International food prices have been soaring up day after day over the last one year: “food prices have jumped almost 60 per cent in the past year” (FT.com). Inflation could be described as the general increase in overall prices of goods and services in an economy that reduces purchasing power. Inflation could either be attributed to changes in supply and demand: “cost-push inflation and demand-pull inflation” (Heakal).
“Most commentators believe we are on the cusp of a new era of volatility and rising prices” (BBC news). The rise and fall in price of one commodity due to changes in demand cannot be referred to as inflation. We can only term increase in prices as inflation only if most prices are soaring high by certain rate across the economy.
Inflation is measured using consumer index and producer index. The consumer price index (CPI) is calculated by “taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance” (Investopedia). The CPI assesses changes in prices of goods and services associated with cost of living.
Supply and demand describes the effects on prices and quantity in the market. Demand is the relationship between prices of goods and the amount of goods buyers are willing to buy whiles, supply is the relationship between goods produced and market prices. “In a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity” (Mcnulty 394). A distortion on equilibrium will as result of shifting in demand and supply caused by factors affecting demand and supply respectively: prices of goods demanded and supplied, price of other related goods, government policies.
The question is what are the reasons behind the continued rise in food prices? As I stated earlier increase in food prices could either be attributed to forces of demand and supply in the market. “Aggregate supply is the total volume of goods and services produced an economy at a given price level at specific time” (Mcnulty 396). Cost of production determines the amount of goods and services to be supplied in the market. If the quantity of goods and services supplied to the market reduces as a result of increased cost of production, then we have cost push-inflation. Increase in cost of production is associated with increase in cost of factors of production such as; labor, land, entrepreneurship and capital when firm is working at optimal level. The firm’s objective is to maximize profits with minimal cost of production.
If the cost of production is high and production is at maximum, “firms cannot maintain profit margins by producing the same amount of goods and services” (Green et al). The firms will transfer the increased costs to consumers through increased prices of goods and services. If the cost of labor increases due to increased salaries or labor becomes more specialized, then the firm will allocate more resources to pay for the production of goods and services. Then the end result of increased labor will be felt by the consumer because producers pass the increased cost to consumer prices. Workers have always demanded for increase in their salaries and wages for their services to cope with the increasing cost of living. If the companies conform to demands for increased wages, then the increased cost of production increases retail prices.
Increase in the cost of raw materials has also contributed to increased food prices. This could be a result of scarcity and increased cost of importing raw material due to depreciating domestic currency (if raw materials are imported). Other factors that have led to rise in food prices through cost of production are; increased taxes imposed by the government to support her budget, increased tariffs on imported goods and quotas.
Apart from cost of production, there are other factors that affect the supply of goods and services and have contributed a lot to the soaring food prices. “Increased population has added environmental pressure and the effects of climatic change have affected food supply” (Josh). Increased population, especially in developing nations has increased pressure on scarce agricultural productive lands. The amount of rainfall received across many parts of the world has been reducing from time to time, causing crop failure. Reduced amount of rainfall has forced people to adopt irrigation as the alternative means to water their grains. Irrigation is a costly exercise compared to free rainfall, increasing the cost of producing food. As a result, the little amount of grains harvested from farms is sold at higher prices than before.
“Global warming has played a significant role in another driver of rising prices: the shift in agricultural production to biofuels” (Josh). For example “ethanol production which is a by-product of corn is accounted for high percentage on corn produced in United States of America” (Chakrabortty). This has significantly reduced the amount of land available for food production, thus pushing up the prices of corn flours on international markets. The above non-cost factors have led to a reduction in the supply of foods to feed the ever growing population.
“Demand-pull inflation occurs when there is increase in aggregate demand” (Grabianowski) in the households, business, government, and foreign buyers. The increasing aggregate demand is rising faster than the corresponding increase in aggregate supply. Demand-pull inflation happens when these four sectors are concurrently demanding more than the economy can produce. What happens is that increased competition for limited goods and services cause the price to rise. Increased government purchases have increased demand, pushing prices up.
Depreciation in domestic currency increases the prices of imported goods and reduces the prices of exports. As a result, the amount of imports reduces while the demand for domestic goods by foreigners increases, increasing the overall aggregate demand. Reduced taxes on consumer income increase their disposable income. As a result, consumers increase their spending, “demand for consumer goods increases resulting to overall increase in aggregate demand” (Froyer & Roger 10). The result translates to demand-pull inflation. The above happening with the assumption that the “aggregate supply cannot not keep up with aggregate demand as result of full employment in the economy” (Volker & Hans 790).
Increased demand for certain goods call for an increase in the production of that goods. In order for the producers to increase production, they will employ more factors of production. Allocation of more resources in production increases the cost of producing additional unit of output. Just like the cost-push, the producers will pass the higher production cost to consumers’ prices. The world population is expanding fast and has increased demand for food production. “There is incredible number of mouths to feed and will put pressure on a range of resources, including land, water and oil, as well as food supply” (Herro). As a result of this souring population growth, the prices of food has increased as people compete for the little available food, especially in developing nations which are prospering.
BBC News. Rising food crisis. 2008. Web.
Chakrabortty Aditya. 2007. Biofuels caused food crisis. 2008. Web.
Froyen, Richard T. and Roger N. Waud. “Demand Variability, Supply Shocks and the Output-Inflation Tradeoff.” Review of Economics and Statistics 67 (1985): 9-15.
FT.com. The global food prices. 2008. Web.
Grabianowski. What exactly is inflation? 2008. Web.
Green, J.R. Mas-Colell, A. and M.D. Whinston. Microeconomic Theory, New York and Oxford: Oxford University Press.1995.
Heakal Reem. Cost-push inflation verses demand-pull inflation. 2008. Web.
Hero, Alana. 2007. Food prices surging, raising hunger concerns. Web.
Investopedia. Consumer price index. 2008. Web.
Josh Gerstein. Food Crisis Eclipsing Climate Change. 2008. Web.
McNulty, P. J. “A note on the history of perfect competition”, Journal of Political Economy 75, (1967): 395-399.
Volker, Böhm and Hans Haller. “Demand theory,” The New Palgrave: A Dictionary of Economics1 (1987): 785-92.