Spatial Price Analysis – Module 2

1. Spatial Price Analysis – Module 2 Markets and Prices in Agribusiness AG BM 420

2. Brief outline of module (see schedule) • Overview of extent of spatial price variation • Over a set of spatial locations – regional, national • At specific locations • Key questions • Why do products flow from one place to another? • Can we predict the direction of flows? • Can we predict the quantity of flows? • Can we predict and analyze the prices across locations? Markets and Prices in Agribusiness

3. Let’s re-consider economics of the story New concepts • Spatial arbitrage • Spatial equilibrium • Exchange rate • Arbitrage equilibrium • Physical balance condition • Trade distortions • Barriers to trade • Open vs closed economy Markets and Prices in Agribusiness

4. What is the nature of spatial variation in prices? • Think of your product • Where are the main supply sources located? • Where are the main demand points located? • How does the product get moved from supply to demand points? • Why does it get moved? Markets and Prices in Agribusiness

5. Regional aggregate prices Markets and Prices in Agribusiness

6. Housing prices • http://www.philadelphiafed.org/index.cfm • Affordability and Availability of Rental Housing in Pennsylvania • The Federal Reserve Bank of Philadelphia has released Affordability and Availability of Rental Housing in Pennsylvania, a study that assesses the needs of lower-income renters. http://www.philadelphiafed.org/community-development/publications/special-reports/rental-housing/ Markets and Prices in Agribusiness

7. Regional Economic Performance • Open vs closed economies • Why focus on regional performance? http://www.philadelphiafed.org/research-and-data/regional-economy/ Markets and Prices in Agribusiness

8. Employment – Why regional differences?http://www.philadelphiafed.org/research-and-data/regional-economy/releases/employment/2009/MSANewsNov2009.pdf Markets and Prices in Agribusiness

9. Markets and Prices in Agribusiness

10. Housing prices vary across neighboring states Media Contact: Katherine Dibling, 215-574-4119, Katherine.Dibling@phil.frb.org Markets and Prices in Agribusiness

11. 2009 Markets and Prices in Agribusiness

12. Markets and Prices in Agribusiness

13. County level data http://www.philadelphiafed.org/research-and-data/regional-economy/historical-data/ Markets and Prices in Agribusiness

14. Check out spatial variation of ag prices • Illinois crop price data base FarmDoc http://www.farmdoc.uiuc.edu/ Check it out! Go to prices & weather……… http://www.farmdoc.uiuc.edu/weatherprices/index.asp Markets and Prices in Agribusiness

15. Crop regions in Illinois Markets and Prices in Agribusiness

16. Example of price variation at one location Markets and Prices in Agribusiness

17. Example: Prices across locations Co-movement of prices due to spatial arbitrage Markets and Prices in Agribusiness

18. Open vs closed economies • An open economy is a geographic space in which the economy (markets, firms, consumers) are linked other spatial locations through economic transactions. • Examples? • What is a closed economy? We could say an economy is closed if there exist “barriers to trade” that prevent transactions between that economy and economies at other spatial locations. Markets and Prices in Agribusiness

19. Similar results for most products~! • Apple prices Lancaster weekly market vs. London weekly market? Markets and Prices in Agribusiness

20. The spatial price difference • Consider PA vs Illinois Corn Grain • Lets get some data first http://www.nass.usda.gov:81/ipedb/#http://www.nass.usda.gov:81/ipedb/ Markets and Prices in Agribusiness

21. Markets and Prices in Agribusiness

22. Markets and Prices in Agribusiness

23. Ok let’s get technical! • How can economics help us understand spatial price variation? • How can you use spatial price variation to better understand the price behavior at a particular spatial location? Markets and Prices in Agribusiness

24. Definition – spatial marketing margin • Suppose you can buy a product in one market and sell it in another market, the difference in price would be a margin of revenue per unit (+ or -). • Def: Spatial marketing margin is the average revenue per unit that can be earned by moving a product from one spatial location (source market) to another (destination market). mij = Pi – Pj where i is the destination market and j is the source market Markets and Prices in Agribusiness

25. Definition - basis • If one market is a central market, then the marketing margin between an outlying market and the central market is called “basis” • Usage? See if you can find an example of the use of “basis” in commodity press or for your product. Markets and Prices in Agribusiness

