3.2.2 Extent of Production Agriculture
3.2.3 The Global Economy and U.S. Agriculture
3.2.4 The Commodity Market, Trading, and Futures
3.2.5 Foreign Trade Agreements
3.2.6 Foreign Exchange Rates and Firms
Ag and Food Statistics: Charting the Essentials - February 2023
The Impact of Recent Trade Agreements on Japan's Pork Market
USDA Economic Research Service Publications: Economic Research Reports
Global Economic Systems and Agriculture
Overview
Affecting Market Performance
Learning Objectives
7d Understand markets and factors that affect market performance including competition.
Competition and Market Structures
Competition in the marketplace affects price, demand, and supply of goods and services. Market structures describe the nature or degree of competition among companies in the same industries and in a free enterprise economy.
Economists have developed a theoretical model of an ideal situation where “perfect competition” occurs. Of course, this is only a model to compare to other types of market structures that are not “perfect”.
For there to be “perfect competition” certain conditions must prevail in the market, such as:
- a large number of buyers and sellers;
- sellers must deal in identical products;
- buyers and sellers act independently and compete with each other;
- both buyers and sellers must be well informed of the conditions in the markets;
- and both buyers and sellers can enter into and leave the market whenever they choose.
So, as you may have determined from the five conditions that must exist to have “perfect competition,” there really is no such thing.
If any of the five conditions are not met, then the market structure is called “imperfect”. There are three “imperfect markets”: monopolistic competition, oligopoly, and monopoly.
Firms face different competitive situations. At one extreme—perfect competition—many firms are all trying to sell identical products. At the other extreme—monopoly—only one firm is selling the product, and this firm faces no competition. Monopolistic competition and oligopoly fall between the extremes of perfect competition and monopoly.
Universal Generalizations
Perfect competition is a theory used to evaluate types of market structures: perfect competition, monopolistic competition, oligopoly, and monopoly. The type of market structure is determined by the amount of competition among firms operating in the same industry.
Three Economic Questions: What, How, For Whom?
Firms behave in much the same way as consumers behave. If the firm is successful, the outputs are more valuable than the inputs. Production involves a number of important decisions that define the behavior of firms. In order to meet the needs of its people, every society must answer three basic economic questions: What? How? Whom?
- What should we produce? (What product or products should the firm produce? What price should the firm charge for its products?)
- How should we produce it? (How should the products be produced? How much output should the firm produce? How much labor should the firm employ?)
- For whom should we produce it?
Although every society answers the three basic economic questions differently, in doing so, each confronts the same fundamental problems: resource allocation and scarcity.
As we said in previous sections, scarcity means that resources are limited. No country can produce everything, no matter how rich its mines, how massive its forests, or how advanced its technology. Because of the constraints of scarcity, then, decisions must be made about resource allocation.
Perfect Competition and Why It Matters
A perfectly competitive firm is known as a price taker because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower wants to know what the going price of wheat is, he or she has to go to the computer or listen to the radio to check. The market price is determined solely by supply and demand in the entire market and not the individual farmer.
Also, a perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
Agricultural markets are often used as an example of perfect competition. The same crops grown by different farmers are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2012, U.S. corn farmers received an average price of $6.07 per bushel and wheat farmers received an average price of $7.60 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, or a wheat grower who attempted to sell for $8.00 per bushel would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
How Perfectly Competitive Firms Make Output Decisions
A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand why this is so, consider a different way of writing out the basic definition of profit:
Profit=Total revenue−Total cost
Profit =(Price)(Quantity produced)−(Average cost)(Quantity produced)
Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. A perfectly competitive firm can increase output without affecting the overall quantity supplied in the market.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. If you increase the number of units sold at a given price, then total revenue will increase. If the price of the product increases for every unit sold, then total revenue also increases.
As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and so on. If, for example, the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on.
Total revenue and total costs for the raspberry farm, broken down into fixed and variable costs, are shown in Table 1 and also appear in Figure 3. The horizontal axis shows the quantity of frozen raspberries produced in packs; the vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward.
Total revenue for a perfectly competitive firm is a straight line sloping up. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature. At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. The maximum profit will occur at the quantity where the gap of total revenue over total cost is largest.
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount.
