There has been a complete transformation of many commodity markets over the last few years. One important change is the growth in the volume of trade in organized futures markets. A second is the decline in the power of many dominant commodity producers. It is well documented that for much of the post-war period the `core' of large producers were able to hold prices above that of the `fringe' of smaller firms. Recently this has broken down, and core producers now set prices much more in line with the fringe. In Discussion Paper No. 1193, Research Fellow Jonathan Haskel and Andrew Powell analyse these changes. They begin with a specific example, the aluminium market, where they document how futures trading has become more important and how core and fringe prices have narrowed. Second, they provide a model to explain these changes, based on the outcome of a series of interviews with market participants. These interviewees all stressed that while the good may be cheaper on the fringe, supply interruptions are more likely (due to less developed technology, political uncertainty, lack of inventory, etc.). By contrast, core prices are higher, but supply is assured.

The authors capture this idea formally by presenting a cartel/fringe model with search. The model adapts the standard approach by assuming that there is uncertainty about the supply of the good in the fringe. This can be thought of as imperfect information about quality, availability, location of the supplier, etc. By contrast, they assume that if buyers go to the core, the good is immediately available. In consequence, buyers must `search' for the good if they go to the fringe. In equilibrium, fringe producers charge a lower price to induce consumers to search. Hence, the model explains why core prices exceed those of the fringe. The model also explains why core and fringe prices narrow as trade is centralized. Centralization removes uncertainty and so makes buyers more willing to go to the fringe. Faced with this, core firms must reduce their prices. As supply becomes more and more assured, core prices tend to those on the fringe.

Cartels, Contracts and Centralization: The Transition to Futures Trading for Primary Commodities
Jonathan Haskel and Andrew Powell

Discussion Paper No. 1193, June 1995 (IO/IT)