree upon the need for policy action to stabilize fluctuations of prices and export earnings, but differ in their prescriptions for the correction of market instability. The heart of the controversy rests on the Common Fund scheme to pool the financing of international stockpiles across commodities.

Opponents to the scheme argue that efforts to improve terms of trade, or increase prices, through commodity agreements have all failed in the past, and are not likely to be successful in the future. McNicol (1978) a r a e d that the commodity agreements had worked, increasing prices above Iong-run trends, and such is likely to be the case with Common Fund schemes.’) He suggested that the “Commodity Price Authority” be set up in order to explicitly handle 1) Various views on the Common Fund scheme are discussed by Behrman, Fisher and Rovss,

Juny and MacAvoy, hlcNico1, and hlichalo boulos and Perey in Adams and Kleinll978).

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the problem of resource transfer between exporting and importing countries. A separate “Buffer Stock Authority” would control the financing of stocking operations. Besides, unless problems of mangement could be solved, the Common Fund would be a repetition of the past commodity agreements. At the same time, McNicol indicates that the cost of managing buffer stocks exceeds the benefit to be derived from the operations of such stocks.

Keynes (1974) was an early advocate of the establishment of an international stockpiling scheme for major raw materials and foodstuffs. His ideas are very close to the UNCTAD proposal. He suggests the organization of a “General Council for Commodity Control” to manage buffer stock operations for several commodities and also organize an “International Clearing Union” to handle related financial problems. Behrman (1977), on the basis of his empirical findings, also supports the validity of the Common Fund scheme. He anticipated substantial gains to both exporting and importing countries from a Common Fund scheme.

An agreement could be reached on the IPC by the explicit division of its role into three separate functions: pure price stabilization through buffer stocks, compensatory financing, and general economic and commodity development schemes. The price indexation to improve deteriorating terms of trade could be handled under a general commodity development scheme, and the inflationary factor would then be considered in the pricing policy of the buffer stock agency. In defining the use of policy instruments, UNCTAD must make clear that the international stockpiling is aimed at pure price stabilization (to eliminate the short-run random movement), not at increasing prices above trends as many previous commodity agreements had attempted through supply control and stock management. Once these basic policy goals and instruments are defined clearly, UNCTAD should be able to carry out the IPC more successfully.

111. A Review on Price Stabilization and M‘elfarc Analysis

The major emphasis of this section is placed on the pure theories of price stabilization and welfare analysis. No contents are allocated to any discussion of empirics. Although many papers reviewed are written in the context of primary products, the theories and arguments are quite general and could be broadly applied. The interaction of price stabilization and consumers’ welfare are reviewed in part 111. 1, with producers’ in part 111. 2, with both consumers’ and producers’ in part 111.3, and an extention to the international trade in part 111. 4. And summary and conclusions are given in part 111. 5.

I I I. 1 Phce stability arid coi~siiii I ers ’ welfare

Price stability has been preferred to price instability by consumers, pro-

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.ducers and the society as a whole, and it is viewed as one of the symbols of an orderly nation. From the economic point of view, the stable prices are an essential element in giving correct signals to the resource allocation process .in the market-oriented economy. Although there exist some disagreements on the degree of desirable price stability (Tomek, 1972) economists commonly .admit that the stable prices are a virtue rather than a vice.

Against this common sense logic, Waugh (1944) has shown that consumers benefit more from an unstable price than from a stable prices. Suppose -two price levels PI and P2 occurring with equal probability and the average price Po which is an arithmetic mean of the two. With the concept of economic surplus, the gain (G) is larger than the loss (L) at respective price levels P2 and PI in comparison with the situation when the price is stabilized at Po (Figure 1). So consumers gain more under price instability, and this holds true as long as the demand curve slopes downward.

