Thursday, January 08, 2015

Lets hear it for the price mechanism

When we experience a prolonged period of rising prices in a particular category (e.g. oil, grains), and as especially prices trickle through to the supermarket shelf and to the petrol pump, books and articles are published lamenting this new state of affairs, with commentators often proposing that due to long-term shifts in global dynamics, the world has moved into a new phase and we had better adapt to it e.g. China will be demanding ever more protein, foodstuffs and energy and that's just the way it is, so you had better get used to higher prices.

I don't deny the changing fundamentals of the world economy but I do think that the dynamic response to prices is overlooked and under appreciated, not just by the layman, but also by journalists, politicians and the city. Oil is a case in point. When the price of oil was on the up, the higher profits on offer made it profitable to dig deeper and invest in more expensive extraction technologies such as fracking. So what happens next? I am simplifying but this is what it boils down to: supply goes up and the price goes down. You can overlay game theory, geopolitics, changing demand outlooks, etc to paint a richer, more complex picture but don't forget the main driver in the majority of these shifts: supply. Let's turn to the world of soft grains such as corn, wheat and soybeans. For many years, the price of these grains was on the up. How did the wily grower respond? Maybe devote a bit more land to the more profitable crop? Bingo. Over the past two years production of these grains has been strong and global stocks are very high. Resource is directed to the profitable activity and away from the less profitable.

Amidst the complex arguments, hypothesis and opinions put forward by commentators, let us not forget that it is the magical price mechanism and the entrepreneurial human being that make this happen.

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