Farm Commodity Price Stabilization through Futures Markets*

ROBERT A. RICHARDSON AND PAUL L. FARRIS

A proposal to stabilize farm prices through government operations in futures n;tarkets was ex­amined using soybeans for 1953-1967. The example showed that soybean pnces would nothave been stabilized. Operation of the proposal might also have modified buying and sellingbehavior and cash-futures price relations.

PRI CE stabilization has long been an objec­tive for American agriculture. Govern­ment farm programs involving price sup­

port arid storage have been used to help attainthis objective, along with other goals such asraising farm income and providing reservestocks to meet production and demand uncer­tainties at home and abroad.

H. S. Houthakker has suggested a programto stabilize commodity prices through govern­ment operations in key futures markets [4].He maintains that wide price fluctuations occurbecause "there are not enough traders who arewilling or able to take a longer view" [4, p. 51]and argues that "the key to successful stabiliza­tion is in the correct distribution of suppliesover time through storage at times of surplusand release from storage at times of scarcity"[4, pp. 52-53]. In Houthakker's view thesestocks should be held by private individuals,and, in fact, the government can assist privatestockholders by taking appropriate action in thefutures market. Houthakker further argues thatthis would withdraw the government fromdirect involvement in commodity storage andmarketing. Moreover, storage by private firmswould be socially desirable because they derivegreater convenience yield! from the stocks thanthe government.

This paper reports the results of a studywhich examined Houthakker's proposal usinghistorical data on soybeans. The existence of anactive futures market and relative freedomfrom government controls in production andmarketing were important considerations in theselection of this commodity.

* Purdue University Agr. Exp. Sm. Journal Paper 5005.Appreciation is hereby expressed to R. C. Haidacher,Robert S. Firch, and to unidentified Journal reviewers forhelpful comments on an earlier draft.

1 Convenience yield is a property similar to that ofliquidity which money possesses. Inventories enable theholder to draw on stocks readily as they are needed for suchuses as processing or merchandising.

ROBERT A. RICHARDSON is a graduate assistant and PAUL

L. FARRIS is professor of agricultural economics at PurdueUniversity.

Houthakker's ProposalConceptually, the proposal implies a simpli­

fied cobweb type interaction between aggregatesupply and demand over time [2, 7]. Currentprice is influenced by the size of the currentcrop, which is in turn a consequence of farmers'reactions to prices in previous years. Houthak­ker suggests that spot prices be stabilizedaround their three year moving average:

Government intervention in commodity mar­kets should therefore be designed to prevent, orat least mitigate, unduly large price movementswhile leaving scope both for the day to dayprice changes that are essential to the market­ing process and for the long run price trendsthat reflect basic developments in productionand consumption. The first of these conditionscan be achieved by limiting official interventionas much as possible to operations in the futuresmarket on a stand-by basis and the second byproviding for gradual adjustment in the rulesgoverning intervention. [4, p. 55]

A Commodity Stabilization Agency (GSA)would be established to operate in futuresmarkets under the following rules:

(1) Prices would be stabilized around a three­year moving average of commodity spotprices called the Indicator Price (IP).

(2) Above and below the I P are Agency Ceilingand Floor prices-CP and FP respectively.These two limits would be a certain per­centage above and below the IP.

(3) Between the I P and GP would be theAgency Selling Price, SP; between the I Pand FP would lie the Agency Buying Price,BP. Spot prices could fluctuate freely be­tween BP and SP. Once spot prices movedoutside this range, the GSA would operatein the futures market to affect demand forthe commodity through time, thus bringingthe spot price back between BP and SP.

(4) The GSA would trade only in contracts sixto nine months from maturity.

The rationale underlying the scheme is asfollows. When P<BP, the GSA would buy

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distant futures contracts. Private traders couldthen store the commodity and sell contracts ata distant point in time as a hedge. This wouldresult in rising spot prices and redistribution ofstocks through time. When P>SP, the GSAwould sell distant contracts; private traderswould close out hedges and place stocks on thespot market, thus reallocating stock utilizationthrough time.

