If you were in a business that suddenly became 10 times more profitable overnight, how would you react?
You would probably stay in the business, and would probably want to increase your sales as much as possible.
But what if this boost in profitability was short-lived? What if your business went from moderately profitable to loss-making in the same space of time? Would you quit and move to something else?
What if you had just begun, not yet paid off your initial investment, and had no resources or expertise to start something new? How long would you endure the loss and scarcity?
In my last article on price elasticity of demand, we focused on how consumers and others react to price changes. This time, we’re looking at the opposite end of the supply chain, to analyse how coffee farmers and others on the production side react to price fluctuation. Read on to find out.
You might also like our article on what would happen if coffee became more expensive.
Price elasticity of supply
Simply put, price elasticity of supply is how much supply is offered onto or taken off of the market by sellers in response to a change in price.
It is generally positive, meaning that as the price rises, sellers offer more. Conversely, as the price falls, sellers generally offer less.
However, it’s important to remember that supply can sometimes be “sticky”. This means that it can’t simply be turned off and on immediately in response to price fluctuations.
In the coffee sector, when the price is high and farmers produce more, the supply rises. However, during the periods of constant demand that follow, the additional volume on the market puts downward pressure on price.
Conversely, when the price is low, less coffee is produced and offered by farmers. Under the same conditions, that reduction in supply (scarcity) would put upward pressure on price.
Are price movements natural? Should we accept them?
In mainstream microeconomics, we generally take for granted that this concept always works perfectly, and that markets unconditionally self-regulate.
However, the markets do sometimes fail to do so, which has an impact on the entire supply chain – but is especially uncomfortable for those exposed to the greatest risk, typically farmers.
If price fluctuations are simply the market’s way of regulating itself, it’s tempting to accept that they are normal, natural, and necessary events that keep the market healthy.
However, while the price of coffee does change in search of equilibrium between supply and demand, this process is often violent and traumatic for many.
Those who are most affected are producers, who are on average the most economically vulnerable, and least able to protect themselves from fluctuation.
Additionally, price movements aren’t always enough to reach equilibrium of supply and demand, especially in periods of low prices. This has to do with the price elasticity of supply.
So what actually happens in the coffee sector?
In the case of tree crops, like coffee, markets can fail to self-regulate, or do it so slowly that the resulting effect is different or even the opposite to what would be considered rational behavior.
When the price is high, more supply is offered. When it is low, less supply is offered. Supply rises and falls in response to price (among other things), which fluctuates for many possible reasons. This theoretically represents equilibrium.
In theory, this makes sense. But in practice, it looks very different.
When the price of coffee is high, farmers often seek to produce more by planting more. However, this rational response to a price movement does not increase supply immediately. There is no downward pressure on price until the new trees produce and their crop goes to market, which can be as long as three to five years later.
By that time, the market may have swung back down, and the influx of new coffee will put more downward pressure on a price that may already be low. Those who planted in response to the spike will have lost out.
This is precisely what happened through the 1980s, when there was an influx of new coffee that had been planted following the 1975 frost in Brazil.
The inverse is also the case when prices fall, as the only way to bring them up is to reduce supply. Since planting and cultivating coffee trees is a significant investment with a delayed return, and coffee trees have a relatively long life, producers are unlikely to cut them down.
Losing their investment because of one or two seasons of low prices would be short-term thinking. Instead, producers will hold out and hope to make back their investment in subsequent seasons.
There are several other reasons that producers, especially smallholders, would be unlikely to attempt to reduce the supply of coffee on the market, even when prices are low.
- For instance, they may be in debt from planting these unprofitable coffee trees, lacking capital to transition to something more profitable.
- Even if they do have the capital, there may not be any alternative crops that they could grow and sell profitably.
- If there are, coffee producers may not have the knowhow to plant and process them.
- Many coffee-producing regions are isolated and economically dependent on coffee, and lack any other opportunities for income.
So, while the market should theoretically regulate itself, this may be delayed while millions of vulnerable families suffer, before eventually supply reduces to a supposed equilibrium level.
Incentives & opportunity cost
When prices are low, there is an incentive to reduce production.
