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Introduction to the Economics of Food: What Goes Up…

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Patrick Westhoff explains how understanding why food prices rise and fall can help us anticipate and react to future market developments and make important decisions as a society about how best to feed and fuel the planet.

Everyone eats, and billions of people around the world work in agriculture and related industries. Food prices are important to everyone and literally a matter of life and death for some.

The prices we pay at the grocery store depend on everything from the weather in Iowa and India to the types of fuel we put in our cars in London and Los Angeles. Economic growth in China affects the price of a pizza in Chicago. Understanding why food prices rise and fall can help us anticipate and react to future market developments. It can also help us make important decisions as a society about how best to feed and fuel the planet.

For many years, food prices did not get a lot of attention. From 1991 to 2006, U.S. consumer food prices increased just 2.5 percent per year, slightly less than the overall inflation rate.1 Crop and livestock prices varied from year to year, but with little overall trend.

Food prices got a lot of attention in 2007 and 2008. Front-page stories highlighted a sudden rise in food prices and a December 2007 cover story in The Economist proclaimed "The End of Cheap Food." U.S. consumer food prices rose 4 percent in 2007, the largest increase since 1990, and the rate of food price inflation jumped to 5.5 percent in 2008. The surge in prices of basic staples was even more dramatic. Corn prices more than tripled between the fall of 2005 and the summer of 2008.2 Prices for wheat, rice, soybeans, and many other staple foods also rose sharply.

The rise in food prices was a concern in the United States, but a crisis in much of the developing world. The average U.S. family of four spent $8,671 on food in 2007,3 and rising food prices made it harder for families to make ends meet. In low-income countries, the average family may spend half or more of its income on food. Sharply higher prices for staple foods meant low-income families were faced with a stark choice of eating less or cutting back on other necessities. The Food and Agriculture Organization estimates that millions of people were added to global hunger rolls in 2007 and 2008, leaving 915 million people undernourished. The world economic crisis could push that number over a billion in 2009.4

What goes up can come down. Just about the time many people became convinced that high food prices were here to stay, prices for grains and other crops retreated. Traders from around the world use futures markets to make or hedge bets about current and future prices for food and other products. Wheat futures prices reached record highs in March 2008, corn peaked in June, and soybeans in July. By late October 2008, wheat and corn futures had declined by more than 50 percent from the high, and soybean futures had dropped almost as much.5 After peaking in June 2008, FAO's food price index fell by one-third over the next six months.6 What happened? After years of stagnation, why did food prices suddenly explode and then collapse? Was this just a short-lived crisis, or are higher food prices and all their consequences likely to be the norm in the years ahead?

Journalists, policy makers, and economists have tried to explain the rapid changes in food prices. Some have provided well-reasoned analyses that carefully identify and weigh the many contributing factors. Others have tried to reduce the complex story to a sound bite, often to make a political point. A lot of information is available, but it is not easy to separate the information from the misinformation.

Increasing amounts of corn, sugar, vegetable oil, and animal fats are used to make ethanol and biodiesel, two biofuels that can be used to fuel cars and trucks. The role of biofuels in the increase in food prices has been especially controversial, and the debate has often generated more heat than light. Some have laid much or even most of the blame for higher food prices on the growth in biofuel production in the United States and Europe. The more grain and vegetable oil is used to produce these biofuels, the less is available to feed people, biofuel opponents argue, and the losers in this food versus fuel battle have been food consumers around the world. Often quoted was a note by a World Bank economist that suggests the increase in biofuel production directly or indirectly accounted for 70 percent to 75 percent of the recent increase in food prices.7

On the other side of the argument, biofuel defenders point to a variety of benefits of the industry and contend that the role of biofuels in raising food prices is minimal. The share of the world's crops used to produce biofuels remains very small, they point out, and farmers around the world can and will increase production to satisfy the demand for both food and fuel. Former U.S. Secretary of Agriculture Ed Schafer frequently claimed that increased corn-based ethanol production only accounted for 3 percent of the increase in global food prices.8 The actual impact of biofuels on food prices was almost certainly greater than biofuel proponents would like to acknowledge, but less than biofuel opponents claim.

This book makes sense of the various arguments about recent swings in food prices. Was the run-up in food prices a fluke, or a sign of things to come? Understanding what happened and why may affect how we spend and invest our money, and determine the types of public policies that make sense. Even if it is not possible to develop a perfect forecast of future food prices, it is helpful to identify some warning signs that prices are likely to rise or fall.