Qiantity

Figure 1

The same result could be shown by an ordinal utility analysis. If the price is stabilized at Po, the budget line moqo reaches the highest indifference curve at X (Figure 2). When prices fluctuate at PI and Pz, the budget line mq, and mq, could reach a higher indifference curve within the ranges of a’ and b‘, and consumers could still continue to buy ax and spend aml and amz on other things. This is possible provided that consumers could distribute expenditures through different periods and that they have no time preference in consumption. The -Waugh theorem reads: “If a consumer has a given sum of money to spend for all goods and services, and if he can distribute this expenditure as he pleases

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111,

Figure 2

among n equal periods, he will be better off if all prices vary than he would be if all prices were stabilized at their respective arithmetic means” (p. 608).

The theorem is based on the native assumption that the price is stabilized at the level of an arithmetic mean. It is quite clear that there is no a priori reason that a price should be stabilized at this level. It is more plausible to argue that the simple mean price is one of the possible levels that could be reached through. a stabilization policy. Howell (1945) and Lovasky (1945) showed that when the price is stabilized at or below the weighted mean P,, a consumer gains more from the stability. In Figure 1, since (PI-Pa)QI = (Pw-PZ)QZ, the consumer’s loss is larger than his gain under the unstable prices. This is also true as long as the demand curve is downward-sloping.

In cyclical economic fluctuations, it is likely to be observed that the demand curve is not stable throughout the period. For example, the demand curve could be dl in the boom and d2 in the recession (Figure 3). Lovasky argued that, under an unstable demand situation such as that shown in Figure 3, consumers benefit more from price stability regardless of the level at which the price is settled. At the same time, the price stabilization at the weighted P,. makes consumers worse off than at the arithmetic mean Po, which is the rcverse of the case under stable demand.

\%ugh (1945) acknowledged these qualifications and rewrote the theorem: “. . . Assuming that demand is stable and that the demand curve slopes downward to the right, stabilization of price at or above the simple arithmetic mean, . . . , would increase the consumer surplus of each individual consumer”

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I Quantity

Figure 3

(pp. 301-2). And later he stated that “Price stability, in it self, appears to be neither a virtue nor a vice, . . . It all depends upon the level at iirhich the price is stabilized and whether one is concerned with the welfare of the consumer or the producer” (1966, pp. 507-8).

Further criticism of the Waugh theorem was made by Samuelson (1972). He observed that “where competitive laissez faire leads to stability deliberate interference . . . to create instability . . . is shown to be harmful. . . .” (p. 493). An intuitive proof is given in Figure 4. When costless storage is

Figure 4

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possible between two periods having output Q1 and Q2, the feasible equilibrium must be on the NN locus, reaching optimum at Q,. The niaiiipirlation of unstable prices always results in a higher average price than the stable price we are considering, such that it reaches equilibrium at a point like Qb beyond NN which is not feasible. The actiral mid feasible unstable prices reach equilibrium a t a point like Qc which is always inferior to the optimum point Q,. Again this is the reverse of the Waugh theorem.

111.2. Price Stability mid Prodircers' Welfnre

Some 20 years after the presentation of the Waugh's proposition, Oi (1961) proved that producers are better off with price instability which is caused by stochastic demand. This result is based on the assumption that producers ma- ximize short-run profits at each point in time by adjusting output to price changes such that P = MC, and that the marginal cost curve is upward sloping over the relevant range of output, Given this marginal cost curve, the profit function is an increasing function of price which is convex to the price axis (Figure i). Let P, and P,* (p2 and P2*) be prices occurring with an equal probability and P a mean price. Then the expected profit is of the order yo < Y , < v2. This implies that producers collect more profit under conditions of price instability, and that the greater the variation, the larger the profit. The proposition is true regardless of the probability distribution of price, i.e. whether it is normal or skewed.

For some products such as agricultural crops, producers are likely to plan in advance and hold the output at the level which maximizes profit at the ex-

-

(Probit) Y

Figure 5

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pected price, rather than adjust the output instantaneously to the price change. Under this fixed output assumption, Tisdel (1963) showed that the expected profit is maximized when the price is set at an average price and that, therefore, producers benefit from price stability and lose from price instability. The Oi result is valid only under the assumption that producers have a perfect knowl- edge of future prices or they can adjust output with perfect factor mobility without incurring additional costs.