A significant reduction (e.g. repurposing existing coffee-growing land) only happens only when the production and sale of coffee represents an opportunity cost.
When profits fall below the potential profits of doing or growing something else, we refer to the difference as the “opportunity cost”. This is the forgone profits of not doing that other more profitable thing.
However, since significant resources are generally invested in a coffee plot, that opportunity cost often needs to be significant enough for producers to decide to abandon it and plant something else.
When there are few or no alternative crops to plant or off-farm opportunities, the price elasticity of supply would be very low, meaning that producers will be unlikely to reduce supply voluntarily. The opportunity cost would also be very low if there is nothing else they could be doing instead.
This means that if the coffee price falls and remains painfully low, the market may not actually experience a supply reduction sufficient to bring it back up again for a long time. During this period, it would operate in a state of disequilibrium.
By some estimations, the global coffee market has, in fact, operated for extended periods under conditions of oversupply, such as those that followed frosts in Brazil in 1975 and 1994
In contrast, there are times when prices are high and coffee presents are a more attractive opportunity than what is currently planted. The decision to plant coffee may be a simple one if the current planting is an annual crop like carrots, beans, or maize. A situation like this favours the overproduction of tree crops versus annual crops.
What about quality & premiums?
In addition to the decision to produce more or less coffee, we also have to consider the type or quality of coffee which price increases incentivise.
When the sale price is low, producers have a greater need to seek price premiums, such as those offered for higher grades or differentiated quality.
At the same time, buyers have outsized purchasing power, because they can get coffee far below their maximum budget. Because they have the ability to offer premiums which producers desperately need to stay afloat, buyers can demand more from producers in exchange.
On the other hand, when prices are high, buyers have less capacity to offer premiums. This is because they must pay prices closer to their maximum budget in order to acquire coffee.
Furthermore, in this situation, producers are better equipped to make ends meet without premiums. Therefore, buyers have much less leverage to demand high quality and special processing methods from producers.
We saw this phenomenon in Colombia for months after the civil unrest in May 2021. A large portion of producers have begun selling wet parchment into the commodity market at the commodity price. However, by doing so, they have been earning in many cases much more than they earned for specialty coffee 12 months prior.
Speculation & hedging
At this point, we need to understand that these price fluctuations are not exclusively based on the supply of and demand for coffee. Instead, they are influenced by the coffee’s futures contract, which largely reflects technical speculation.
Most studies have shown that the futures price doesn’t necessarily move counter to physical fundamentals. Instead, they posit that these responses are exaggerated – meaning that the highs are higher and the lows are lower than they would be otherwise.
Why does this matter? Well, it’s complicated, but to put it simply, this means the supply of real coffee isn’t always completely responding to the demand for coffee. Instead, it’s responding to the demand for coffee futures contracts – the vast majority of which will not become physical purchases.
Likewise, the demand for real coffee doesn’t only respond to the supply of coffee, but instead the supply of coffee futures contracts.
Let’s say that the price elasticity of supply is such that a 10% increase in the market price (based on the futures price) eventually causes a 10% increase in global supply.
However, hypothetically, technical speculation, not shortage of physical coffee, is responsible for half of that price swing.
In that case, a 5% increase in supply would be enough to cover the shortage. So, instead of simply filling a need, this reaction creates an oversupply. This eventually causes prices to crash. In time, technical speculation then jumps on board and exacerbates that downward swing.
In summary, exaggerated market signals cause exaggerated reactions from market actors, which results in even greater volatility. This is the lifeblood of short-term speculation.
In the coffee sector, price changes create incentives that theoretically ensure that the quantity supplied equals the quantity demanded.
How much sellers increase or decrease the quantity they offer the market in response to price changes is the price elasticity of supply. This depends on many factors, but is complicated by the fact that coffee, as a tree crop, responds painfully slowly to market signals.
Each shift presents an opportunity for some and adversity for others. However, some actors are better positioned to take advantage of opportunities and more able to protect themselves from adversity. Furthermore, this compounds over time with every market rally and every crash.
Want to learn more about the coffee supply chain? Take a look at Karl’s course on PDG Education.
Photo credits: Karl Wienhold
Perfect Daily Grind
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