Monday, June 18, 2007

Gas, food, substitutions, and grocery bills

An article in today's USA Today reports that food costs in May had increased 3.9% from the prior year. This is 1% more than inflation in general. Part of this increase, apparently, is driven by the diversion of corn to the production of ethanol which can be mixed with traditional gasoline to reduce the need for refined oil.

The reasons for the high gasoline prices we are currently experiencing are complex. Aside from the world petroleum supply per se, a major limiting factor in the U.S. gasoline supply is refining capacity. That is, buying more crude oil on the world market is not going to do a whole lot of good if it cannot be refined. Although many U.S. refineries have undergone expansion, apparently, one one new refinery has been constructed in the U.S. since the 1970s. Since refineries raise major environmental concerns, government approval to build new ones appears to be difficult, if not essentially impossible, to obtain. Can we import refined oil? Some countries may not feel they can "afford the luxury" of environmental protection, but I imagine that carrying refined gasoline in tankers may be a dangerous undertaking.

Although ethanol maintains some of the air quality concerns associated with gasoline, it at least does not have to be refined. "Stretching" the gasoline supply by adding ethanol, then, offers a way to expand the fuel supply in the face of limited refining capacity. "Diverting" corn from food and agricultural markets, however, significantly increases the demand for corn, increasing corn prices. Increased corn prices, in turn, "cascade" into the food market as a whole.

One might object that Americans, for the most part, do not eat that much corn. Even if corn prices increased 50%, if the average family only buys one can every three weeks and four cobs per month, this shouldn't be a big deal. But that is not how most corn is consumed. Sodas, and many foods, are often sweetened with corn syrup. Depending on the immediate relative prices of sugar cane and corn, bottlers may switch back and forth. If the price of corn goes up, then, the price of sugar cane will, too. Corn is also fed a great deal to pigs (explaning why so many are raised in states like Iowa). This would cause the price of pork to increase. But the bad news is that even if you do not eat pork, this will also cause the price of substitutes such as beef and chicken to increase as well. And it gets worse. If the price of corn increases, it may be more economical for farmers, under some circumstances, to substitute grain for some of the corn they may have fed the pigs. Grain, as a substitute for corn, then, would face a higher demand, causing increasing prices both to bakers who buy wheat and to cattle ranches feeding corn.

With both gas and food prices rising, less money is available for consumers to spend on other purchases. In terms of food, it is often possible to switch to less expensive foods--e.g., eating more chicken instead of beef--but reducing the overall quantity of food bought is more difficult. Cutting down on gasoline usage in the short run is difficult, too, given limited public transportation options in many U.S. areas and the reluctance of many Americans to car pool. Higher prices paid for food and gas, then, leave less money to spend on thigns that can more easily be eliminated. Discount retailers such as Wal-Mart are apparently feeling this impact strongly as many consumers reduce their purchases.

When we talk about supply and demand, it is important to recognize that consumers to not respond in unison. Certain consumers may be rather insensitive while others, facing severe budget constraints, will tend to respond quite severely.

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