A Specific ModelTo evaluate the proposal in terms of the soy­

bean example, the following assumptions weremade:

(1) Alternate BP and SP levels of ±15 percentand ±20 percent of I P were used.

(2) Alternate aggregate farm level demandelasticities of -1.0 and -0.5 were assumed.In general, the more elastic the demandfunction at a given point, the larger thequantity of the commodity that would haveto be stored or released from storage tobring a given rise or fall in price.

(3) Long-run supply response was not affectedby operation of the scheme; short-runsupply (within a year) was predetermined;i.e., supply elasticity was zero. These as­sumptions permit examination of shifts ofsupply through time purely as a result ofstock accumulation or depletion. The onlyeffect of the proposal carried over from onemonth to the next was the change in stocklevels.

(4) Existing stock demand was not affected byoperation of the proposal j-thus stockholdersdid not adjust stockholding positions inanticipation of the operation of the pro­posal.

(5) Soybeans stored as a result of GSA actionreturned to the market seven months later.This simplification of Houthakker's pro­posal that hedging occur only six to ninemonths from maturity did not greatlychange the results. With GSA operations inone direction for several consecutive months,it made little difference if each month'scontracts expired in two to three separatemonths or all in one month.

(6) Intertemporal prices were unrelated, so theredistribution of stocks through time wasthe sole concern. Associated with this wasan assumption that the supply of storagefunction is infinitely elastic,so storagespace was always forthcoming to holdwhatever stocks needed to be held.

It was implicitly assumed that the operationwas technically feasible. Also, the assumptionsoutlined were believed to be favorable tosuccessful operation of the scheme, includingthe assumption that implementation of theproposal would not alter the behavior of marketparticipants nor basic supply and demand re­sponse relationships. Assumption 6 was an at­tempt to determine the minimum amount ofcontract trading necessary to achieve Hout­hakker's stock redistribution objective, giventhe assumptions of the model.

The Data and Calculation ProcedureData used were average monthly farm level

prices and average monthly reported sum of ex­ports plus crushings of soybeans for the period1953-1967. GSA trading policies would beestablished at the beginning of each month andwould remain constant for one month. Markettraders would know trading policies in advance,thus minimizing uncertainty about GSA ac­tions.

The I P was calculated as a three year movingaverage of 36 monthly prices, held at that levelfor the following 12 months, then recalculatedevery 12 months thereafter. Monthly priceswere then examined to determine what GSAaction, if any, was called for. Where price wasbelow BP (above SP), the percentage by whichprice needed to be raised (lowered) to reachBP (SP) was determined. Through use of theformula for demand elasticity, this yieldedmonthly quantities that needed to be redistri­buted through time by CSA action. The aver­age price prevailing in any month thus de­termined GSA actions for the following month.

When P<BP occurred, CSA action resultedin a given quantity of soybeans reaching thespot market seven months later. When thismonth was reached later in the calculations, thedepressing effect on price was calculatedthrough the formula for elasticity of demand.Adjusted prices were then inspected to de­termine if GSA action was necessary. Thisprocedure is the equivalent of "rolling-forward"contracts if further GSA action is involved. Theprocedure for P>SP is analogous to that out­lined above, except that operations and out­comes are opposite to those for P<BP.

At the end of each marketing year I P wasrecomputed. For the year beginning October1953, IP was based on the 36 months fromSeptember 1950 to September 1953. The I Pfor the year beginning October 1954 used

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~ !54 55 56 57 M 59 ED 61 62 63 64 65 66 erYEAR

Figure 1. Soybean price, actual and indicated underalternative asswnptions

1 For IP± 15% the estimated large carryover of 51.8 million bushels inAugust 1958indicated a negative price. The carryover was then droppedand the calculations started anew.

September 1951 to September 1953 monthlyprices plus prices resulting from operation ofthe scheme for October 1953 to September1954. Thus the effects of the scheme on pricesandquantities were carried forward.