Samuelson (1971) also indicated the futility of Oi’s proposition on the same ground he used to refute the Waugh’s argument. He wrote that “ . . . the price instability needed to make the theorem applicable to Oi’s title is simply not feasible. In other words, no bootstrap operation of manufactured price instability can accomplish the wonderful promises of the Waugh and Oi prospectuses, namely to make both producers and consumers simultaneously better off” (p. 488).

The assumption adopted by TisdeI that producers make output decision on the basis of expected prices was further developed by Turnovsky (1974). He worked out two situations where firms, or producers, make output decisions on the basis of anticipated prices by forming either adaptive expectations or rational expectations. He found that the Oi proposition could be either true or false depending on how a price expectation is generated and on the particular autoregressive properties of the stochastic residuals in the demand function. Under adaptive expectation, the Oi result does not hold true unless the residuals in the demand function are very positively autocorrelated; whereas under rational expectation, the Oi conclusion is correct if the residuals in the demand function are either positively or negatively autocorrelated. If the residuals are not autocorrelated, the welfare of producers is unaffected by price stabilization.

Another extention of the Oi discussion was made by Zucker (1965). Pro- vided that producers are more concerned about the sales of items whose prices are affected by stochastic demand, producers benefit more from conditions of stable demand. This result items from the assumption that profit does not vary with respect to revenue changes under a constant elasticity supply function. Consequently the unstable demand will only result in additional costs for making output adjustments. This result is consistent with the fact that producers prefer price stability to price instability.

In formulating a price stabilization policy, producers’ income is an important variable to be taken into account. Price stability leads to the stabilization of producers’ income and ultimately contributes to its improvement in the long run. In the short run, however, price stability does not always promise higher returns to the producer. The effect on producers’ income is a product of the interaction between the particular shapes of the supply and demand functions and the price level. Given normal demand and marginal revenue curves

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which slope downward to the right, price stabilization by means of buffer stock schemes increases producers’ income. In Figure 6, the buffer stock operation to maintain Qo brings out a net increase in producers’ revenue, since A is larger than B with this shape of the marginal revenue curve. However, this is not always the case. Bateman (1965) indicated that for commodities having low price elasticities (less than one) and constant elasticity demand functions, the marginal revenue curve is rising and negative over the.relevant range. Con- sequently, a price stabilization program which maintains a mean quantity Qo through buffer stock operations reduces producers’ income, since I B I < I A I as seen in Figure 7. This point was also noted by Waugh (1944, p. 613). In Figuares 6 and 7, it is implicitly assumed that the demand cuke is stable throughout the periods and that the infinitely inelastic supply curve shifts only over the periods. Duloy (1966) further extended the Bateman result and con- cluded that different outcomes could be obtained depending on whether the price change is induced by the demand side or the supply side.

So far we have discussed the effect of a stable current market price, i.e., the spot price, on producers’ welfare. In contrast, Mckinnon (1967) suggested that stabilization, whether on the national or international levels, should be directed toward the distant ftctrcre price rather than toward the spot price. He argued that price stabilization through buffer stock schemes is not efficient in that it fails to protect producers’ income when the market is disturbed by problems. In addition, arbitrary price controls interfere with the efficient allocative roles of price signals, and thus are likely to induce incorrect adjustments and losses in the long run on the part of producers. Producers’ income is

Quantity I

Figure 6

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31

Figure 7

more effectively protected through the stabilization of future prices which better reflects long-term trends without interfering with resource allocation. This could be made possible by producers’ attempts to hedge through forward sales under an appropriate institutional arrangements and through individual buffer stock operations. If the proposition is valid, the government or an international agency could more easily manage and administer a stabilization scheme, since physical storage is not needed. Later Massel (1970) found that the variance of producers’ income under a buffer stock scheme is smaller than that under forward pricing measures.