26. Illinois PA 2000 Jan 1.97 2.62 0.65 Feb 2.03 2.57 0.54 Mar 2.11 2.57 0.46 Apr 2.02 2.55 0.53 May 2.2 2.65 0.45 Jun 1.89 2.47 0.58 Jul 1.66 2.34 0.68 Aug 1.54 2.14 0.6 Sep 1.64 2.06 0.42 Oct 1.8 1.89 0.09 Nov 1.92 1.89 -0.03 Dec 2.03 2.1 0.07 2001 Jan 1.97 2.18 0.21 Feb 2 2.35 0.35 Mar 2 2.3 0.3 Apr 1.92 2.28 0.36 May 1.86 2.31 0.45 Jun 1.83 2.25 0.42 Jul 1.95 2.38 0.43 Aug 1.99 2.33 0.34 Sep 1.94 2.32 0.38 Oct 1.85 2.14 0.29 Nov 1.91 2.22 0.31 Dec 2.06 2.35 0.29 2002 Jan 2.01 2.35 0.34 Feb 1.98 2.36 0.38 Mar 1.98 2.36 0.38 Compute Spatial Marketing Margin Margin Spatial margin can be substantial and it clearly varies! Markets and Prices in Agribusiness

27. Graph the prices Pa-Illinois Arbitrage? What do you notice about the behavior of these prices? Markets and Prices in Agribusiness

28. Graph of the spatial margin Basis responds to price transmission speed, what else? Markets and Prices in Agribusiness

29. Graph the basis ~ Are there profits here? Does positive basis mean profit? Markets and Prices in Agribusiness

30. Illinois PA 2000 Jan 1.97 2.62 0.65 Feb 2.03 2.57 0.54 Mar 2.11 2.57 0.46 Apr 2.02 2.55 0.53 May 2.2 2.65 0.45 Jun 1.89 2.47 0.58 Jul 1.66 2.34 0.68 Aug 1.54 2.14 0.6 Sep 1.64 2.06 0.42 Oct 1.8 1.89 0.09 Nov 1.92 1.89 -0.03 Dec 2.03 2.1 0.07 2001 Jan 1.97 2.18 0.21 Feb 2 2.35 0.35 Mar 2 2.3 0.3 Apr 1.92 2.28 0.36 May 1.86 2.31 0.45 Jun 1.83 2.25 0.42 Jul 1.95 2.38 0.43 Aug 1.99 2.33 0.34 Sep 1.94 2.32 0.38 Oct 1.85 2.14 0.29 Nov 1.91 2.22 0.31 Dec 2.06 2.35 0.29 2002 Jan 2.01 2.35 0.34 Feb 1.98 2.36 0.38 Mar 1.98 2.36 0.38 Compute Spatial Marketing Margin Margin Spatial margin can be substantial and it clearly varies! Markets and Prices in Agribusiness

31. How can we explain this spatial structure in prices? Markets and Prices in Agribusiness

32. What makes multiple markets work? We need three types of agents • Consumers in each • Producers in each • Arbitragers to knit the markets together Markets and Prices in Agribusiness

33. Arbitrage - Review of concept Definition Arbitrage is the economic function of taking a product from one market to another for a profit. Sometimes product transformation occurs, but always product attributes change at least with respect to location, time, etc. Markets and Prices in Agribusiness

34. Types of Arbitrage • Arbitrage can move products • Spatially • Vertically • Horizontally • Over time How? Markets and Prices in Agribusiness

35. Arbitrage as an economic function • Demand • Supply • Arbitrage Competition  Equilibrium Balancing of demand and supply via price adjustment Markets and Prices in Agribusiness

36. Notation • Suppose we have two markets, #1 and #2 • One product, lets use the symbol Y to indicate the quantity of that product, and P to indicate its price. • We will use subscripts to indicate in what market we are measuring the quantity or price. Markets and Prices in Agribusiness

37. Define the profits from arbitrage Step 1: Determine the direction of product flow Look at the prices, PA > Illinois suggests product flow from Illinois to PA Define region 1 as Illinois Step 2: Define profits from spatial arbitrage Markets and Prices in Agribusiness

38. Now, suppose we have competition! • Using the notion of competition, and free entry, we can establish some important implications of spatial arbitrage! • Arbitrage profits will attract entry • Entry will drive profits to zero • With profits at zero, prices in the two markets are bound together! Markets and Prices in Agribusiness