Raspberry Farm Total Revenue and Total Cost Table | |||||
Quantity | Total Cost | Fixed Cost | Variable Cost | Total Revenue | Profit |
(Q) | (TC) | (FC) | (VC) | (TR) | |
0 | $62 | $62 | - | $0 | −$62 |
10 | $90 | $62 | $28 | $40 | −$50 |
20 | $110 | $62 | $48 | $80 | −$30 |
30 | $126 | $62 | $64 | $120 | −$6 |
40 | $144 | $62 | $82 | $160 | $16 |
50 | $166 | $62 | $104 | $200 | $34 |
60 | $192 | $62 | $130 | $240 | $48 |
70 | $224 | $62 | $162 | $280 | $56 |
80 | $264 | $62 | $202 | $320 | $56 |
90 | $324 | $62 | $262 | $360 | $36 |
100 | $404 | $62 | $342 | $400 | −$4 |
In Table 3.2.1a, the vertical gap between total revenue and total cost represents either profit (if total revenues are greater than total costs at a certain quantity) or losses (if total costs are greater than total revenues at a certain quantity). In this example, total costs will exceed total revenues at output levels from 0 to 40, and so over this range of output, the firm will be making losses. At output levels from 50 to 80, total revenues exceed total costs, so the firm is earning profits. But then at an output of 90 or 100, total costs again exceed total revenues, which means the firm is making losses. The highest total profits in the figure occur at an output of 70–80, when profits will be $56.
Entry and Exit Decisions in the Long Run
The line between the short run and the long run cannot be defined precisely with a stopwatch or even with a calendar. It varies according to the specific business. The distinction between the short run and the long run is, therefore, more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production.
If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms enter the industry in response to increased industry profits it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will shut down at least some of their output, and some firms will cease production altogether. The long run process of reducing production in response to a sustained pattern of losses is called exit.
Promoting Innovation
Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of abundant information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation.
The U.S. has a combination of patents, trademarks, copyrights, and trade secret laws. These things are collectively called intellectual property because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which patents and copyrights in one country will be respected in other countries.
The combination of improvements in production technologies in the U.S. and a general sense that the markets could provide services adequately led to a wave of deregulation. This deregulation started in the late 1970s and continuing into the 1990s. This movement eliminated or reduced government restrictions on the firms that could enter, the prices that could be charged, and the quantities that could be produced in many industries, including telecommunications, airlines, trucking, banking, and electricity.
Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies.
Attributions
Title Image: "Interior of REMA 1000 supermarket/grocery store in Tønsberg, Norway. Fruit and vegetables displayed for sale." by Wolfmann, Wikimedia Commons is licensed under CC BY-SA 4.0
"2.9: Competition and Market Structures" by CK-12 Foundation is licensed under CC BY-NC 4.0
Extent of Production Agriculture
Learning Objectives
7a Identify the extent of production agriculture.
What is Agriculture’s Share of the Overall U.S. Economy?
The U.S. agriculture sector not only includes farms and ranches but also includes a range of farm-related industries. According to the 2017 Agricultural Census, the market value of U.S. agricultural products sold was $300,000,000. In 2021, agriculture, food, and related industries contributed 5.4% to U.S. gross domestic product and provided 10.5% of U.S. employment. On average, 12% of American household budgets is assigned to purchasing food. And nutrition assistance far outpaces other federal assistance programs.
Agriculture and GDP
Agriculture, food, and related industries contributed roughly $1.264 trillion to U.S. gross domestic product (GDP) in 2021, which was a 5.4% share. The output of America’s farms contributed $164.7 billion of this sum—about 0.7% of U.S. GDP. The overall contribution of agriculture to GDP is larger than 0.7% because sectors related to agriculture rely on agricultural inputs in order to contribute added value to the economy. Sectors related to agriculture include food and beverage manufacturing; food and beverage stores; food services and eating/drinking places; textiles, apparel, and leather products; and forestry and fishing.
Agriculture and Employment
In 2021, 21.1 million full- and part-time jobs were related to the agricultural and food sectors—10.5% of total U.S. employment. Direct on-farm employment accounted for about 2.6 million of these jobs, or 1.3% of U.S. employment. Employment in agriculture- and food-related industries supported another 18.5 million jobs. Of this, food services accounted for the largest share—11.8 million jobs—and food/beverage stores supported 3.3 million jobs. The remaining agriculture-related industries together added another 3.4 million jobs.
Food and Households
Expenditures on food accounted for 12.4% of U.S. households’ spending in 2021, an increase from 2020 when it was 11.9%. The share of household expenditures on food ranked third behind housing (33.8%) and transportation (16.4%).
Food Employees by Sector
In 2021, the U.S. food and beverage manufacturing sector employed 1.7 million people, or just over 1.1% of all U.S. nonfarm employment. In thousands of food and beverage manufacturing plants throughout the country, these employees were engaged in transforming raw agricultural materials into products for intermediate or final consumption. Meat and poultry plants employed the largest percentage of food and beverage manufacturing workers, followed by bakeries and beverage plants.
USDA Budget Outlays
USDA outlays, money spent on things such as programs, increased by 48% from 2006 to 2015. The largest increase coming from food and nutrition assistance programs, which grew especially fast since 2008, reflecting higher recession-related participation and a temporary increase in per-person benefits from the Supplemental Nutrition Assistance Program (SNAP). An improving economy and expiration of the larger SNAP benefits caused growth of food and nutrition assistance program outlays to slow by 2012 and decrease in 2014.
