What’s your phone made of?
What are the materials needed to build electric vehicles?
What has been the main cause of food and energy price inflation?
To answer these questions, we need to examine the “economics of commodities”.
Why commodities are critical to a functioning economy
Commodities are a particular type of good. Everything from metals to energy to basic foodstuffs.
For commodities, they are not very differentiable. In particular, the market will often treat the good as the same or very similar, no matter the producer.
This concept is called “fungibility“.
Think of commodities like oil or wheat – all units of these goods are, more or less, interchangeable, whoever the producer is.
Also commodities are often inputs used for producing other goods.
Metals like copper, lithium and cobalt are used to produce phones and their electrical components. This includes wires, computer chips and batteries.
Why are commodity prices important?
Rising energy prices in 2022 and 2023 had a very large impact on Western economies.
Higher inflation, higher fuel poverty, slower economic growth, as well as higher government spending on energy support schemes.
Commodity prices can clearly matter for the whole economy.
Suppose the price of a commodity, such as oil, rises. What are the consequences for the whole economy?
- Higher costs for firms. This can slow economic growth and lower employment.
- Higher prices for consumers if the commodity is consumed directly by consumers.
- As a result, the rate of inflation may rise.
- Higher revenues and profits for sellers of the commodity. For these kinds of countries, growth and employment may rise.
- Resource curse risks for countries that sell commodities.
The diagram below summarises these key effects. Can you think of further, knock-on impacts from these primary effects?
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How an economist evaluates impacts
The skill of evaluation is a key part of the economist’s toolkit, whether you’re an A-level economist or a professional economist.
Evaluation means weighing up impacts. Are the impacts of higher energy prices likely to be large or small? Why?
Moreover, the effect of commodities is a great example to practise this.
What determines the effects of a rise in commodity prices?
To evaluate like an economist, first break down our “chain of analysis” into stages.
Then think about what factors may determine the strength of link in our chain of analysis.
Here’s an example of what I mean:
A. Suppose oil prices rise 10%.
B. This increases firm costs.
Evaluation: By how much? Do firms switch away from oil towards substitutes, including renewable energy? Does the higher price force firms to use their oil more efficiently?
C. Firms pass higher costs onto consumers, in the form of higher prices.
Evaluation: What determines how much of the higher costs the firms can pass on to consumers? If consumers are very responsive to price (price-elastic demand), the firm may not want to pass on the costs, fearing loss of customers.
D. This raises inflation.
Evaluation: What fraction of goods in the economy rely on oil as an input? Might this change over time? Think about different sectors: manufacturing vs labour-intensive services.
Question to consider: can you apply this evaluation method to one of the other consequences of the commodity price rise?
Why are commodity prices volatile?
Commodity prices are often volatile.
This affects the economy too – firms may find it harder to plan ahead if their future costs are uncertain.
Firms may use “futures contracts” to reduce the impact of uncertainty.
A futures contract is a promise to buy/sell a commodity at a guaranteed price and guaranteed future date.
In exchange for this certainty, the firm may pay a premium, increasing their costs.
But why are commodity prices so volatile?
- Price-inelastic supply and demand. If the price changes, supply does not respond easily. It may take time to find new mines or grow new crops. Similarly with demand – the commodities are often necessities for their particular uses, making it hard to cut back demand.
- Insecure supply and risk of large shocks to the market, such as conflicts, trade wars or global downturns. This can create large shifts in supply and demand.
The dangers of relying on commodity exports
Specialising in producing and exporting a single commodity carries risks:
- “Dutch disease“. Higher demand to export the commodity, such as oil, raises demand for the currency to buy the oil. The resulting appreciation in the currency reduces demand for other exports, such as tourism. An example is oil exports from Venezuela.
- Prebisch-Singer hypothesis. Assuming real incomes grow over time, demand for certain goods will rise more quickly (luxuries, services, manufactured goods goods) while demand for other goods will rise at a slower rate (primary sector goods like commodities). Therefore, the price of commodities will fall relative to the price of manufactured goods over time. This worsens the “terms of trade”, the amount of imports that one unit of exports enables an economy to purchase.
- Exposure to price volatility, which we have already mentioned.
As a result, often relying on the exports of a single commodity to support economic growth can be a “resource curse”.
The example of cobalt
Cobalt is used in making lithium-ion batteries for electric vehicles for instance.
Over 50% of demand for cobalt comes from these kinds of batteries.
A reliable supply of cobalt will be critical to any country’s plans to decarbonise.
Because of this, demand is rising significantly year on year.
While the extraction of some metals is scattered around the globe, cobalt supply is different. The Democratic Republic of Congo (DRC) extracts about two-thirds of the world’s supply of cobalt.
Relying on one country for the supply of cobalt is risky. Any domestic problem in the DRC, which has been vulnerable to civil war and conflict, could have knock-on effects globally.
The European Union is trying to increase the percentage of recycled cobalt in use. Specifically by imposing a minimum level of recycled content in batteries.
In addition, some of the supply of cobalt is coming from workers working in unsafe conditions, particularly in small scale mines.
As consumers and firms become more aware of the working conditions, will there be greater regulation or a flight towards alternative suppliers?
Related resources
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You can also find resources for A Level Economics students here.
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