Commodity Prices
Unexpected effects

Primary commodities are vitally important to the less developed countries (LDCs), and the recent crisis in the tin market has underlined the problems caused by violent fluctuations in commodity prices. Many developing economies depend on revenues from one or two commodity markets as their main source of income and foreign exchange: 46 out of 74 developing countries listed in the 1980 UN Yearbook of trade statistics had a non-fuel commodity as their main export; and for 29 of them, non-fuel commodities provided over 75% of their export earnings. Few LDCs are sufficiently diversified to be able to absorb commodity price fluctuations: they contribute to internal instability and interrupt the flow of finance for development. The LDCs have therefore sought commodity market stabilization agreements in which prices would be more stable, higher on average, or would help redistribute productive resources from consumers in the 'North' to producers in the 'South'.

Copper is one of the ten 'core' commodities singled out by UNCTAD as being particularly suited to a stock-piling agreement. It is also a prime candidate for stabilization. The free market (London Metal Exchange) price, at which the bulk of the metal outside the communist bloc exchanges, is notoriously volatile. Indeed, since 1945 only the sugar price has fluctuated more violently. Most of the metal is produced in LDCs for which it represents 50% or more of export earnings. UNCTAD and the intergovernmental council of copper exporting countries (CIPEC) have consistently pressed for a marketing system that is more favourable to the LDC producers.

Despite the growing importance of commodity price stabilization as a policy issue, however, there have been no estimates of the extent to which price fluctuations might be eliminated, or of the costs of running such a market stabilization programme, or of the size of the North-South redistribution this could bring about. In Discussion Paper No. 98, Research Fellow Andrew Hughes Hallett explores the potential for stabilization in the copper market, by examining whether conventional buffer stock interventions could stabilize prices, and whether redistribution could be achieved at an acceptable financial cost. Price stabilization, he finds, has some surprising results.

All existing or proposed agreements specify buffer stock interventions triggered by price movements. Hughes Hallett therefore uses an estimated model of supply and demand in the copper market, to which he applies optimal control techniques. This allows him to compute for the period 1970-80 the sequence of buffer stock interventions which would have served to minimize a (weighted) combination of deviations in the market price from its trend and fluctuations in the level of the buffer stock held.

Hughes Hallett first simulates the effects of stabilizing the copper price around its pre-1970 trend. Intervention does reduce the variability of prices, especially in periods of greater instability, but the financial costs of intervention are significant. In general the financial costs prove to be very sensitive to the trend about which prices are stabilized.

Hughes Hallett finds that in his simulations prices are stabilized, but at a lower average level. There is a net transfer of resources from the South to the North, which ranges from 4 to 8% of the annual revenue from copper sales, which may surprise the LDCs who advocate such schemes. Hughes Hallett argues that although the magnitude of the transfer depends on the particular market in question, commodity price stabilization will generally transfer resources from the South to the North.

Why should stabilization schemes have this effect? Hughes Hallett argues that the distribution of commodity prices is typically skewed: prices are higher in booms than they are lower in slumps (relative to their trend). Stabilization of prices therefore tends to reduce higher price levels more than it raises lower levels: this reduces the average price. The asymmetry in prices can be explained in turn by the asymmetric nature of stockholdings. Supply is inelastic in the short term: excess demand in the market can only be met by running down existing stocks, and once these stocks are exhausted prices rise sharply. If there is excess supply, however, producers can simply accumulate stocks and reduce production, provided finance is available. Hence price falls due to excess supply tend to be smaller than price rises due to excess demand.

Nevertheless, price stabilization can generate transfers to the South by forcing a sustained increase in average prices: the buffer stock is being used in effect to cartelize the market on the producers' behalf. Hughes Hallett explores the behaviour of the copper market when prices are stabilized around a higher trend growth rate. He finds that it is feasible to generate higher average prices and resource transfers, but it proves to be very expensive: the financial costs triple and prices are no longer stabilized as effectively. The countries of the South, moreover, are unlikely to agree on such schemes. Some countries benefit significantly from more stable prices even without transfers. Schemes which transfer resources to the South will benefit some countries, but they stabilize prices less effectively and so are less beneficial to other countries that gain from more stable prices. Disagreements among countries of the South are therefore likely to be as pronounced as those between North and South.

These results indicate that stabilization of the copper market is unlikely to yield large resource transfers to the South. It can, however, bring other benefits. It is relatively easy, for example, to use such arrangements as a means of stabilizing producers' earnings: revenues fluctuate less sharply than prices whenever there are non-zero elasticities. Thus price stabilization agreements do offer a cheap way of reducing the risks faced by producers. But even then, the results do not benefit the countries in the South uniformly, although the South as a group does gain. Stabilization schemes designed to reduce uncertainty must therefore be supplemented by redistributions toward the weakest South economies.

Hughes Hallett concludes that commodity agreements are better designed to direct investment toward areas where there are cost advantages in production, while market stabilization programmes should be used to reduce the uncertainties about future earnings.


Commodity Market Stabilization and 'North-South' Income Transfers: An Empirical Investigation
A J Hughes Hallett

Discussion Paper No. 98, April 1986 (IM)