Outlays on Federal crop insurance also decreased in 2014 as extreme weather events subsided and crop prices declined. Commodity program outlays declined in 2015 with the passing of the new Farm Act in 2014. Food and nutrition assistance accounted for more than 73% of USDA outlays in 2015.
The agricultural industry is a far-reaching industry that uses input from other industries and provides inputs to other industries. Much of our economy is based on the ability to produce nutritious, safe, affordable food for the population. Another portion of our economy relies on jobs being available. No matter what your job is you are involved in agriculture, your food, your attire, your house, all made with things that originate somewhere in the agricultural industry.
Attributions
"Ag and Food Sectors and the Economy" by Kathleen Kassel and Anikka Martin, USDA Economic Research Service is in the Public Domain
"U.S. Agricultural Trade at a Glance" by James Kaufman, USDA Economic Research Service is in the Public Domain
The Global Economy and U.S. Agriculture
Instructor Ideas:
- Students could research trade between the U.S. and various countries. Students could create a presentation over the information or write a short research paper. This could be done in groups or individually.
- Instructor could assign reading material for students, such as the USDA Reports linked below, then lead a class discussion over the far reaching effects of trade.
Learning Objectives
7c Discuss the impact of U.S. agriculture on the global economy.
America’s Farmers and Ranchers
America’s farmers and ranchers make an important contribution to the U.S. economy by ensuring a safe and reliable food supply and improving energy security, as well as supporting job growth and economic development. Agriculture is particularly important to the economies of small towns and rural areas, where farming supports a number of sectors, from farm machinery manufacturers to food processing companies.
Access to world markets will be important for continued success due to increasing agricultural productivity. Population growth in the decades ahead will be concentrated in developing countries, and 95% of the world’s potential consumers live outside of the United States. As these countries grow and their citizens’ incomes rise, their demand for meat, dairy, and other agricultural products will increase.
Agricultural exports currently support nearly one million jobs across the country. But U.S. farmers, ranchers and food producers are well positioned to capture an increasing share of the growing world market for agricultural products. The United States is the world’s leading exporter of agricultural products. At $141.3 billion, agricultural exports made up 10% of U.S. exports in 2012. Since 1960, the United States has posted a trade surplus in agriculture. This surplus totaled $38.5 billion in 2012. Capturing a growing share of the world market for agricultural products will benefit the entire economy.
Despite recent success, challenges remain for U.S. agriculture, including uncertainty about future farm policy. U.S. agricultural exporters often confront barriers imposed by countries that keep U.S. products from reaching their target markets. Small and beginning farmers, ranchers and processors may face added burdens in navigating the complexities involved in exporting their products. America’s deteriorating transportation infrastructure and uncertainty regarding the agricultural workforce because of unsettled immigration policy add to the challenges facing agricultural exporters. Addressing these challenges will benefit U.S. agriculture and the economy overall.
The Economic Impact of U.S. Agriculture
The United States has a robust farm economy. In 2012, total farm cash receipts exceeded $390 billion, including $219.6 billion in cash receipts for crops and $171.7 billion in cash receipts for livestock and related products. Some products such as wheat, coarse grains, cotton, and soybeans are sold in bulk either in the United States or abroad, while most others undergo various levels of processing. Wheat flour, soybean oil, meats, cereals, and dairy products are examples of products that receive additional processing prior to their final sale. After accounting for production expenses, net farm income totaled $112.8 billion in 2012, about 125% higher than a decade prior in 2002.
A successful agricultural sector supports economic growth overall. By producing a wide variety of foods inexpensively—including fruits, vegetables, grains, meat and dairy products, America’s farmers and ranchers ensure a safe and reliable domestic food supply. This sector also improves U.S. energy security and reduces dependence on foreign oil through the production of biofuels and the development of other alternative sources of energy. These new sources of energy can help reduce costs for businesses and consumers. For example, some studies have found that an increased supply of biofuels reduces gas prices, especially as biofuel production technology improves.
A healthy farm economy is especially important to small towns and rural areas. Farmers and ranchers invest in their operations, supporting jobs in farm machinery manufacturing and other industries, and they purchase goods and services from local businesses. High levels of farm production, in turn, improve the prospects for downstream businesses, such as food processing companies and biofuel refineries. Businesses up and down the agricultural product supply chain have benefited in recent years because of the strong agricultural economy. An increase in sales of organic, specialty and bio-based products, as well as a recent expansion in agritourism, has contributed to this success.