111.3 Price Stability and Social Welfare

The welfare implications of price stability have been treated separately with respect to consumers and producers. Massel (1969) has shown that the society as a whole is always better off with price stability; the gains are sufficient enough to compensate for the losses. By employing partial equilibrium analysis, he combined and generalized the results obtained by Waugh and Oi. The Waugh case in which the price movement is induced by the supply side is reproduced in Figure 8 and the Oi case in which the price movement is lead by a shift in demand is given in Figure 9. In addition to the results of IVaugh and Oi, it was shown that “if the instability is due to shifts in demand (supply), then consumers (producers) as a whole gain from a buffer stock scheme that stabilizes the price at Up. And the net gain to consumers (producers) is sufi- ciently large to permit compensation, leaving both parties better off” (p. 289). In both cases, the social benefit is represented by (b + e) in Figures 8 and 9.

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I

F

1’* U, I’,

Figure 8 ic’e

Quamt ity Figure 9

A more general analysis for a case in which there are shifts in both supply and demand can be made with linear supply and demand functions. Suppose functions of supply and demand

(1) S = a P + x (a>O)

(2) D = - p P + y @ > O )

where x and y are random disturbances with means U, and U,, variances S,, and a,,, and covariance a,, = 0. Then the expected gains of consumers (GJ, producers (G,) and society as a whole (G) are derived as

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The Waugh and Oi conclusions, where S,, = 0 and S,, = 0, respectively, could be deduced by equations (3) and (4). At the same time, given positive 6xx and 6yy, the net social gain is always positive and increases along with the degree of price variability and slopes of the demand and supply curves ,(equations 5 and 6).

In order to arrive at the Waugh and Oi propositions, it does not matter which stabilization measure the policy maker adopts. However, the Massel result holds true only when a buffer stock scheme forms the tool of stabilization policy, since no alternative measure is neutral to both producers and consumers i n its welfare implications. The above net social gain does not take into account storage costs. Assuming there are no storage costs, the buffer agency earns zero profit if the profit is stabilized a t Up. If the price fluctuates, the agency could .earn or lose depending on whether the prices are rising or falling.

111.4 Price Stability arid Global Welfare

In international and national commodity negotiations and policy making, producers’ interests have been more strongly advocated than consumers’ interests. At the same time, the producer group is well-organized and is able to agree on their objectives in lobbying political decision makers. For instance, farmers’ income is an important policy concern in almost all countries. Simi- larly, the export earnings of less developed countries producing primary pro- .ducts constitute a major policy issue in setting up the international commodity arrangements. This is largely due to the fact that producers depend on a single .good or on only a few products as their major source of income, while consumers spend only a small portion of their total income on any particular product.

Massel (1970) examined the impact of international price stabilization through buffer stock schemes on producers’ income. Producers are in gerreral .risk-averse, and will try to obtain maximum income for the least risk. This is exactly the situation in portfolio management, where there is a trade-off between an expected value and variance. Massel pursued an optimal stabilization policy by observing these two parameters of producers’ income.

In Figure 10, an expected value of producers’ income (U,) is plotted on the vertical axis and a variance (S,J on the horizontal axis. Wi is an indifference curve on which producers feel indifferent to any combination of UI and SIl. T h e curve AE is an income possibility locus (IPL) which maps the income levels

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I u I "

Figure 10

obtained by alternative degrees of stabilization. Given a certain level of demand elasticity (and assuming infinitely inelastic supply), the buffer stock operation could reduce the variance of income without affecting expected income by absorbing random elements in the demand function. This shifts the: point A (no market intervention) to point B. Up to point C, the buffer stock operation could decrease price variance and result in higher U, and lower &. Beyond point C, a reduction in price variance would result in higher expected income until point E (complete price stabilization), but with a higher degree of income variance. The point C, where IPL is tangent to W,, is the optimum point of intervention by the buffer stock agency. Through mathematical manipulation, Massel proved that complete stabilization is not desirable unless the correlation between an aggregate supply and individual supply is zero, a situation which is highly unlikely to occur. Therefore, a risk-averse producer would normally desire lower income with less variance (the point D rather than the point E). The implications of the model depend on the parameters of the variance of individual output and its correlation to aggregate supply, conditions which usually differ greatly among producers. In addition, the indifference map cannot be defined generally to represent a producer group. Although the model is theoretically elegant and interesting, it seems to have little relevance: to policy decision making, especially in the international commodity area.

