Chapter 1: The basics of supply and demand

“From the taste of wheat it is not possible to tell who produced it, a Russian serf, a French peasant or an English capitalist.”

Karl Marx

At its basic level a commodity is an input into the production of a good or service – the lithium used in the battery powering the device you’re reading this book on, for example. In general, households rarely purchase commodities directly; rather they are typically the raw materials purchased by manufacturing companies to be refined into the goods and services that we use.

One of the basic characteristics of a commodity is that it should be uniform in quality and lacking in product differentiation. Fungibility, as it is known, means that the market treats its instances as equivalent, or nearly so, with no regard to who produced them. Given these properties, one of the characteristics of a commodity is that its price is determined as a function of its market as a whole. In reality, things are not quite so simple and so there is a spectrum of commodification. Few commodities have complete differentiability and hence fungibility. Even wheat is not a uniform commodity. Bread makers prefer “hard” varieties with more protein, and cracker makers prefer “soft” wheat.[i]

The three main categories of commodities are: energy, metals and agriculture. However, the term “commodity” can also be extended to other things, many of which you would not even consider, but share the same properties: internet bandwidth, water or carbon emission credits, for example.

The demand for a particular commodity is closely connected to the demand for a related product or service – known as “derived demand”. For example, the demand for steel and many other metals is strongly linked to the demand for new vehicles and other manufactured products, so when an economy goes into a recession, we expect the demand for those metals to also decline or at least not grow as fast.

In order to understand the level of demand you need to know something about the price elasticity of demand (the responsiveness of consumption to a change in the price). As prices rise, will consumption start to wane or will it stay constant (called perfect elasticity of demand)? Typically, if a good is seen as a necessity the price elasticity will be low (otherwise known as inelastic), meaning that an increase in its price will only lead to a relatively small drop in demand. Remember though, what is considered a necessity in the US and other developed economies (gasoline, for example) may be considered a luxury in other parts of the world.

The availability of substitutes also affects a particular commodity’s price elasticity of demand. If there are many alternatives (eg, you and I may decide to eat more pasta made from Durum wheat if the price of rice increases) then a commodity is likely to be price elastic.

Increasingly, commodities are being seen as financial assets and so are in demand for their own sake. In contrast to other assets though (eg, a stock, bond or property), a commodity provides no income stream. Some commodities like gold and many other precious metals are seen as a store of value in times of uncertainty.

The supply of commodities responds to incentives. High demand and high prices typically encourages farmers, miners and other commodity producers to respond by increasing supply in order to capture higher margins. However, supply is also sticky. In economic terms, commodity supply tends to be price inelastic, ie, it takes time for supply to respond, whether it is a mine, planting crops and waiting for the harvest or drilling an oil well. The supply of commodities is also prone to disruption and can be affected by many factors: adverse weather, disease, war, transport problems, environmental damage and cartel behaviour, for example.

As we will see later, changes in commodity prices can affect entire economies, be the spark that causes war and cause damage to the environment and in turn be influenced by the changing climate. In addition, they are often transported across the world to satisfy demand and they are frequently a source of fear and concern for the future.

A bushel of wheat or a tonne of lead look much the same now as they did thousands of years ago. What’s changed is what they can be used for, the wide ranging impact they can have and the threat and opportunity that bottlenecks in their supply and demand represent.

The essential thing:

A commodity is an input into the production of a good or service and by definition is uniform in quality, lacks product differentiation and is fungible.

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