Model on commodity price movements

Simple models can tell a story far better than a thousand books. Here is one that brings in a lot of clarity to the raging debate that is going on about the future of commodity prices.

Standard economic theories argue that in response to increased demand (as is happening now, due to increased demand in emerging economies), prices increase first since the supply response is constrained in the short run. In the long run, as firms expand their capacities, supply increases and prices drop. This movement, as depicted in Mark Thoma's blog here, is represented in the graph below.



The short-run supply curve (SRS) is steeper than the long-run supply curve (LRS), so at first the price rises from Pa to Pb, and this generally happens fairly quickly as shown on the second graph tracing price movements over time (i.e. the time to move from T1 to T2 is relatively short). LRS and LRS1 are supply curves for two different commodities having varying elasticities of supply. The movement of the price path over time depends on the commodity in question.

Mark Thoma writes, "For some goods, like wheat, we expect to see a price movement from a to b to c, i.e. the new long-run price will be near the old long-run price (as shown in the second diagram). However for other goods like oil or copper, we expect that the price path will move from a to b to c', i.e. the new long-run price will be much higher than the old long-run price (not shown on the second diagram, but easy to visualize)."

Therefore, for oil and minerals, whose supply is relatively inelastic, the equilibrium price is likely to not fall by much and will therefore be closer to the short run increased price. In contrast, the prices for commodities like foodgrains whose production can be increased relatively easily, are likely to fall substantially from the short run higher price and settle at a price closer to the previous equilibrium. The same logic would apply to the time taken for the shifts to take place - faster for agriculture commodities and slower for oil and minerals.

Admittedly, the model is a fairly simplified version, but a fairly valuable starting point nevertheless. More complex models involve accounting for shifts in the LRAS itself. This happens when there are changes in labour (eg. shifts in occupational patterns), capital (eg. a credit squeeze driving down investments), natural resources (eg. high costs resulting in changes in consumption patterns), and technology (eg. search for alternative sources of fuel). As can be seen from the graph below, the supply and demand response to such changes and its impact on long run prices are not easy to predict, and depends on the relative elasticities of the supply and demand curves and the interaction with substitute goods.