Exporting is particularly important for agriculture, since growth in demand for agricultural products in the coming decades is expected to come largely from developing countries. U.S. agriculture has been successful in exporting its products, even as other industries have struggled in the global market. According to a U.S. Department of Agriculture (USDA) model, each $1 billion of agricultural exports supported 6,800 American jobs in 2011. These jobs include positions on farms, in the food processing industry, in the trade and transportation sector and in other supporting industries. In general, high-value (processed) exports supported more jobs and economic activity per dollar of exports than bulk exports of raw products. Assuming the number of jobs supported by each $1 billion of agricultural exports stayed within a range of the values estimated for 2010 and 2011, U.S. agricultural exports supported nearly one million jobs in 2012.
Recent Trends in Agricultural Exports
Since 1990, high-value agricultural exports, which include consumer-ready products and processed goods used as inputs by other industries, have made up the largest share of agricultural exports. The real value of U.S. agricultural exports has increased substantially over the past decades, due largely to rising demand for food and other agricultural products in developing countries. In 2012, U.S. agricultural exports totaled $141.3 billion. Rounding out the top five export destinations in 2012 were Canada, Mexico, Japan and the European Union. Grains and feeds accounted for nearly one-quarter of agricultural exports in 2012, representing $32 billion in export sales. And soybean exports totaled approximately $25 billion and made up 17.5% of export sales. Soybean exports increased by over 35% from the previous year. And global demand for soybeans, as well as soybean oil and soybean meal, is expected to continue to grow substantially. Red meats accounted for nearly 10% of agricultural exports, as did animal feeds and oil meal. The following products each made up roughly 4 - 5% of U.S. exports: tree nuts and preparations, fruits, cotton and linters, vegetables, poultry, sugar and tropical products and dairy products.
Challenges remain that could keep the United States from taking advantage of these growth opportunities. These challenges include uncertainty about long-term farm policy, trade barriers imposed by foreign countries, issues facing small and beginning farmers, ranchers and processors, the deterioration of U.S. transportation infrastructure and uncertainty in the agricultural workforce resulting from an unsettled immigration policy.
Export Issues
Agricultural exporters often encounter trade barriers. Despite some progress, average agricultural tariffs remain substantially higher than those imposed on other products. Consequently, there has been a continual push for lower average tariffs on agricultural products for small and beginning farmers, ranchers and processors, as well as for better export opportunities.
Overseas markets offer tremendous growth opportunities for small and beginning farmers, ranchers, and agricultural processors. These individuals and businesses face particular challenges in exporting their products. They may not be able to finance losses of a shipment at the border if a country imposes trade barriers, and they are more likely to lack the resources to identify and address such barriers. In addition, small farmers and food producers face many of the same challenges that small businesses in other industries face in exporting. For example, compared with larger businesses, they may have limited knowledge of foreign markets or technical expertise regarding export procedures.
The Export Promotion Act (2010)—which was part of the Small Business Jobs Act—connects small businesses with export promotion and outreach resources through the Department of Commerce; these connections are made to help them expand into new markets. This law also expands the outreach program through the Department’s Rural Export Initiative to ensure that small businesses located in rural areas know about available export-promotion services. Improving export opportunities for small farmers and agricultural producers could contribute to increasing exports overall.
Infrastructure Issues
America’s deteriorating transportation infrastructure may inhibit agricultural export growth. The agricultural sector relies on various forms of transportation infrastructure to move products from farms and factories to consumers at home and abroad, including roads, rails, and ports. Inland transportation infrastructure is particularly important for agricultural exporters. However, infrastructure surveys show that the United States is falling behind in investing in and maintaining its transportation infrastructure compared to global competitors. In 2012, inadequate investment in harbor maintenance and other water infrastructure negatively affected exporters who rely on the Mississippi River and the Great Lakes to transport their products.
Workforce Issues
Uncertainty regarding the agricultural workforce stemming from an unsettled immigration policy adds to challenges facing agricultural exporters. Foreign-born workers are critical to U.S. agriculture, making up 72% of the workforce. Seasonal and temporary workers are especially vital. Many of the positions these immigrants and temporary residents fill would not otherwise be filled by native-born workers.
Conclusion
The agricultural sector makes an important contribution to the U.S. economy, from promoting food and energy security to supporting jobs in communities across the country. Exports are critical to the success of U.S. agriculture, and population and income growth in developing countries ensures that this will continue to be the case in the decades to come. U.S. agricultural exporters are well positioned to capture a significant share of the growing world market for agricultural products, but some challenges remain. Taking actions that can facilitate exports would help to strengthen the agricultural sector and promote overall economic growth.
Attributions
"The Economic Contribution of America's Farmers and the Importance of Agricultural Exports." by Joint Economic Committee is in the Public Domain
The Commodity Market, Trading, and Futures
Learning Objectives
7e Discuss commodity market, trading, and futures.
Commodity Markets
Producers—farmers and ranchers, merchandisers, processors, retailers, and consumers rely on each other. Producers need to be able to sell the raw products they produce to processors. Processors then use these raw materials to create goods that are sold to retailers. Producers and processors both require a place to negotiate prices and either buy or sell their agricultural products. And that place is commodity markets—the place where prices are determined.
