Market demand and supply

Activity 2

DA (Discussion Activity)                                 Time: 1 hours

The following article enables you to apply the demand and supply model to a real world market and to examine a number of problems within that market.

Cappuccino crisis

Coffee is more fashionable than ever. And yet many coffee growers are facing ruin because of soaring production and a worldwide glut. Exporters are meeting in London to try to establish a cartel to push up prices. In fact, such efforts are unlikely to work. A better bet would be to move upmarket by branding coffee more like wine.  Sipping a cappuccino at a Starbucks in Seattle, London, Manila or even Shanghai, it is hard to imagine that the contents of the cup come from an industry in crisis. Yet despite the proliferation of coffee-shop chains and the robust profits of processors and retailers, millions of coffee growers are facing financial ruin. The reason is a collapse in the price of coffee caused by massive oversupply. At the World Coffee Conference, held in London from May 17-19th, representatives will attempt to put some order back into the market by restricting supply to force up prices.

The collapse in the price of coffee beans, although hardly apparent in the prices charged by coffee shops, has been dramatic. The price of robusta, which is used in blended and instant coffee, slumped to a 30-year low in the London commodity markets in April. This is despite attempts by the Association of Coffee Producing Countries (ACPC) to create a cartel similar to that of OPEC, the oil cartel. ACPC has tried to get growers to hold back 20% of their exports to force prices back up. While some countries have gone along with this, only 70% of the retention target has been met, Sergio Amaral, ACPC’s chairman, admitted on May 16th. And still prices have remained stubbornly low.  One of the problems is that not every big coffee producer is a member of ACPC. Brazil, the world’s largest coffee producer, has tried to reduce exports. But Brazilian growers suspect that other countries have been cheating and trying to grab their business. Colombia, the world’s second-biggest producer, would like to see a return to the International Coffee Agreement, a system of quotas which collapsed in 1989.

That is unlikely to happen. Mr Amaral says coffee growers will continue to withdraw supplies from the market in an effort to raise prices but, in addition, will now try to eliminate the production of low-quality coffee as well.  Some countries have doubts that this will be successful. Coffee production has changed dramatically since the 1980s. For a start, Asian producers such as Vietnam, Indonesia and India, have vastly increased production and exports, challenging the traditional coffee centres in Africa and South America. Vietnam has grown rapidly from a relatively modest producer to become the world’s third biggest. At the same time, traditional producers, especially Brazil, have become more efficient. Making matters worse for the growers is that soaring production has come about while coffee consumption, despite the proliferation of coffee-shop chains, remains relatively flat.

A huge roasting

Many coffee growers are not the wealthy plantation owners, but poor farmers who face utter destitution if their businesses fail. This, in turn, would be a blow to the countries where they live, which are also poor.  Some farmers, especially in South America, may turn from growing coffee to that other cash crop for which there seems to be endless demand: drugs.   “The crisis in coffee markets is producing record profit for some and mass poverty for others,” says Celine Charveriat, a policy advisor to Oxfam. The British-based charity has released a report calling for an international initiative to stabilise coffee prices above $1 a pound. Some coffee now sells for less than 50 cents a pound. In addition to the retention programme, Oxfam thinks coffee producers should destroy 15m bags of low-grade coffee and pay compensation to farmers. The charity argues that this can be paid for with a windfall tax on large coffee roasters, such as Nestlé, Kraft and Sara Lee.

While price-fixing mechanisms and the destruction of low-grade coffee may provide a temporary respite, some people in the industry think a better solution would be to try to increase demand, especially for the higher-value speciality coffees. This could be done by trying to woo younger consumers and by promoting coffee drinking in potentially huge markets, such as China, where it is not yet fashionable. More quality coffees could be branded and sold with boasts of their country of origin, or even the estates where they are grown, much as wine is marketed. Better branding should help maintain, or even increase, prices, especially in rich countries where consumers can pay for higher quality.

Some exporting countries have already tried something like this with relative success. In Colombia, where coffee is mainly grown by smallholders and still accounts for a third of rural employment, a local federation helped develop the Café de Colombia brand. Colombia also operates a national coffee fund, which has intervened in the market as a buyer of last resort when prices fell below a minimum level. Colombian coffee attracts a premium over other arabica beans, which are used to make speciality coffee, although in the present crisis even the guaranteed price has been cut and many farmers are struggling. Some Colombian producers think the country should have been quicker to market and promote more higher-priced speciality coffee.

The growth of coffee-shop chains has proved that there is a demand for speciality coffee. Starbucks, the leader in the market, increased its net profits in the second fiscal quarter of 2001 by 38% to $32m, compared to the same period in 2000. The company, and others like it, have been the target of anti-globalisation protesters.  News that the price of coffee beans has collapsed even while such chains are increasing profits will only confirm the protesters’ view that such firms are brutal exploiters. In fact, attacks or consumer boycotts against the very chains which have made coffee a fashionable item in rich countries, and are best equipped to spread the fashion more widely, is the last thing that exporters need. The coffee chains should be the growers’ best allies. For example Starbucks, with more than 4,000 outlets worldwide, has pioneered not only a market for upmarket coffee but also new outlets for growers of organic coffee and shade-grown coffee, which is more environmentally friendly. Starbucks also boasts that it operates a “fair trade” scheme which it claims helps farmers and their families. Most coffee farmers would happily raise a cup to that.

© From The Economist Global Agenda

Questions

1. Using the supply and demand model analyse the effects of “soaring production and a worldwide glut.”

2. Explain the reasons for the overproduction.

3. Suggest ways which the coffee growers could use to force prices back up.

4. What is the picture on the demand-side of the market? How might demand be increased in order to more closely match supply?

5. Explain how Colombia’s national coffee fund operates to protect the prices that farmers are paid.