A more comprehensivc analysis was made by Hueth and Schmitz (1972) of the welfare implications of price stability in world trade under the same, framework employed by Massel. They argued that international price stabili-. zation is Pareto superior in the world economy provided some compensatory measuies are in effect between countries, since gains are more than sufficient enough to counterbalancelosses, thus making both countries better off. The

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distribution of gains and losses, however, depends on the source of instability. This conclusion is an extention of the Massel result to international trade.

A shift of the demand curve in the importing country (Figure 11) generates. instability, while both producers and consumers in the exporting country gain with total social gain s-u (Figure 12). In the importing country, consumers benefit and producers lose with net social loss f - (b + c) (Figure 11). Under a program of price stabilization, the gains of producers in the importing country are sufficient to offset the losses of other groups, with a net gain to the world of p + n (Figure 13). In Figure 13, world trade equilibrium is depicted by excess supply and demand curves. The two excess demand curves, El and E2, are the the result of a demand shift in the importing country. As in the Waugh-Oi- Massel results, a country in which instability is generated prefers price stabili-

"I

Figure 11

' I

Figure 12

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Figure 13

zation, while other countries prefer price instability. Only through an appropriate system of compensation can all traders be better off with price stabilization. Although a system of compensation between countries is difficult to arrange in practice, the conctusion is nevertheless interesting.

111.5 Simiiriiary arid Conchis(ons

The welfare implications of price stability were revieived by covering the impact of price fluctuations on consumers, producers and the society as a whole. The Waugh-Oi-Massel results were discussed and a number of qualifications and alternative views were raised. If was then shown how their framework of analysis could be extended to international trade. Under the short-run partial equilibrium framework of welfare analysis, it is difficult to generalize a particular theorem or draw a policy conclusion. Any policy decision should b e made and. analyzed separately according to the specific circumstances and variables the policy maker must deal with. But it is certainly true that in the short run either producers or consumers could benefit from price stability and that both could not be happy at the same time without some form of coun- terbalancing compensation. One could gain only at the expense of the other. The distribution of gain depends entirely on the source of instability and the level at which the price is stabilized.

The Waugh-Oi-Massel thesis is based on the assumptions of linearity and additive disburbance terms. However, the recent work by Turnovsky (1974, 1976) and Just et a1 (1978) proved that, given price expectations, non-linearity, and multiplicative disturbance terms, the Waugh-Oi-Massel thesis is not valid. Certainly, the most serious drawback of the Waugh-Oi-Massel thesis is that its anaiytical framework is short-run and based on the partial equilibrium model. In long-run general equilibrium analysis, price stability is always

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desirable for both producers and consumers, as Samuelson (1972) proved. Thus price stability should be pursued for its own merits, while the problems of international resource transfers should be dealt with separately.

IV. Policy Alternatives for Commodity Control

A wide range of commodity stabilization policy alternatives have been adopted on both national and international levels. As indicated in the previous section, the international commodity arrangements made by the United Nations as well as individual commodity agreements have adopted various stabilization policy tools designed to control volatile commodity markets. For importing countries, it is important to secure key raw materials at stable prices. In this section, the discussion on commodity control measures is limited to national devices that can be undertaken by importing countries. These include buffer funds, buffer stocks, multiple exchange rate systems and multilateral contracts.