What is a Commodity?
A commodity is a raw product. Examples of commodities include grains—like corn, wheat and soybeans; livestock—like cattle and hogs; metals—like gold and silver, and energy sources—like crude oil and natural gas. This raw product is typically sold, and then processed and/or packaged in some way. So, corn may be sold to a processor who makes ethanol or to a processor who packages food, while crude oil may be sold to a processor who makes plastic or one makes fuel. These processed goods are then shipped to retailers, who sell finished products to consumers.
To make it easier to buy and sell these raw goods, the quality of the commodity must be uniform from all producers. So, all the bushels of corn, all the bales of cotton, and all the barrels of crude oil are essentially the same, regardless of who produced them.
Marketing Commodities and Managing Risk
Farming is full of risk. In any year, growers can face weather perils that include droughts and floods. Even when producers escape those extremes, conditions must be favorable at key periods during planting, growing, and harvesting. And even after crops are grown and harvested, producers still encounter risk. Changes in consumer demand, unforeseen international events, costs for fuel, and other circumstances can all influence profit. But the greatest risk of all may not be associated with producing commodities; rather, the greatest risk is associated with marketing—or selling for a profit. Two methods that are commonly used to market commodities are cash marketing and forward contracting.
Cash Marketing
The cash sale of the physical commodity is the most common sales method used by farmers, and it is ultimately involved in all grain sales. At times, it is used as a stand-alone transaction; at other times, it represents the completion of a hedge or other strategy.
Cash marketing takes place when a farmer sells his commodity for cash. For a grain farmer, this is usually done at a local cooperative or elevator. The farmer has not entered into any kind of contract to deliver the commodity at a certain time or at a certain price. In fact, cash marketing can take place any time after harvest, and it can be delayed by months if the producer stores his/her/their crop. The primary risk revolves around prices lowering while the commodity is held in storage; then, the farmer will have missed the opportunity to sell at the higher price.
A trade on the cash market always involves transfer of the actual commodity. The farmer delivers their grain to the elevator after harvest or from storage and, then, receives the current price. Every grain marketing transaction, involving price protection, results in the sale of the physical commodity in the cash market. In other words, all spot, forward cash, futures hedges, options, basis, hedge-to-arrive contracts, etc., are not considered complete until the cash sale is made. This is a key point to remember when we discuss the mechanics of alternatives that employ more than one transaction in the cash, futures, or options markets.
The majority of all cash sales do not require any further action in terms of using additional marketing alternatives. Once the cash sale is complete, any further action taken regarding previously sold grain results in the "speculative" use of grain marketing alternatives, futures or options. We will be covering the ideas of “speculation”, hedging, and options in later sections.
It is important to remember that the cash sale often represents the best sale that can be made at a given point in time. Deciding when to use the cash sale as the primary pricing method for a given unit of grain, instead of other marketing alternatives, depends on many factors. Most of the factors are quite similar to those used in making all grain sales decisions.
Spot Marketing
A spot market price is for current purchase, payment, and delivery. In commodity spot contracts, payment is required immediately, as is delivery.
How Does the Spot Sale Work?
- The price for the spot sale is based on the nearby futures contract plus or minus the basis and is stated as a cash price ($/bu. or, in some cases, $/lb. or $/cwt.).
- The farmer agrees to sell a specific quantity of grain at the spot price on the day that the grain is delivered. Note that premiums may be available for special qualities or large volumes. These premiums are negotiated between the seller and the grain merchant.
- Payment for the grain sold may be taken immediately or deferred to a later date.
Advantages of the Spot Sale
- The exact price is known.
- Further downside price risk is eliminated for the quantity sold.
- Carrying charges are eliminated on the quantity sold.
- The sale may be for any quantity of grain.
Disadvantages of the Spot Sale
- Since the price is fixed on the quantity sold, flexibility in pricing is eliminated or greatly reduced.
- Because title and control change hands, USDA's Commodity Credit Corporation (CCC) loan and loan deficiency payment (LDP) are no longer available on the grain.
Best Time to Use the Spot Sale
- When the price represents an acceptable profit.
- When the basis is stronger than normal (in most regions, a positive basis is highly indicative that the spot price represents a good sales opportunity).
Forward Contracting
A forward contract is a way to minimize the risk that the price of a commodity might go down before a farmer sells. A forward contract is an agreement to deliver a specific amount of a specific commodity at a specific time in the future. Because no one really knows whether prices will go up or down, a forward contract "locks-in" a price that is higher than the current cash price.
A farmer who forward contracts with the local elevator is guaranteed a known price for a specific amount of his crop; however, the arrangement doesn't offer much flexibility. If prices move higher before the delivery date, the farmer is still obligated to deliver the contracted grain at the lower, previously agreed to price. Also, the farmer is obligated to deliver the contracted amount of the commodity, even if his yields are lower than expected.
