World Wheat Market Instability: An Analysis of EC Price Insulation Effects

Supply variability (due to natural phenomena) and (to a lesser extent) demand variability are the natural causes of market price instability. Standard theory suggests that a country employing a fixed price policy through tarriffs and subsidies rather than through buffer stocks will export its domestic price instability to the foreign market. An example is the European Community's (EC) variable levy system, which raises and stabilizes prices in the EC. A stochastic simulation with an econometnc model of world wheat markets was used to evaluate the impact of the EC policy on the world price level and stability. In comparison with current policies, the estimated impact of border pricing by the EC was to raise the world market price by 13 percent and reduce its standard deviation by 2.3 percent. The stabilizing effect on prices is smaller than the theory suggests, because EC production variability increases as a result of greater price uncertainty. Theoretical models usually assume supply price certainty with and without the price policy; but, under border pricing, production responds in an adaptive expectations framework. As a consequence, the effects of a price insulation policy on price stability are reduced.