IV.l Buffer A d s

The national buffer fund scheme was originally designed to protect producers’ income from price fluctuations through controlled producer prices. The scheme was operated by a newly established Marketing Board. When export prices are high, efforts would be made to raise stabilization funds from profits, which in effect are the difference between the actual export prices and lower producer prices paid by the Marketing Board. When the market is sluggish, the Board pays higher prices than the actual prices to maintain producers’ income above a certain level. This operational scheme can be employed by .other importing countries to protect the interest of local consumers from the volatile world market prices. By the same logic, the Importing Board supplies commodities to domestic consumers at controlled prices, thus accumulating profits when world market prices are low and subsidizing consumers when the prices are high.

IV.2 Buffer Stock

The buffer stock scheme is intended to intervene the market to defend the price target by managing stocks of commodities. Usually, the price band, having ceiling and floor prices, is adopted as a stabilization target. When the free-market prices rise above the ceiling prices, stocks are released and, when the prices decline below the floor prices, the buffer stock agency purchases a ielevant quantity of stocks until the prices reach the target levels. The price band can be set arbitrarily around the target price path, i.e. 510% or 520%’ and the smaller the range of the price band target, the greater the need for funds.

Determination of the target price is thc most controversal issue of the

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buffer.stock management and a key to its successful implementation. The target price should be set at the long-run equilibrium price which is determined by the long-run supply and demand curves of each particular commodity market, This would be the long-run marginal cost of production upon the entry of competitors. Thus, inefficient and costly producers would be driven out of the market and, consequently, the global market efficiency would be increased. If the price target is adopted incorrectly at either above or below the long-run equilibrium level, the stocks would continuously decrease or accumulate, which would cause the failure of a buffer stock scheme. The market intervention by stock management can only be justified by correct estimation and prediction of the price target on the basis of the long-runequilibrium trend, inasmuch as the buffer stock control smooths out only the stochastic parts of the free- market price path.

The buffer stock policy has been widely adopted on both national and international levels. A typical example is the stock management of the In- ternational Tin Agreement, which has been in effect during the last three decades. Similar arrangements are being considered for other commodities such as copper, natural rubber, and cocoa. As pointed out in section 11, UNCTAD is working on the Common Fund scheme which pools world-wide buffer stock operations involving 10 core primary commodities. The national buffer stock scheme is adopted by. both producer and consumer countries to protect the domestic interest from external disturbances. In the case of those commodity markets which have arrangements for international buffer stock operations, the national scheme would need a smaller amount of financial resources than it would otherwise.

The financial requirement often constitutes a bottleneck in implementing the buffer stock policy. The idea of establishing a price band rather than pursuing a complete stabilization is an outcome of the financial considerations. Under the assumption that the price movements of major commodities under consideration are stochastic, the pooled buffer stock management across. commodities would reduce financial need, since the buying and selIing ac- tivities can occur simultaneously. This motivated UNCTAD to promote the Common Fund scheme.

There are two types of storage rule which determine the quantity of buffer stock: the price rule and the quantity rule. The price rule is represented by-the storage equation as

u, = - &(P, - P,) where the level of buffer stock U, is estimated by the difference between a current market price P, and a target price P,. 6, is the storage coefficient which reflects the price elasticities of supply, demand and private stock-holding be- havior. The quantity rule is explained by the similar storage equation as

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where the buffer stock U, is obtained by the difference between a current production or consumption quantity Q, and a production or consumption target Qt. Again 6, is the storage coefficient. In general, the quantity rule is more appropriate to strategic commodities such as food and oil. In this case, the exact projection of consumption or production is important in order to prevent the waste of financial resources. The price rule is more conveniently applied to most of the market-oriented commodities under the free-market system. In this case, the accurate estimation of the price target is essential to the success of buffer stock management.