Table 1. Stock accumulation and depletionunder the alternative assumptionsused, 1953-1967

IP±20% IP±15%Year

E=-1.0 E=-0.5 E=-1.0 E=-0.5

million bushels1953 -4.14 -2.07 -7.51 '-3.761954 2.09 1.05 4.49 2.251955 9.73 4.87 34.57 17.291956 0.75 0.38 35.35 17.681957 66.53 33.2719581959 16.96 8.481960 -24.25 -12.13 -42.74 -21.371961 -3.23 -1.62 .,...55.19 -27.601962 -23.53 .,...11.771963 -10.63 -5.321964 -2.92 -1.461965 -11.94 -5.97 -17.67 -8.841966 -1.08 -0.541967

of the elasticity or an increase in the rangeofpermitted price fluctuations reduced the amountof stock redistribution through time.

Effects on futures tradingTable 2 indicates the number of contracts

traded under alternative assumptions. Over theperiod 1954~1958 with P<BP the CSA wouldhave bought contracts. Private traders wouldhave held stocks and hedged by selling con­tracts to the CSA. Seven months later thesestocks would have returned to the marketnecessitating purchase of more target contractsuntil P?.BP again. This is equivalent to "roll­ing over" of contracts held by private traders.

-- I"iA I· ~~ " ~

Ir- /j

/ ./Iy

fl -- ACTUAL DATA:I. I ---- IP:t20%~ I --IP:tIS%

~-::.d

1/

2.00

2.20

2.60

2.80

The ResultsEffects on prices

By assumption the proposal stabilized month­ly prices. Stabilization at I P ±15 percent re­quired substantial involvement in futures trad­ing and caused a more pronounced time trendin annual average prices received by farmers(Fig. 1). This resulted because falling prices(1953-1959) were accentuated by shifting stocks

numbers of contracts1953 828 414 1502 7521954 418 210 898 4501955 1946 974 6914 34581956 150 76 7070 35361957 13306 665419581959 3392 16961960 4850 2426 8548 42741961 646 324 11038 55201962 4706 23541963 2126 10641964 584 2921965 2388 1194 3534 17681966 216 1081967

Table 2.forward on a falling market. During the 1960­1964 period P>SP depleted stocks thus ac­celerating the rise in prices in subsequent pe­riods. Stabilizing at IP ±20 percent resultedin less intervention but had a similar influence;

The implication of the above conclusion isthat a three-year moving average is backwardlooking and fails to predict correctly the pricetrends from year to year. Stocks were nothedged far enough in advance to be carried overinto a time period when the trend in prices wasreversed.

Effects on stocksThe proposal constrains the spot market to

put pressure for adjustment on stocks ratherthan prices. Changes in annual stock levels areshown in Table L A fall in the absolute value

Year

Number of contracts traded underalternative assumptions 1953-1967

IP±20% IP±15%-------E= -1.0 E= -0.5 E= -1.0 E= -0.5

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When prices were rising (P>SP) over theperiod 1960-1966, the GSA would continuallyhave sold contracts. After the first seven monthsthe GSA would have been forced to sell short.Stocks would have to have been held for de­livery in the event the GSA could not buy backbefore maturity. The size of stocks would havedepended on elasticity and stability assump­tions and would have ranged from 19 to 155million bushels.

Evaluation of the ProposalSeveral aspects of the model should be

recognized in evaluating the proposaL Theanalysis is comparative statics in the sense ofcomparing final equilibria under alternativerestrictive assumptions. The adjustment pathfrom one equilibrium position to another is notspecified. Assumptions also need to be care­fully evaluated as to their plausibility.

It was assumed that the proposal would nothave altered long-run supply response fromthat which occurred. If, over the 1953-1959period, the proposal raised average prices,production may have been stimulated, neces­sitating larger volumes of futures trading andstock accumulation than indicated in this study.If prices were lowered in the 1963-1966 period,production might have been restrained thus in­creasing the volume of short selling of futurescontracts and the amount of stock depletion.Since the proposal did not stabilize annualprices, the argument that more stable priceswould have altered supply response cannot bemade. Even if annual prices had been stabilized,it is not clear how supply would have responded.

