Food and energy prices are notoriously volatile and make it difficult to read consumer price indices. But why are they so volatile? Why are things that we buy everyday in relatively constant quantities so volatile in their prices? Well, it’s all explainable by looking at the price elasticities and the slopes of the supply and demand curves. Since we do buy them in relatively constant quantities, that makes demand relatively inelastic. Since supply in the short term is also inelastic (it takes time to plant and grow more food), the result is that even very small shifts in demand (more people or a preference for meat which takes more grain) or small shifts in supply (a poor harvest in some country) will make price shift a lot. For a more detailed explanation and graphs, see below the fold how EconomicsHelp.Org explains it:
In a recent post, we looked at food inflation and noted how prices were often volatile. Primary products like food and oil tend to be volatile because:
Diagram showing price volatility when demand and supply are inelastic
Supply is inelastic in the short run. It is not easy to increase the supply of agricultural production in the short term. You need to plant more seeds, trees, which take at least a year. Therefore, supply cannot easily respond to increases in price. A manufacturing firm can probably pay workers to do overtime and increase supply in response to rising prices.
Demand is price inelastic in short run. Because many agricultural products are basic necessities, a fall in price doesn’t encourage people to buy more food. If potatoes are cheaper would you eat more potatoes? If coffee was cheaper, would you drink more coffee? – probably not very much. Therefore, an increase in supply leads to a correspondingly bigger fall in price. If demand is more price elastic, price wouldn’t fall as much.
Supply influenced by weather / nature. Growing crops is influenced by weather and disease. A sharp frost can wipe away a crop leading to higher prices. This kind of volatility is not prevalent in manufactured goods.
Speculation. Many commodities are made more volatile by speculation. Often this speculation is based on economic fundamentals, but can exaggerate price movements. For example, if oil prices are predicted to rise, investors will buy now causing prices to rise. It is hard to separate speculation from economic fundamentals as they are often intertwined. But speculation is a much bigger effect on price in agriculture than manufacturing.
Elastic demand leads to smaller change in price