39. Spatial arbitrage + competition establishes a systematic spatial structure in prices Importantly, the last line defines a spatial structure in prices! The price in the two regions will be inextricably bound together by arbitrage + competition. Arbitrage is the glue that binds markets together! Markets and Prices in Agribusiness

40. How fast does spatial arbitrage happen? • What happens when a hurricane strikes? • Price of plywood in strike zone goes up • Agents outside of the strike zone see profits and load their trucks! • Price is driven down in the strike zone • Ethics of arbitrage………. If we do not have adequate arbitrage, substantial price swings may occur ……….and persist. • Social role of arbitrage Spatial arbitrage plays an important role in stabilizing prices over time and ensuring access to products. Markets and Prices in Agribusiness

41. Arbitrage is driven by profits Consider the simple case, suppose two regions i, j with prices, Pi , Pj Three questions are of interest: • In which direction will arbitrage (trade) carry the product? • What will be the effect of spatial arbitrage? • Price effects • Quantity moved (traded) • Can we predict the price in one region, with the prices of another? Markets and Prices in Agribusiness

42. The problem of where to sell… Suppose supply is located at the green dot, say coffee….and demand (orders) are received from tan dot locations. How should the producer allocate supply to these points? Markets and Prices in Agribusiness

43. What if………there were topography? Markets and Prices in Agribusiness

44. What if………there were political borders with walls or taxes? Markets and Prices in Agribusiness

45. Profits drive arbitrage… define spatial arbitrage profits Profits(i,j)=Pei dij Yij -PjYij - AcijYij Pei price you hope to receive in market i i.e. it is our expected price dij proportion left after deterioration in physical quantity due to shipping Yij quantity purchased in jth & shipped to ith market Acij unit cost of shipping Markets and Prices in Agribusiness

46. Unit cost of transp 0.22 Ill-PA Illinois PA Spatial Margin Profits 2000 Jan 1.97 2.62 0.65 0.43 Feb 2.03 2.57 0.54 0.32 Mar 2.11 2.57 0.46 0.24 Apr 2.02 2.55 0.53 0.31 May 2.2 2.65 0.45 0.23 Jun 1.89 2.47 0.58 0.36 Jul 1.66 2.34 0.68 0.46 Aug 1.54 2.14 0.6 0.38 Sep 1.64 2.06 0.42 0.2 Oct 1.8 1.89 0.09 -0.13 Nov 1.92 1.89 -0.03 -0.25 Dec 2.03 2.1 0.07 -0.15 2001 Jan 1.97 2.18 0.21 -0.01 Feb 2 2.35 0.35 0.13 Mar 2 2.3 0.3 0.08 Apr 1.92 2.28 0.36 0.14 May 1.86 2.31 0.45 0.23 Jun 1.83 2.25 0.42 0.2 Jul 1.95 2.38 0.43 0.21 Aug 1.99 2.33 0.34 0.12 Sep 1.94 2.32 0.38 0.16 Oct 1.85 2.14 0.29 0.07 Nov 1.91 2.22 0.31 0.09 Dec 2.06 2.35 0.29 0.07 Get some real data on costs • Add a column to your spreadsheet to compute profits Markets and Prices in Agribusiness

47. Question #1: In which direction will arbitrage (trade) carry the product? We can answer this just by recognizing that: Arbitrage will not occur if it is not expected to be profitable Profits(i,j)=Pei dij Yij -PjYij - Acij*Yij  0 ? If so, then arbitrage will carry the product from region j to region i. If not, then flow from region j to region i = 0 Markets and Prices in Agribusiness

48. Question #1: In which direction will arbitrage (trade) carry the product? Check both directions……………… Profits(j,i)=Pei dji Yji -PiYji - Acji*Yji  0 ? If so, then arbitrage will carry the product from region i to region j. If not, then flow from region i to region j = 0 Markets and Prices in Agribusiness

49. In the real world • Flow direction may change over time! Why? Markets and Prices in Agribusiness

50. Spatial equilibrium – how everything balances out • In a single market, price is determined by demand =supply. • When we have multiple spatial markets interacting, life gets a bit more complicated! • Lets keep our focus on two market case Markets and Prices in Agribusiness