LICOS Discussion Paper Series
Discussion Paper 359/2014
Trading-off Volatility and Distortions?
Food Policy During Price Spikes
Hannah Pieters and Johan Swinnen
Faculty of Economics and Business
LICOS Centre for Institutions and Economic Performance
Waaistraat 6 – mailbox 3511
3000 Leuven
BELGIUM
TEL:+32-(0)16 32 65 98
FAX:+32-(0)16 32 65 99
http://www.econ.kuleuven.be/licos
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Trading-off Volatility and Distortions?
Food Policy During Price Spikes
Hannah Pieters
1
and Johan Swinnen
1,2
1
LICOS Centre for Institutions and Economic Performance
KU Leuven
2
Centre for Food Security and the Environment
Stanford University
Version: 25 November 2014
Abstract
This paper addresses to what extent governments have traded off price distortions for
reduced volatility in intervening in agricultural and food markets during the recent food
price spikes. We develop a model to derive how much distortions a government would
introduce when it cares about stability in a situation with limited policy options. We
show a trade-off and identify the optimal combination of distortions and stability for
given international price shocks and interest groups preferences for stability. Empirical
evidence shows that several countries have been able to reduce (short run) price
volatility in the domestic markets while at the same time allowing structural (medium
and long term) price changes to pass through to producers and consumers. However,
this is not the general case. For many countries, even when explicitly taking into
account the trade-off (and the benefits of reducing volatility) government policies
appear far removed from the optimal trade-off and there appears to be much room for
policy improvement.
This research was financially supported by the KU Leuven (Methusalem Program) and
the European Commission (FoodSecure FP7). The authors thank Koen Deconinck,
Steve McCorriston, Will Martin and participants at conferences in Ljubljana (EAAE)
and Minneapolis (AAEA) for comments on earlier versions of the paper.
Corresponding author: hannah.pieters@kuleuven.be
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1. Introduction
A large literature has focused on what Kym Anderson (2009) refers to as “distortions
to agricultural incentives”. A key element of these distortions is how government
interventions cause prices to diverge from “market prices” or “equilibrium prices” and
thus distort incentives for consumers and producers in their respective decisions,
causing inefficiencies throughout the economy. The basic model behind the literature
on price and market distortions is one with static supply and demand equations where
consumption and production adjust in response to long term prices.
However in recent years, much of the discussion on global agricultural and food
prices has focused on the, often short-run, volatility of these prices. It is argued that
such short-run volatility of prices is causing inefficiencies in consumption and prices
as it is difficult for consumers and producers to make optimal decisions in such volatile
environments (Barrett et al., 2013). A typical example is the problem of farmers to plan
their output if prices are volatile and uncertainty is large.
This is not only an issue for producers and consumers but also for governments.
As is well known, all over the world, politicians and governments are regularly under
pressure from agricultural producers and food consumers to intervene in agricultural
and food markets. In the longer run, this has led to a series of “patterns” of policy
distortions in agricultural and food markets (Kreuger et al., 1991; Anderson et al.,
2013). In recent years, many governments have intervened in an attempt to reduce short
run price fluctuations with global food price spikes (Barrett, 2014; Naylor, 2014;
Pinstrup-Andersen 2014)
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. These government interventions have often been ad hoc -
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Government interventions to counter market fluctuations are not unusual. To the contrary, they are a
key ‘stylized fact’ of agricultural and food policies (Anderson et al., 2013) and there is much evidence
to document this for other periods and regions (e.g. Gardner, 1989; Swinnen, 2009)
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resembling what Swinnen (1996) called “fire brigade policy-making” when
governments are confronted with shocks in the external environment.
Many economists and policy advisors have been critical of these attempts,
criticizing governments for (a) being ineffective, (b) causing distortions in the
economy, and (c) reinforcing price fluctuations, etc. (Anderson et al., 2013).
However, at the same time many economists and advisors point at the
importance of reducing price volatility based on efficiency gains (FAO, 2011; FAO and
OECD, 2011; Prakash, 2011; World Bank, 2012). In fact in environments with
important market imperfection (e.g. in insurance and other factor markets) government
interventions that reduce price instability could be efficiency enhancing. (After all that
is why one uses various insurance-type instruments in private markets.) Yet, the basic
economic model with static supply and demand equations and perfect markets is not
very adequate to capture and measure distortions and inefficiencies in such conditions
of market imperfections and volatility
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.
The question therefore can be raised to what extent governments have traded
off price distortions for reduced volatility in intervening in agricultural and food
markets. This question has both positive (“is this the case? If so, why ?”) and normative
(“is this good or bad; and why ?”) aspects. In this paper we analyze how much
distortions a welfare maximizing government would introduce when it cares about
stability (i.e. if it wants to limit price volatility for domestic producers and consumers)
in a situation with limited policy options, and we compare this with empirical evidence.
Key findings of our paper are (a) that several countries have been able to reduce
(short run) price volatility in the domestic markets while at the same time allowing
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Of course, the more fundamental issue is one of the policy instrument choice and the (transaction) costs
and capacity of governments to implement certain policy instruments.
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structural (medium and long term) price changes to pass through to producers and
consumers; (b) that there is a trade-off between volatility and distortions in situations
with limited policy options for welfare maximizing governments; and (c) that even
when explicitly taking into account this trade-off (and the benefits of reducing
volatility) that many countries (governments) are far removed from the optimal
distortion-volatility (DV) combination and that there is, thus, much room for policy
improvement.
The paper is organized as follows. Section 2 presents two cases of important
staple food markets where governments have significantly reduced (short run) price
volatility in the domestic markets while at the same time allowing structural (medium
and long term) price changes pass through. Section 3 develops a conceptual model of
the trade-off between distortions and volatility for a welfare maximizing government.
Section 4 links the theoretical framework to empirical indicators. Section 5 presents
empirical indicators of the distortions-volatility (DV) trade-off for staple food markets
and develops a single “efficiency” indicator. Section 6 presents the empirical results on
distortions in staple food markets in developing and emerging countries. Section 7
concludes.
2. Trading of Volatility and Distortions: Two Examples
To start, we will illustrate the key issue with two cases of government interventions in
important food markets over the past decade. The first example is that of rice markets
and prices in China; the second example is that of wheat markets and prices in Pakistan.
Figure 1 illustrates the evolution of rice prices on global markets and in China.
The graph illustrates two important observations. First, rice prices in China have been
much less volatile than on global markets. The sharp global price fluctuations in 2008-
2010 have not occurred in China. This was due to important policy interventions by the