Given the size and complexity of the world food system, the list of forces that determine the price of food is incredibly long. This book is not intended to examine every aspect of the issue, but instead focuses on a few of the most important factors:

  • Biofuel production
  • Energy prices
  • Government policies
  • The weather
  • Economic growth and changing diets
  • The value of the U.S. dollar
  • Speculation

None of the items on the list would surprise anyone who has been following news reports about food prices. Indeed, a lot of the reporting did get important parts of the story right. Expanding biofuel production has increased the demand for grain and vegetable oil with impacts across the entire food system. Higher energy prices do increase the price of producing, processing, and transporting food and encourage the growth of the biofuel industry. Government policies did contribute to the increase in world food prices by supporting growth in biofuel production, restricting food exports, and eliminating buffer stock programs. Poor weather in 2006 and 2007 did reduce grain production in a number of key exporting countries. Economic growth in China and elsewhere has led to changing diets that have increased the demand for meat and dairy products, with important implications for world trade and food prices. A weaker U.S. dollar does contribute to an increase in U.S. food exports and in dollar-denominated prices. Market speculators can amplify price swings, and many nontraditional investors were heavily invested in futures markets for farm products.

While many of the conventional explanations for the rise in food prices in 2007 and early 2008 are at least partially correct, the story is often much more complicated. For example, it is true that poor weather reduced grain yields in 2007 in Australia and Europe, but production elsewhere rose and global grain production actually increased. Rising incomes in middle income countries do result in dietary changes that affect world food markets, but these changes didn't suddenly begin in 2006. Changes in currency values mean that price movements do not look the same when expressed in dollars, euro or yen, but food prices increased sharply in every major currency between 2005 and the summer of 2008. Much of the reporting would have led one to believe that food prices could only increase, yet prices for major staple foods declined sharply in the final months of 2008.

The story of biofuels and food prices is anything but simple. The biofuel industry did not fall unexpectedly from the sky, but grew rapidly in response to government policies and energy market developments. In the United States, current policies include minimum use requirements, tariffs on imports and tax benefits for those who blend biofuels with gasoline and diesel fuel. This creates a very complicated relationship between fuel and food markets. Under some circumstances even modest changes in petroleum prices may translate into significant changes in food prices; in other cases the relationship may be weak.

An important argument of this book is that almost all of the major factors that caused food prices to rise from 2005 until the first part of 2008 were reversed and contributed to the decline in food product prices in the final months of 2008. Better weather led to sharply higher yields in Europe and Australia. The world financial crisis reduced purchasing power of countries and individuals, and this translated into lower consumer spending on some types of food. The dollar strengthened, petroleum prices fell, biofuel production growth slowed, policies were reversed, and many speculators abandoned food product markets. Food prices will continue to be volatile as long as the weather varies, the macroeconomy experiences periods of growth and recession, petroleum prices rise and fall, and politicians can change the rules of the game.

This book is an outgrowth of work done by the Food and Agricultural Policy Research Institute (FAPRI), a joint institute of the University of Missouri and Iowa State University. Each year, FAPRI prepares a very detailed set of baseline projections for U.S. and world agricultural markets. These baseline projections are then used as the point of departure for analyses of alternative policies and market conditions. For example, during recent debates on 2007 energy legislation and the 2008 farm bill, FAPRI estimated how food markets would be affected by some of the many policy changes that were proposed.

One thing FAPRI has learned over the years is that people who make and use market projections need a good sense of perspective—and humor. In a rapidly changing world, even the best projections have a very short shelf life. The economic models used to develop the projections necessarily rely on a long series of assumptions, and at least some of these assumptions always prove to be incorrect when viewed with 20-20 hindsight. Just to take three obvious examples, FAPRI baseline projections assume average weather conditions prevail around the world, current policies remain in place, and petroleum prices follow a particular path over time. In reality, the weather is never average, policies change, and petroleum prices evolve differently than anyone could predict. The "garbage-in, garbage-out" rule applies: If the assumptions underlying the baseline are incorrect, the projections will also be incorrect.

For all these reasons, this book uses market projections by FAPRI and other institutions simply to illustrate important points, rather than to predict what will actually happen. If there is one lesson readers should take away from this book, it is that analysts who say they know exactly how food prices will evolve in the future are misleading their audience or fooling themselves. By focusing instead on the factors that will drive future food price changes, the goal is to provide the tools needed to understand a fast-changing world.

Chapters 1 through 8 explain some of the factors that have contributed to recent volatility in food prices. Each chapter starts with a rule of thumb, discusses how it applies to the 2005–2009 period, and then explains how the full story can often be a little more complicated. Chapter 9 takes a longer view, identifying some of the forces that will determine what the price of food will be 10, 20, or 50 years from now. An appendix provides a primer on world food markets as background for the material presented in the rest of the book.

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