IV.3 Mirltiple Exchaiige Rate Sclieine

-

Whereas the buffer fund scheme protects the domestic consumers from the overseas market instability by means of stabilization funds, the multiple exchange rate scheme counterbalances the losses or windfall profits of private importers through manipulating foreign exchange rates. If world market prices are high, the import prices would stabilized by appreciating the domestic currency. In a reverse situation, the currency would be depreciated. The reva- luation of the domestic currency can be made on an ad hoc basis covering only a particular commodity or commodity group; or two different exchange rates can be used, as was the case in the Philippines. This policy has several advantages over buffer fund or buffer stock schemes, since it can be implemented without the need of stabilization funds and without running the risk that accompanies buffer fund or buffer stock operations. This can be interpreted as a tax-cum- subsidy scheme. Yet it is a convenient policy instrument because it can be maneuvered easily. Another merit of the scheme is that the government can profit from the multiple exchange rate system. Moreover, since the government can control the inflow and outflow of the domestic currency accruing from the foreign sector, an inflationary or deflationary impact can be minimized to protect the balance of payments position. Despite these merits, few countries tend to adopt the system because of difficulties in balancing various policy objectives, which sometimes conflict one another. An attempt to manipulate the exchange rate to increase government revenues and improve the balance of payments is incompatible with an effort to curb inflation. Furthermore, the adjustment of an exchange rate on an ad hoc basis would entail many un- desirable side effects on the national economy.

IV.4 Multilateral Contract

Multilateral contracts are made between exporting and importing countries. Such contracts impose some responsibilities on the member countries. For example, the International Wheat Agreements regulate minimum quantity of

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demand and supply in order to maintain the price of wheat within predetermined range. This is a diplomatic commodity arrangement which differs from the buffer stock or buffer fund schemes which require separate financial resources. A bilateral contract is a common version of such arrangement, which is made between two countries, i.e. a producer-exporter and a consumer-importer. This arrangement can be viewed as one form of a long-term contract for a specific commodity. A purchase guarantee is another type of multilateral contracts. Under this type of arrangement, only importers have an obligation to purchase a certain quantity of a relevant commodity. This can be worked out in coordination with a national buffer stock scheme. When private importers purchase less than the guaranteed quantity, the government would make an additional procurement to fill the gap and also to stockpile. In the case of excess demand, the government would thus be able to increase supply from the buffer stock.

V. Concluding Remarks.

Heavy dependence on imports for primary commodities poses many economic and diplomatic problems. Especially for small countries like Korea, the national economy is always vulnerable to major external changes. It is important to clearly identify problems arising from the market instability and to take appropriate policy actions accordingly. Given an array of alternative stabilization policies, policy makers should consider the theoretical aspects of price stability and consequences of welfare distribution. The small importing countries are always price-takers in the world market. Therefore, careful attention should be given to supply-shifting factors of major producer countries as well as demand-shifting factors of major consumer countries.

The government should take positive steps toward making various international commodity arrangements such as commodity agreements and multilateral contracts. In particular, diplomatic contracts with resource exporters, largely the Third-World countries, should be made prior to concluding international arrangements such as bilateral contracts or purchase guarantees. While it is difficult for a multi-country agreement to reach a consensus because of the different interests between the member countries, a bilateral agreement provides a practical and efficient way of achieving policy objectives. In addition to such a diplomatic commodity policy, the national buffer stock and buffer fund schemes constitute important stabilization policies toward providing a buffer against the adverse impact of world market disturbances. Since these policy tools are not mutually exclusive, the government should work out a optimum policy mix, depending on the market situation of individual commodities.

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Reviews on the Instability of Word Primary Product Markets arid Stabilization Policies

‘World Bank, The Probfetiis of Stabilization of Prices of Pritiurry Products, Washing-

Waugh, F.V. “Does the Consumer Benefit from Price Instability?”, QJE, 1944, pp. ton, D.C., 1969.

602-14. , “Reply”, QJE, 1945, pp. 301-3. , “Consumer Aspects of Price Instability”, Econonzetrica. 1966, pp. 504-8. , “A Comment”, QJE, 1972, p. 499.

Zucker, A. “On the Desirability of Price Stability: An Extension the Discussion”, Ecorzonzetrica, 1965, pp. 437-41.

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Reviews on the Instability of World Primary Product Markets and Stabilization Policies