The forward contract is the second most common way to sell grain. This is a cash contract that allows the farmer to sell a specific quantity of grain for a specified cash price for delivery at a later date. It allows the farmer to set a price for a crop that is to be grown, growing in the field, harvested, or being held for later delivery. For example, in July, a farmer contracts to deliver 5,000 bushels of corn to a grain elevator operator in November, and the contract price is $4.00 a bushel. The cash price of corn could go higher or lower between July and November. In November, even if the market price for corn is only $3.60 a bushel, the elevator operator is obligated to pay the farmer $4.00 a bushel. Likewise, if corn sells for $4.75 a bushel, the farmer still receives only $4.00 a bushel.
How does the Forward Contract Work?
- Forward contracts can be made with a local grain dealer (or end user) any time—before planting, during the growing season, at harvest, or after harvest.
- The contract can be written to allow the seller to take payment at the time the grain is delivered or to defer payment until a later date (see section on "Cash Sale with Deferred Payment").
- Forward contracts are made for a specific price, quantity, and delivery date.
Advantages of Forward Contracting
- The exact price is known.
- The exact quantity is known.
- The date of delivery is known.
- Downside price risk is eliminated for the quantity contracted.
- Any quantity can be contracted.
- Premiums can be negotiated for large-volume contracts or special qualities.
- Generally, farmers who irrigate can safely contract up to 100% of intended production.
Disadvantages of Forward Contracting
- The seller is obligated to fill the contract, even in the event of a production shortfall, depending on price and local conditions.
- Upside price potential is eliminated on the quantity contracted.
- You give up flexibility in choosing your delivery point.
- The seller must fill the contract even in the case of a production shortfall. As a result, farmers who produce crops on dry land generally limit the amount they contract to 50% of intended production; crop insurance or the use of options may boost this amount.
Best Time to Use the Forward Contract
- When the contract price represents an acceptable profit.
- When basis is stronger than normal.
- When you expect prices to fall.
The Cash Sale with Deferred Payment
The cash sale for deferred payment—whether a spot sale or forward contract—is generally used for tax management, to defer income into the next tax year.
Advantages of the Cash Sale with Deferred Payment
- The exact price is known.
- Payment is taken in the tax year the seller chooses.
Disadvantages of the Cash Sale with Deferred Payment
- Deferred income can present a tax problem in the event production and commodity prices are higher—or income is up for other reasons—in the following year.
- There is a credit risk. Should the buyer go out of business, the seller may have trouble collecting his or her payment. Some, but not all, states have indemnity funds to protect farmers in the case of elevator bankruptcy, but coverage often is not 100% and the protection does not apply to direct sales to end users such as livestock producers. The credit risk with this contract is less, however, than one with "deferred pricing"—in which the price is not determined at time of delivery.
What are Commodity Markets?
A commodity market is a place where you can buy, sell, or trade these raw products. But imagine having to transport all of the world's grain, gold, crude oil and other commodities to a single place in order to sell them. It would be unwieldy and costly to have a huge central location, to which all the sellers would deliver their commodities and from which all the buyers would haul them away. So, instead of trading the physical commodity, buyers and sellers in a commodity market trade contracts representing specific amounts of each commodity. For example, a producer could sell a contract to deliver 5,000 bushels of grain at a set price at a certain time. In exchange for payment, the contract would require the producer to deliver the grain to a specific location by a certain date. A processor could then use the market to purchase the contract for 5,000 bushels of grain at a set price and time.
It is in the commodities market that the prices of raw commodities, such as grain and livestock, are set. In the example of a grain farmer, it is these markets that set the price a farmer will receive when she sells her grain at the local elevator. By understanding how the markets work, processors attempt to buy their raw goods at the lowest price, and producers attempt to sell their commodity for the highest price.
There are many commodities markets around the world. Regardless of their names or locations, these trading centers all provide the same thing: a central location for buyers and sellers to negotiate prices and execute trades. The world's largest commodities market is the CME Group, which is the combination of the two largest commodity exchanges in the world—the CBOT (Chicago Board of Trade) and the CME (Chicago Mercantile Exchange).
There are a variety of participants in the commodities market. Traders are anyone who buys or sells a contract—also known as “taking a position" in the commodities market. Speculators are those traders who buy or sell in an attempt to profit from price movements. Hedgers are traders who "hedge their bets" for favorable prices in one market by buying or selling a commodity in another.
Market Prices & Decision Making
Commodity markets are big business, and for farmers the rise and fall of commodity prices can have a significant impact on the bottom line. Keeping up to date on prices and factors influencing the market helps producers make informed business decisions. Things that can impact the price of many commodities include the weather, government policies, international events, consumer preferences, shifting input costs, and general supply and demand for the commodity.
