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Reflections In A Cup: Where Do Prices Come From?

Where Do Prices Come From?


June 13, 2008
By Stuart Daw

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For a series of reports dealing with the impact of Katrina on coffee
prices, the reader might consult the Heritage website
(www.Heritage-coffee.com). Here, however, I would like to look at how
commodity prices are determined, given a free market.

For a series of reports dealing with the impact of Katrina on coffee prices, the reader might consult the Heritage website (www.Heritage-coffee.com). Here, however, I would like to look at how commodity prices are determined, given a free market.
 
We in the coffee business have a right to be concerned about costs other than the coffee itself, such things as the high price of gasoline used in distribution, natural gas in roasting, and the increased cost of petroleum-based packaging materials, to name just a few.

On the Tuesday morning following the hurricane that hit Louisiana, but just before the news arrived of levees bursting and the flooding of New Orleans, I answered a telephone call from the anchor of a CBS morning program. She was preparing an item dealing with the “corporate rip-off” in gasoline prices, already high, but sure to be higher following Hurricane Katrina’s devastation of offshore drilling in the Gulf.
 
She had heard of something similar going on with coffee. What would the effect be on coffee prices, given the news of New Orleans’ importance and huge inventory of green coffee stored there?

She came to my office along with her cameraman for an interview. The ensuing conversation demonstrated the kind of reaction to rising commodity prices shown by many media people, reflecting a total lack of understanding of the free market, with respect to how prices get where they are.
 
As an aside, most coffee people know that pricing at the retail level is quite different from that of foodservice. The large retail giants normally raise wholesale prices in step with the current market, whereas foodservice suppliers normally work out of inventory. That means a spread of around two or three months between the time of retail and foodservice price changes.

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It normally follows that the same method applies to a falling market. This causes considerable stress for the foodservice suppliers when, as happened shortly before Hurricane Katrina, Folgers announced a small price decrease.
 
Foodservice customers, reading the papers or listening to the news might unthinkingly react with,  “Hey, where’s my decrease?” The truth be told, when the market had risen around 80 cents per pound (US$, green), the retail roasters had wasted no time in quickly following. So when the market receded to a level commensurate with current foodservice costs, the retail types looked like heroes in dropping prices, while there was no room for the foodservice roaster to do the same.

For the impatient buyer, there should be satisfaction in knowing that competition makes it impossible for a roaster to “rip off” the customer. But if prices rise rapidly in any commodity, surely someone must be to blame. And, “we don’t want to hear that old excuse about shortages,” the customer might say.

So who is ripping off whom?

There are good examples from coffee’s past about public confusion over rapidly rising prices, accompanied by politicians and consumerists wanting to launch “investigations.” But the best example currently is perhaps that of oil.
 
Nightly newscasts are replete with worried-looking anchors grilling oil industry executives or economists in search of “the truth.” Somebody must be hiding something.

Fears about oil prices were exacerbated by the hurricane, for in the few days following the storm they did indeed rise. The effect on coffee may turn out to be minimal, but there was no hesitation regarding oil, for gasoline prices took an immediate and visible hit, driving politicians to either flee from any responsibility or to rush into the breach, blaming everyone in sight but themselves.
 
So who or what is to blame anyway? Could it possibly be that there is no one to blame, and that instead of blame, warm thanks are due to that most vilified and misunderstood thing called the Free Market? Could it be possible for everyone to understand the dynamics of the free market and to stop thrashing around searching for scapegoats?
It isn’t just media people, politicians, or consumers that seems to be confused. This was demonstrated a few days before this writing in another television interview that I witnessed. A professor of economics from a leading university was being interviewed by a popular anchor who was aggressively hitting at “corporate rip-off artists,” those cold, heartless tycoons who were not only greedy but racist in their motivation as well. Citing the oil companies’ “obscene profits,” the anchor was anxious to find the true culprits in the whole supply chain.
The professor calmly diffused any idea that gas station operators were to blame, pointing out that their markups of a few pennies a gallon were not increased when new inventory arrived. He also, though rather lamely, exonerated the oil companies, citing the need for new drilling and exploration, and saying they had a right to profits in a free country, however “obscene” they may seem.
He even raised the entirely reasonable argument that when rapidly rising well-head prices occur, wholesale and retail selling prices should reflect those increased costs immediately, or else where would the money come from to pay these new replacement costs? After all, if a company has been collecting one dollar per gallon for gas, but the replacement cost is two dollars, the transition could be painful – how would it pay for the new inventory?

But as brave as the professor’s answers were so far, he copped out when the anchor demanded to know, “then just who is responsible?” He meekly answered that it must be the “speculators,” those mysterious operators in the backroom that no one ever sees. Who are these guys (or gals) anyway, those non-operating people dealing in futures and raking in all the money?

In fact, those much-vilified speculators play a crucial role, not just in “discovering” proper prices, but in ensuring that there will always be a supply of the item in question. Those gutsy chance-takers can often be the unsung heroes of a serious predicament, such as during the OPEC crisis in the early 80s.
 
Saudi Arabia was to oil then what Brazil is to coffee now. As I recall, OPEC tried to maintain a price of $24 per barrel and the Saudis, by simply turning the tap on and off, were regulating supply, thereby keeping it limited. Other producing countries needed (wanted) more money, and deals were being made under the table. So it was a phony shortage and traders, seeing a growing imbalance, a rising glut of oil, went short, and soon there were few who would take the long side. Prices collapsed.
 
In the case of a real shortage, the tendency is for politicians to meddle in the process by wanting to freeze prices, or take other action such as “price gouging” that only distorts the situation. The proper    prescription for shortages is higher prices, curbing demand and eventually restoring equilibrium.
To charge suppliers with gouging is not only unfair, it is immoral. And the only way politicians can get away with it is because they know they are dealing with an economically illiterate electorate.
Governments forcing oil companies to lower prices would only increase demand. Lower prices would also encourage the purchase of more SUVs, those guzzling monsters so unpopular with modern liberals and environmentalists.
 
The same governments encourage shortages by refusing to drill for oil in their own country, as in the case of Alaska, or by denying clean coal-generated power, or the ultimate resource, atomic power. They don’t seem to recognize that the earth is one big ball of energy to its very core.

Coffee is subject to the same forces of supply and demand as oil. If supply exceeds demand, prices fall. If demand exceeds supply, they rise. And it isn’t just the current relationship of supply and demand that matters. The perception of future supply and demand is crucial as well.
 
Thus, as mentioned above, if the perception of future world production is that there will be an over-supply of coffee next year, unless and until that is proven wrong, prices are not likely to rise in the interim. Meanwhile, the good news is that it’s raining in Brazil.