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Wednesday, January 24, 2007

The dynamics of a competitive market

As described in the latest Crop News Weekly:
Not only are there good economic reasons to plant more corn this year but there's the issue of supply and demand. As ethanol production goes into overdrive around the country more and more corn is going to be needed to keep the pace. The down side for the industry could be as more and more corn is used for fuel production, there will be shortages, at least cost increases, for livestock producers and consumers. Combine this with the potential for shortages in cotton, soybeans and other crops where fields were converted to corn production, and it becomes apparent that too much of a good thing could, in the end, make for other types of industry problems in the months and years ahead. Is it a catch 22 scenario? Perhaps not initially, but down the road we may all pay a little more for taking advantage of the popular and developing trends in corn farming. But then, who wouldn't be lured by strong prices and high crop demand? Converting production to corn from other traditional crops may well be "gold" initially. But let's not forget that the day will come when switching back to other types of crops may be just as profitable and necessary.

In other words, the freedom of entry and exit in the agricultural sector is key to the near-term future of the industry. In the short run the increased price for corn will lure some farmers to switch from crop A to growing corn. The supply of corn will increase, but more importantly the supply of Crop A will decrease. If the demand for Crop A doesn't decline, the price of Crop A will increase. Meanwhile, it isn't clear that the price of corn will decrease in the medium run as the demand for corn might continue to increase through government mandate.

The end result is that the price of corn might permanently increase, with subsequent cost increases for other agricultural producers, and the price of other crops might also increase as a) current farmers move into the corn market and b) marginal lands are brought on-line to produce soybean and other crops.

This is going to be an interesting natural experiment. However, given that the ag sector is less than 5% of the nation's economy and employs less than 3% of the labor force, it is unlikely that even seismic changes in the ag sector will generate excitement beyond the principles classroom.

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