Sunday Reflection: Elasticity - Price Anchoring and X backed Y's

Another interesting relationship related to elasticity is the idea of price anchoring. A typical example is between wheat and corn.

Wheat and corn supply needs have very similar characteristics. The primary ingredients are land, labour, fertilizer, weather etc. Now I'm sure there's probably an intrinsic ratio describing the value of wheat to corn (although I'm not sure what it is... Although it's probably directly proportional to the amount of land required). The assumption is that from a farming perspective, you can describe the production of these products strictly as consumption of the primary supply resources with a high correlation between the inputs and the outputs and they are intimately related.

Now from a financial perspective, you can take this operating relationship and extrapolate that since the supply is so interrelated (there exists a relationship where their supply attributes are almost perfect substitutes for each other) you would anticipate that there is a natural price ratio that should always exist between them, even if on the demand side people prefer consuming corn over wheat 10 to 1 (perhaps ethanol fuel becomes increasingly popular driving up demand of corn). But the price ratio between them should still be the same. Why is this?

As the demand for corn increases beyond the equilibrium point, between bankers and farmers, there should be an obvious opportunity to profit by "arbitraging" the increase in the price of corn. Essentially, both bankers and farmers would slowly change their positions: becoming long corn and short wheat. For farmers, this would mean converting land from growing the previous equilibrium levels of corn and wheat to the new equilibrium introduced with the increased demand. Although this shifts the respective supply curves, this should restore the price of both commodities to within their natural intrinsic value ratio. In this way, the price of corn is anchored against the price of wheat and vice versa.

This is exactly the same relationship many world currencies used to have with gold. When the US government had the gold backed dollar, each dollar of currency was essentially a certificate of deposit on a quantity of gold held by the US government. In that way, price fluctuations in the value of the US dollar were stabilized on the world market because of the stability of gold.

However, now because this is no longer the case (US dollars were taking off the "gold standard" in 1973) the US dollar fluctuates much more (especially when the government must print more bills, diluting the value of each individual bill, in order to maintain its spending programs in recessionary times). The aforementioned relationship is particularly notable in this case, because dollars and gold shared many important characteristics were very interchangeable as stores of value (although perhaps not as much for mediums of exchange - few people make purchases with gold).

There has been a lot of buzz about the deflation of the dollar, especially after the recession is over as the debt spending to get out of the recession catches up with us. Although people are more concerned about job growth and stimulating the economy, it would be foolish to ignore the next hurdle on the horizon.