Cobwebs in My Yogurt: Are Organic Commodity Prices Converging or Diverging?

One of my all-time favorite “discoveries” while an undergraduate student was encountering what is known as “The Cobweb Theorem” or “The Cobweb Model.”  While the Cobweb Model doesn’t offer guidance on as many facets of life as Mario Puzo’s “The Godfather” (“Leave the gun; take the cannoli”), it does incorporate a time element that impatient mobsters will never internalize: the delay.

Rather than repeat or re-post a good explanation of the Cobweb Model, I refer you to Wikipedia’s wonderful explanation and diagrams: http://en.wikipedia.org/wiki/Cobweb_model

But what does that have to do with my yogurt?

As the strawberry example in the first Wikipedia paragraph hints, in most organic commodity markets there is nearly a full year’s delay between observing a market price and seeing an outcome related to production quantity decision.  For an organic dairy producer, the supply of organic corn for feed is characterized in the supply curve, while the demand for organic corn for feed by the dairy producer depends on the profitability of feeding organic dairy cows at different organic feed prices.  Consumers aren’t represented in my labeling of Wikipedia’s charts, one of which I copied below so you wouldn’t have to keep flipping back and forth.

As a corn grower, you can respond to high organic corn prices by growing more corn (more acres), as when price P1 causes a shift from Q1 to Q2. But when quantity Q2 is supplied in the market, price P2 must prevail to clear the market.  My organic dairy operations are profitable and the supply of organic yogurt expands (so to speak).  But before I can count my milk check money, you, as a reasonable steward of your economic resources, cut production of organic corn from Q2 to Q3 because the price P2 is too low for profitable organic corn production.   Maybe you decide to put the land into organic rutabagas instead, to make more money. 

The following year, when Q3 is produced, my organic dairy peers and I fight over the reduced supply of organic feed corn in an economic manner, by bidding the price up all the way to P3.  Yikes.  Clearly, some of us need to sell some cows if P3 is going to prevail in the feed market.  Who can make money at that price?  And so it goes, year after year.

Now, there are two fundamental determinants of whether I can clear the cobwebs from my mind.  The first, as the Wikipedia article elegantly illustrates in both math and layman’s terms, is the concept of elasticities, or in graphical terms, the relative slopes of the supply and demand curves (you can think of elasticity as responsiveness to price). If the price elasticity of demand is greater than the price elasticity of supply (demand is less steep than supply), prices will tend to converge, dampening out the year-to-year effect.  This scenario is characterized (between you and me) as me, the organic dairyman, being able to adjust my cow numbers in response to organic corn prices faster and more readily than you can adjust your corn acreage in response to corn prices, stabilizing prices by expanding and contracting demand quickly. While this notion is appealing, it is biologically inconsistent.  Cows take longer to bring into production, since becoming mothers is what causes them to let down milk, right?  They are adults.  If I cull the cows, they cannot be easily replaced within a few years.  In contrast, corn can be seeded or not each year.  Thus, it is intuitively consistent, though merely a maintained hypothesis, that organic dairy production is less elastic to organic corn price than is organic corn production. Thus, it follows that we would expect the markets to diverge, having an increase in price volatility.

 While the data is thin, there is some data.  USDA’s Ag Marketing Service recently reported the organic feed corn prices appearing in this chart. (http://www.ams.usda.gov/mnreports/lsbnof.pdf)

For comparison, I made the chart below of prices of conventional corn received by farmers from USDA data.

A similar pattern exists for organic soybeans.  Both organic corn and soybeans were trading at slight premiums to their conventional GMO cousins a few years ago. In fact, in the summer of 2010, there was barely any premium for organic corn over conventional corn.

Current organic prices are more than twice conventional prices, indicating wide price variation in one-year steps.  Smells like divergence, doesn’t it?  If you want to go back a few years, you will notice that tremendous price premiums for organic feed commodities existed for a short while prior to 2010.

Lastly, there is another determinant in clearing up the cobweb problem, and that is the concept of rational expectations.  Continuing our hypothetical situation, you are going to act rationally based on your expectation of the organic corn price next year at harvest.  I am going to act rationally based on my expectation of the organic corn price after harvest and beyond.  But the organic pricing system is broken, or was never completely built.  Conventional grain markets have futures markets for determining the price 3 months from now or 18 months from now.  Organic markets have avoided any correlation with conventional markets and have no analog for forecasting prices 12 to 18 months forward.  Therefore, we cannot expect a convergence of expectations because these markets have not adopted the stabilizing characteristic of reference pricing. 

My yogurt is destined to have more cobwebs before it has fewer.  Altogether, the evidence points toward more chaotic pricing in organic commodity markets, with shortages and high price premiums followed by severe over-production/under-utilization until something changes.  I’m pretty sure a futures market or a reference pricing mechanism would help.  And I’d like a definitive measurement on some of those squigglies, as C. Robert Taylor called them, specifically the price elasticities of supply and demand in a multi-market framework.