Assumption (4), that existing stock demandis not affected by operation of the proposal,may not be justified. Given confidence that theCSA could achieve P?:.BP, private tradersmay take up stocks when P<BP occurredwithout any GSA futures trading being neces­sary. This would reduce the amount of futurestrading by the GSA. The GSA would have tooperate on a trial and error basis facing thedifficulty of predicting the behavior of futurestraders and stockholders in varying situations.Reliable estimates of stock redistribution andvolumes of futures trading would be difficultto make.

Assumption (6), which is implicit in theproposal, seems unrealistic. It recognizes onlyfirst round effects of CSA actions. In a perfectlyoperating market the range of inter-temporalprices differs solely by the cost of carrying in-

ventories. When P<BP, GSA action wouldhave the first round effect of raising spot pricePs and distant future price Pn, This changes thedifferential between these two prices ·and allother inter-temporal prices. Private traderswould bid all other prices up, or bid Ps and Pnback down until such time as the differencesbetween prices represented only inventorycarrying charges, not allowing for any profitsfrom holding a particular position.

In a perfectly operating market the GSAwould have to bid up all inter-temporal prices.This would create no incentive for redistribu­tion of stocks through time. The question thenarises as to what amount of CSA trading wouldbe necessary to raise the whole spectrum ofprices by enough to yield the stabilized patternof spot prices. Monthly spot quantities of soy­beans plus the monthly open interest in soy­bean futures would be used as the calculationbase. Since open interest in soybeans is gen­erally two or three times the monthly volume ofcrushings plus exports, the GSA would have toincrease its trading 200 to 300 percent abovethe results shown in Table 2.

Houthakker's proposal thus appears to be in­ternally inconsistent. On the one hand heclearly states that we need to redistributestocks through time which would require unre­lated inter-temporal prices. On the other hand,to the extent that bidding up one price createsa profit incentive for private traders to bid allother prices back in line, there may be no redis­tribution of stocks through time.

Working suggests that hedging has "the ef­feet ... of promoting the stockpiling of com­modities in private hands in times of surplus,inducing the economical storage of such stocks,and prompting their release for consumption atthe most appropriate times" [8, p. 555]. Fur­ther, the spot-futures price relation may be aguide in inventory control which encouragesholding of surplus stocks and discourages stock­holding when supplies are short [8, p. 555].Elsewhere, Working has commented that theargument that government should carry stocks"rests in large part on ignorance of the effective­ness with which the hedging facilities of futuresmarkets assure private carrying of stocks inabout as large a volume as can be justified onpurely economic grounds" [9, p. 327]. This sug­gests that private stockholding can stabilizeprices and quantities without any GSA action,and Working claims that while futures marketsmay not produce as much flexibility of stocks as

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desirable, at least they operate in the rightdirection. Other writers [1,5] have argued forprivate stockholding and futures market hedg­ing to stabilize prices through time. GSA actionwould have some effects on all traded contractsand may result in misallocation of stocksthrough time [6]. This in turn may confuseprice signals for both inventory and productiondecisions.

The roles and functions of futures marketparticipants may be affected by the proposal.It is based primarily on the risk avoidancehedgingJunction of futures markets and ignorestrading motivated either by, the possibility ofbasis changes or to insure a steady grain supplyfor processing. Further, speculators are at­tracted by price instability that would be re­duced if the GSA fulfilled its objectives. In somecases futures markets have declined for lack ofspeculator interest [10]. The GSA would tradeas a speculator and perhaps would merely fillthe gap in the speculative side of the marketvacated by private speculators as a direct resultof GSA action.

Spot and futures prices could become increas­ingly unrelated as a result of the operation ofthe proposal. Over the period of falling prices1954-1958 the GSA would continually have toroll over stocks held by private traders. To in­duce private traders to hold stocks over a five­year period, the contract price would have torise continually so there would be a price-of­storage incentive to hold stocks. The GSAwould continually have to bid up contract pricesso hedgers could earn a long run return fromstorage and retain stocks while rolling over con­tract holdings.

When P>SP occurred, stocks would have tobe held to cover short sales. Stocks may be ac­cumulated by direct purchase or by acceptingdelivery on contracts purchased while P <SPprevailed. In either case the GSA would havebeen drawn into a storage program which theproposal was attempting to avoid. Some pre...dictor more reliable than a moving average ofpast events would be needed to anticipate longrun price trends and associated stock require­ments. Problems of forecasting exist for Hout­hakker's proposal just as for alternative sta­bilization proposals.

