Answer

% change in quantity demanded

% change in price

The article states that, although coffee prices are rising analysts predict that demand is unlikely to fall much. Therefore, PED is likely to be less than one, i.e. inelastic. For example, if prices have risen by 25%, but demand has not fallen much, by less than 25%, PED is <1.

The result is that equilibrium price falls from P to P1.

A market failure is a situation when free markets fail to allocate resources efficiently. Three other examples are:

Information failure, which occurs when information is not available to all participants in a market transaction.

Failure to provide public goods, which are goods which when supplied to one consumer are freely available to others – hence the ‘free rider problem’

Failure to provide enough merit goods, like education and healthcare, because markets do not take into account positive consumption externalities.

Buffer stocks are stocks of commodities like coffee and sugar that are stored and then released to stabilise prices from year to year. Buffer stock managers will buy up excess stocks when there is a very good harvest, and then release them from stock when there is a very bad harvest. When there is a good harvest, the price would fall too low, so buying up the stock raises price. When there is a very bad harvest, prices would rise too high, and releasing stock reduces price back to an ‘average’ level. This can be seen below:

The result is that equilibrium price of P is established from year to year.

However, in evaluating buffer stocks it is argued that they cannot be used for all types of commodity. For example, perishable commodities like fruit cannot be stored. However, coffee and sugar can be stored, so buffer stocks can be used effectively.

Secondly, the system needs to start with a good harvest, so that the stock can be built up. Buffer stocks could not be used in a situation of several years of a bad harvest.

Thirdly, the intervention of buffer stock managers may create a ‘moral hazard’ where producers do not bother to behave efficiently because the buffer stock is a kind of insurance.

 Fourthly, buffer stocks cost money to set up and manage.

In conclusion, the instability of many commodity prices means that buffer stocks can be effectively used to regulate price, but they have a number of weaknesses.

Another method of regulating commodity prices is using a ‘guaranteed price’ system, where producers are guaranteed a price, usually guaranteed by the government, irrespective of the amount they produce. The guaranteed price can be set to the long term average of prices, or more usually above the long term average, so that as well as stabilise prices, producer’s incomes can also be stabilised.

In the diagram, Pg is the guaranteed price, and the effect is for producers to expand their output to Q1, and consumers to contract their demand to Q2.

In evaluating guaranteed prices, it can be seen that there is a danger that they lead to a large surplus of production. The price mechanism sends out conflicting signals - for producers to increase their output, but for consumers to reduce their demand. This causes a surplus, which can be regarded as a waste of scarce resources. The bigger the elasticity of demand and supply the bigger the surplus.

Secondly, the use of a guarantee costs the government money, and this creates an opportunity cost, where the money could have been spent on another worthy cause, such as education or healthcare.

Thirdly, the excess output will need to be stored, and this creates an extra cost in terms of storage and insurance.

Finally, a guaranteed price can also create ‘moral hazard’ where inefficient producers see the guarantee as insurance against inefficiency and over production. Guaranteed prices were a common method of protecting European farmer’s incomes up until the 1990s, but because of the huge cost of dealing with vast surpluses, they were gradually withdrawn, and farmers were given direct subsidies not related to output.