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Price Determination in Agricultural Commodity Markets: A Primer

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Publication Date: January 2006

Publisher(s): Library of Congress. Congressional Research Service

Series: RL33204

Topic: Banking and finance (Commodity exchanges)

Abstract:

This report provides a general description of price determination in major U.S. agricultural commodity markets for wheat, rice, corn, soybeans, and cotton. Understanding the fundamentals of commodity market price formation is critical to evaluating the potential effects of government policies and programs (existing or proposed), as well as of trade agreements that may open U.S. borders to foreign competitors. In addition, an understanding of the interplay of market forces over time contributes to flexibility in making policy for what may be short-term market phenomena. The general price level of an agricultural commodity, whether at a major terminal, port, or commodity futures exchange, is influenced by a variety of market forces that can alter the current or expected balance between supply and demand. Many of these forces emanate from domestic food, feed, and industrial-use markets and include consumer preferences and the changing needs of end users; factors affecting the production processes (e.g., weather, input costs, pests, diseases, etc.); relative prices of crops that can substitute in either production or consumption; government policies; and factors affecting storage and transportation. International market conditions are also important depending on the "openness" of a country's domestic market to international competition, and the degree to which a country engages in international trade.

A distinguishing feature of U.S. commodity markets is the importance of futures markets. Unlike cash markets which deal with the immediate transfer of goods, a futures market is based on buying (or selling) commodity contracts at a fixed price for potential physical delivery at some future date. A futures exchange provides the facilities for buyers and sellers to trade commodity futures contracts openly, and reports any market transactions to the public. As a result of this activity, futures markets function as a central exchange for domestic and international market information and as a primary mechanism for price discovery, particularly for storable agricultural commodities with seasonal production patterns.

The U.S. Department of Agriculture (USDA) plays a critical role in monitoring and disseminating agricultural market information. Commodity markets rely heavily on USDA reports for guidance on U.S. and international supply and demand conditions. The release of USDA supply and demand estimates has the potential to substantially alter market expectations about current and future commodity market conditions and are, therefore, closely watched by market participants.

In general, certain characteristics of agricultural product markets set them apart from most non-agricultural product markets and tend to make agricultural product prices more volatile than are the prices of most nonfarm goods and services. Three such noteworthy characteristics of agricultural crops include the seasonality of production, the derived nature of their demand, and generally price-inelastic demand and supply functions. In addition, wheat, rice, corn, soybeans, and cotton each have certain unique structural characteristics that further differentiate the nature of market price formation from each other. This report will be updated as conditions warrant.