Wednesday, May 18, 2011

Commodities: Do High Prices Destroy Demand?

From University of Illinois' farmdocDAILY:
During the period of rapidly increasing commodity prices since the summer of 2010, there has been occasional reference to “demand destruction” resulting from higher prices. That terminology is misleading and conceptually incorrect. What commentators are generally referring to, of course, is that high and increasing prices would be expected to result in less consumption of the commodity than would have occurred at lower prices. That relationship, however, does not constitute demand destruction. That is, a change in consumption in reaction to a change in price does not represent a change in demand.

Demand for a commodity is generally described as the negative relationship between price of that commodity and the quantity that end users are willing to consume. That is, all else equal, users would be expected to consume more at lower prices and less at higher prices (figure 1). Conversely, producers of the commodity would be expected to produce more at higher prices and less at lower prices (positive relationship between price and quality), all else equal. The market equilibrium price and quantity are established by the intersection of supply and demand (figure 2). For annually produced crops, supply for a particular marketing year is essentially fixed (vertical supply curve) at the level of production plus stocks on hand at the beginning of the year. With a given demand structure, a small crop would result in less consumption and a higher price than would occur with a large crop (figure 3). That change in consumption, however, does not represent demand destruction, but rather a movement along the demand curve.