ConclusionsImplementation of Houthakker's proposal

would have caused a larger movement in annualsoybean prices during the 1953-1967 period

than actually occurred. The three year movingaverage imposed "backward looking" trends onfuture prices and quantities during a periodwhen long time price trends prevailed. To makethe proposal work, the government would havebeen drawn into some kind of acquisition andstorage program, which Houthakker was seek­ing to avoid.

Houthakker's proposal fails to consider possi­ble side effects on the futures market. Such aproposal could great!y change the existing struc­tural relationships between spot and futuresmarkets. It could reduce the ability of futuresmarkets to evaluate likely future prices andsupplies and further add to price instability sug­gested by this evaluation of the proposal. Therecould be adverse effects on other futures marketparticipants such as processors, stockholders,and speculators in addition to farmers. The im­portance of expectations in the relationshipsbetween spot andfutures markets would add tothe complexity of effects of such a proposal.

Buying and selling limits of IP±15 percentwould reduce monthly but not annual pricefluctuations. The effect on uncertainty woulddepend on the confidence of farmers and othersthat the scheme would be successful. A largeeducational and information effort by CSAwould be required. The acceptable degree ofstabilization would depend on trial and errorresults of operation of the scheme in the futuresmarket, cost to the GSA, and political accept­ability to various interest groups.

Commodities with cobweb patterns of pricebehavior (for example potatoes, hogs, and cat­tle) may be amenable to price stabilization bythis method. Even then costs of storage andlack of identifiable markets, grades, and stan­dards may limit the practicability of the pro­posal. Commodities with long term price trendsmay face problems similar to those found in thisstudy.

The evaluation of Houthakker's proposal as­sumes the existence of a stability problem. Inthe postwar period farm incomes have beenincreasingly stabilized as a result of stability inthe whole economy [3]. Policy makers havefrequently failed to distinguish the level anddistribution from the stability of farm income.Existing stabilization plans have therefore beenconcerned, at least partly, with raising prices.Unless Houthakker's proposal was expected tooffer prices as high as those under existing farmprograms, it may not be acceptable. Aside fromthese considerations exists the question of

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in the futures markets would not solve theproblem of price instability.

whether price instability adversely affectsfarmers. Even if there are adverse effects, thisresearch suggests that government operations

References[1] ELDER, W. A., Risk, Uncertainty and Futures Trading

Impluations for Hedging Decisions of Beef CattleFeeders, Dept. of Agr. Econ. Staff Paper P 69-20,University of Minnesota in cooperation with USDA­ERS.

[2] EZEKIEL, M., "The Cobweb Theorem," Quart. J.Econ. 52:255-280, 1938.

[3] FIRCH, ROBERT S., "Stability of Farm Income in aStabilizing Economy," J. Farm Econ, 46:323-340,May 1964.

[4] HOUTHAKKER, HENDRICK S., Economic Policy for theFarm Sector, Washington, D. C., American Inst. forPublic Policy Research, Nov. 1967.

[5] McKINNON, R. I., "Futures Markets, Buffer Stocks,and Income Stability for Primary Producers," J.

Polito Econ. 75:844-861, Dec. 1967.[6] TOMEK, WILLIAM G., ~J) GRAY, ROGER ·v.l., "Tem­

poral Relationships Among Prices on CommodityFutures Markets: Their Allocative and StabilizingRoles," Am. J. Agr. Econ. 52:372-380, Aug. 1970.

[7] WAUGH, F. V., "Cobweb Models," J. Farm EGon.46:732-750, Nov. 1964.

[8] WORKING, HOLBROOK, "Hedging Reconsidered,"J. Farm Econ, 35:544-561, Nov. 1953.

[9] --, "Futures Trading and Hedging," A m, Econ,Rev., 18:314-343, June 1953.

[10] --, "Price Effects of Futures Trading," StanfordUniversity, Food Research Inst, Studies 1:1-31, Nov.1960.

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