Because of all of the different factors that influence prices, buying or selling contracts in a commodity market requires detailed data-gathering, critical thinking, and an ability to tolerate and manage risk. There are many sources a producer or trader can use for this data, including industry publications, weather forecasts, news headlines, and government reports. Many traders rely on personal experience and an understanding of market history and trends to help make decisions.
Attributions
"Understanding Commodity Markets" by Tyler Schau, OER Commons is licensed under CC BY 4.0
Foreign Trade Agreements
Learning Objectives
7b Explain the importance of foreign trade in agribusiness.
7g Discuss NAFTA.
Trade Agreements and Organizations
Free trade is encouraged by a number of agreements and organizations set up to monitor trade policies. The two most important are the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO).
Business Language
English is the international language of business. The natives of such European countries as France and Spain certainly take pride in their own languages and cultures; nevertheless, English is the business language of the European community. Whereas only a few educated Europeans have studied Italian or Norwegian, most have studied English. Similarly, on the South Asian subcontinent, where hundreds of local languages and dialects are spoken, English is the official language of business. Different cultures have different communication styles, but in most corners of the world, English-only speakers—such as most Americans—have no problem finding competent translators and interpreters because their language is considered the Lingua Franca—common language.
General Agreement on Tariffs and Trade
After the Great Depression and World War II, most countries focused on protecting home industries, so international trade was hindered by rigid trade restrictions. To rectify this situation, twenty-three nations joined together in 1947 and signed the General Agreement on Tariffs and Trade (GATT), which encouraged free trade by regulating and reducing tariffs, as well as by providing a forum for resolving trade disputes. The highly successful initiative achieved substantial reductions in tariffs and quotas, and in 1995 its members founded the World Trade Organization (WTO) to continue the work of GATT in overseeing global trade.
World Trade Organization
Based in Geneva, Switzerland, with nearly 150 members, the World Trade Organization (WTO) encourages global commerce and lower trade barriers, enforces international rules of trade, and provides a forum for resolving disputes. It is empowered, for instance, to determine whether a member nation’s trade policies have violated the organization’s rules, and it can direct “guilty” countries to remove disputed barriers (though it has no legal power to force any country to do anything it doesn’t want to do). If the guilty party refuses to comply, the WTO may authorize the plaintiff nation to erect trade barriers of its own, generally in the form of tariffs.
Affected members aren’t always happy with WTO actions. In 2002, for example, the Bush administration imposed a three-year tariff on imported steel. In ruling against this tariff, the WTO allowed the aggrieved nations to impose counter-tariffs on some politically sensitive American products, such as Florida oranges, Texas grapefruits, Wisconsin cheese, and computers. Reluctantly, the administration lifted its tariff on steel.
Trading Blocs
The complete absence of barriers is an ideal state of affairs that we haven’t yet attained. In the meantime, economists and policymakers tend to focus on a more practical question: Can we achieve the goal of free trade on the regional level? To an extent, the answer is yes. In certain parts of the world, groups of countries have joined together to allow goods and services to flow without restrictions across their mutual borders. Such groups are called trading blocs. Let’s examine two of the most powerful trading blocks—NAFTA, now known as USMCA, and the European Union.
North American Free Trade Association
The North American Free Trade Association (NAFTA) is an agreement among the governments of the United States, Canada, and Mexico to open their borders to unrestricted trade. The effect of this agreement is that three very different economies are combined into one economic zone with almost no trade barriers. From the northern tip of Canada to the southern tip of Mexico, each country benefits from the comparative advantages of its partners: each nation is free to produce what it does best and to trade its goods and services without restrictions.
When the agreement was ratified in 1994, it had no shortage of skeptics. Many people feared, for example, that without tariffs on Mexican goods, more U.S. manufacturing jobs would be lost to Mexico, where labor is cheaper. More than two decades later, most such fears have not been realized, and, by and large, NAFTA was a success. Since it went into effect, the value of trade between the United States and Mexico has grown substantially, and Canada and Mexico are now the United States’ top trading partners.
As of July 1, 2020, NAFTA was renamed the U.S.-Mexico-Canada Agreement (USMCA). Making this change nearly quadrupled exports (by value) to Canada and Mexico. USMCA expands more on topics that were already included in NAFTA and also adds new chapters. Some of the new or changed information for USMCA include policies and regulations surrounding digital trade, anticorruption, intellectual property, rules of origin, and more. The agreement is meant to create more balanced trade supporting high paying jobs for Americans while still growing and supporting the economies of North America. It benefits farmers, ranchers, and other producers by strengthening agricultural trade within the continent. This agreement is beneficial to the economies and workers within North America.
