Price, Substitution and Purchasing Power

AFP/GENYA SAVILOV

Kyiv mayor Vitali Klitschko congratulates the servicemen of Ukrainian territorial defence, Valery (R) and Lesya (C), with their wedding not far from check-point on Kyiv outskirts on March 6, 2022.

In economic theory, there is a type of offer curve that is conceptually similar but not the same as the offer curve we are generally familiar with. The concept of an offer curve was first developed by English economists Edgewoth and Marshal (Salvatore, 2001) to explain international trade, but it can be also used for microtransactions.

An offer curve illustrates the relationship between relative prices or the terms of trade with a country or an individual in the role of a net exporter/producer or net importer/consumer.

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If production exceeds consumption, the difference, also called the surplus, can be exported. Conversely, if production is lower, the deficit can be imported. A country can switch from being a net importer to a net exporter depending on the terms of trade, changes in technology/productivity, and consumer preference.

The case of wheat

The Russia-Ukraine war has disrupted 31 percent of the world's grain supply. Ukraine produces 25 percent of the world's wheat, with Russia producing the rest. The global wheat price has increased by 56 percent from around US$8 to $12.4 per bushel since the war broke out.

However, along with these changes, a production-substitution effect occurred that enabled India to enter the world supply chain for wheat.

Before, the price of Indian wheat was higher than the global price, making it difficult to penetrate exports. However, along with these changes, a production-substitution effect occurred that enabled India to enter the world supply chain for wheat.

In the case of India's wheat exports, the impact of the global price in the domestic market has been limited because the substitution space is wide. Staple foods and consumer preferences vary. Indians consume not only wheat, but also rice, other grains, and potatoes. In addition, it has abundant surplus, producers are decentralized, and wheat is part of the government’s national food security program through institutions similar to Indonesia’s Bulog. The country has found it easier to control the domestic impacts of the increase in global wheat prices.

The case of cooking oils

Global prices for crude palm oil (CPO) have been increasing since the end of 2021, before Russia invaded Ukraine. The increase was caused by a rise in consumption in countries with large populations, such as China and India, in line with economic recovery. Additional pressure came from the conflict in Ukraine, which is a producer of sunflower oil.

AFP/DANIEL SLIM

Gasoline prices are seen on a gas pump in Arlington, Virginia, on March 8, 2022. - The AAA reported the average price of gas in the US on March 8 was $4.173 per gallon. US President Joe Biden announced a ban on US imports of Russian oil on Tuesday, in the administration's most far-reaching action yet to punish Moscow for invading Ukraine.

Supermarkets in Iceland, for example, due to the supply shortage and the increase in the price of sunflower oil, had to compromise on their anti-palm oil stand by restocking shelves with palm cooking oil. The substitution caused the global price of CPO to increase.

In every country, the increase in global commodity prices has often prompted local producers to export. Governments have taken policies to reduce the gap in domestic and foreign prices by increasing export duties since March 21, rather than by restricting exports.

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Although there are other potential factors that can depress prices, such as the Covid-19 lockdown in China and global recession, the policies taken by Indonesia and Malaysia, which contribute 85 percent of the world’s CPO, have been able to keep the difference in CPO prices down. Global CPO prices fell from a peak of 7,200 ringgit per ton in March to 5,450 ringgit per ton in April, a decline of 33 percent.

Substitution space

It is worth noting that world CPO prices remain high due to a shortage in sunflower oil supplies. Consequently, domestic CPO prices also remain high and burdens vulnerable groups. The long queues of people buying cooking oil in recent months show that vulnerable groups have limited space for substitution because of a lack in available alternatives.

Even if they are available, they have now become premium products, such as virgin coconut oil (VCO).

Vegetable oils produced by micro and small businesses in remote villages as part of the local economy before the triumph of palm oil, such as coconut oil, have disappeared or become scarce because they are unable to compete. Even if they are available, they have now become premium products, such as virgin coconut oil (VCO).

As a result of globalization, CPO has become an internationally traded good that generates foreign exchange. However, at the same time, it is one of the basic needs in Indonesia, so CPO still requires serious attention. Domestic and foreign markets cannot be separated completely (separating equilibrium) if there is a high price difference.

Kompas

Journalists wait for an interview with an official, at the Russian stoke exchange in Moscow, Russia, Tuesday, March 10, 2020. Oil prices are plunging after Saudi Arabia started a price war against Russia. The Saudis tried to get the Russians to cut oil production to keep prices from falling even more due to the coronavirus.

Insulating the domestic market from developments in global prices is not easy. An increase in prices can encourage substitution and offer savings to consumers. Meanwhile, price increases encourage producers to increase production, including new players that produce substitute products. For people, price increases encourage them to find another way to prepare food that saves on using cooking oil.

The effect of diversification is to expand the substitution space so as to minimize the impact on household or individual welfare. In addition to reducing the difference between global and domestic prices, eliminating the retail price ceiling (HET) has led to incentivizing the producers of substitute products.

Market operations can be carried out to keep the market competitive and provide wider options for vulnerable groups. However, supervision is needed, but difficult to fully implement in the field.

The policy the government should take is to maintain purchasing power for vulnerable groups by providing cash aid (BLT) to offset the decline in their incomes. This will not only help maintain their welfare, but also provide alternatives.

KOMPAS/HERU SRI KUMORO

Ari Kuncoro

ARI KUNCORO is rector of the University of Indonesia

(This article was translated by Hendarsyah Tarmizi)