The European Union
The forty-plus countries of Europe have long shown an interest in integrating their economies. The first organized effort to integrate a segment of Europe’s economic entities began in the late 1950s, when six countries joined together to form the European Economic Community (EEC). Over the next four decades, membership grew, and in the late 1990s, the EEC became the European Union. Today, the European Union (EU) is a group of twenty-seven countries that have eliminated trade barriers among themselves (see Figure 3.2.5a).
At first glance, the EU looks similar to USMCA. Both, for instance, allow unrestricted trade among member nations. But the provisions of the EU go beyond those of USMCA in several important ways. Most importantly, the EU is more than a trading organization: it also enhances political and social cooperation and binds its members into a single entity with authority to require them to follow common rules and regulations. It is much like a federation of states with a weak central government, with the effect not only of eliminating internal barriers but also of enforcing common tariffs on trade from outside the EU. In addition, while USMCA allows goods and services, as well as capital, to pass between borders, the EU also allows people to come and go freely: if you possess an EU passport, you can work in any EU nation.
Attributions
"An Introduction to Business v.2.0" by Anonymous , 2012 Book Archive is licensed under CC BY-NC-SA 3.0
Foreign Exchange Rates and Firms
Learning Objectives
7f Discuss exchange rates, trades, and tariffs and their effects on commodities.
Dollarize
Most countries have different currencies, but small economies commonly use an economically larger neighbor's currency. For example, Ecuador, El Salvador, and Panama have decided to dollarize—that is, to use the U.S. dollar as their currency. Nations can also share a common currency. A large-scale example of a common currency is the decision by many European nations—including some very large economies such as France, Germany, and Italy—to replace their former currencies with the Euro at the start of 1999.
Apart from exceptions already mentioned, most of the international economy takes place in a situation of multiple national currencies. People and firms often need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. We call the market in which people or firms use one currency to purchase another currency the foreign exchange market. The exchange rate is a price—the price of one currency expressed in terms of units of another currency. The key framework for analyzing prices is the operation of supply and demand in markets.
The Extraordinary Size of the Foreign Exchange Markets
If you travel to a foreign country that uses a different currency, you will undoubtedly need to make a trip to a bank or foreign currency office to exchange your currency for that country’s currency. Even though this is a simple transaction, it is part of a very large market. The quantities traded in foreign exchange markets are breathtaking. A 2019 Bank of International Settlements survey found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2019 U.S. real GDP was $21.4 trillion per year. There is an average of $6.6 trillion worth of exchanges per day.
Your transaction is simple enough. Suppose you carry a $100 bill. You bring it into the foreign currency office and look up, and you see a bunch of different numbers on a digital board.
If you are traveling to Turkey, whose national currency is the Turkish Lira, one line of the board might read: “U.S. DOLLARS: BUY 5.50; SELL 5.80.” This means that the office will give you 5.50 Turkish Lira in exchange for 1 U.S. dollar. If you have $100, the office will give you 550 Turkish Lira.
If you want to sell Turkish Lira for U.S. dollars, the office will surely buy them from you. They will not buy it at the same exchange rate since the office will make a profit on the exchange. If you bring 550 Turkish Lira and ask for U.S. dollars, it will not give you 100 dollars, but instead about $95.
Demanders and Suppliers of Currency in Foreign Exchange Markets
In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency—and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market:
- firms that are involved in international trade of goods and services;
- tourists visiting other countries;
- international investors buying ownership (or part-ownership) of a foreign firm;
- and international investors making financial investments that do not involve ownership.
Example: Financial Investor
Business people often link portfolio investment to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing U.K. issued bonds. For simplicity, ignore any bond interest and focus on exchange rates. Say that a British pound is currently worth $1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth $1.60 in U.S. currency. Thus, as Figure 3.2.6a part (a) shows, this investor would change $24,000 for 16,000 British pounds. In a month, if the pound is worth $1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate, and you will have $25,600—a nice profit.
Now consider Figure 3.2.6a part (b). An investor expects that the pound, now worth $1.50 in U.S. currency, will decline to $1.40. That investor could start off with £20,000 in British currency (borrowing the money if necessary); convert it to $30,000 in U.S. currency; wait a month; and then convert back to approximately £21,429 in British currency—again making a nice profit. Of course, this kind of investment comes without guarantees, as the market can move in ways not predicted.
Example: Foreign Contract Hedging
Many portfolio investment decisions are not as simple as betting that the currency's value will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. However, you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Let’s say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against a risk from one of your investments (in this case, currency risk from the contract).
With hedging, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. However, if the value of the euro in dollars declines, then you are protected by the hedge.
Attributions
"Principles of Economics 3e" by Steven A. Greenlaw, David Shapiro, Daniel MacDonald, OpenStax is licensed under CC BY 4.0
Access for free at: https://openstax.org/books/principles-economics-3e/pages/29-1-how-the-foreign-exchange-market-works