Volatile Situation

Published online: Mar 18, 2022 Articles Patrick Hatzenbuehler & Liang “Jimmy” Lu
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This article appears in the March 2022 issue of Potato Grower.

Do you remember the last time you heard that common refrain in the business community: “You have to spend money to make money”?

Well, hearing that phrase may be more common in the 2022 crop year, and it may also need to be adjusted to: “You have to spend more money to make money.” That is because the USDA Economic Research Service (ERS) estimates that nearly all farm input costs, inclusive of seed, electricity, fertilizer, fuel and oil, repairs and maintenance, labor, interest, and rent, will be higher for the 2021-22 crop year than the 2020-21 crop year.

Pesticide is the only input category for which a year-to-year increase is not projected. The inputs with the largest changes from the last to the current crop year are fertilizer, with an estimated greater than 12% year-to-year increase; and fuel and oil, with an estimated greater than 32% increase. ERS projects that total farm production input costs will increase by more than 8% for this crop year compared to last year. The goal of this article is to discuss the profitability implications of this new, higher-production-cost environment for potato producers for the 2022 crop year.

There are three key takeaway messages, and we discuss each in greater detail below. First, based on the ERS projections, potato producers should expect that production costs will be higher in 2022 than 2021. Second, whether these production cost increases matter for industry profitability depends on the price elasticity of demand for potatoes. Third, individual potato farm profitability will be influenced by the marketing arrangement and, specifically, the degree to which higher revenues and/or steady or lower costs can be obtained via risk management tools such as contracts.

Cost Increases

Since we have already discussed the projections of increased producer costs, the question that remains is, Will these cost increases necessarily imply lower profits? We argue that this is not the case in a general sense because higher costs can be passed on to other entities in the supply chain via higher potato prices. The key market characteristic that allows for costs to be passed along is the price elasticity of demand. Fortunately for potato producers, the demand for potatoes is price inelastic, with a value of -0.6 as estimated by Richards and Kaiser. There are two important properties of this elasticity estimate. First, it is negative and, therefore consistent with the law of demand in which higher prices correspond with lower quantity demanded (and vice versa). Second, it is less than 1, which means that for any percentage price increase, quantity demanded decreases by a lower percentage. In a general sense, the more necessary a good is, the more price inelastic is its demand. Thus, since potatoes are the most popular vegetable among U.S. consumers, the demand for potatoes is more price inelastic than that for less popular vegetables.

Let’s do a brief example to illustrate why this is important. Suppose that the current price of potatoes is $10 per hundredweight and quantity demanded is 400 million hundredweight. Then, current potato industry revenue is $4 billion. Next, suppose the price increases by 10% to $11 per hundredweight. With an elasticity of demand of -0.6, this implies that quantity demanded will decrease by 6%, or 24 million hundredweight, to a value of 376 million hundredweight. Under this scenario, total industry-wide revenue after the price increase is a higher value of $4.136 billion. Thus, with price inelastic demand for potatoes, higher prices can correspond to higher industry revenues.

But is the price elasticity of demand inelastic for the fresh retail, processing and foodservice segments of the potato industry? In a general sense, yes, but there are reasons to believe that they would not be equally inelastic. Richards and Kaiser estimate that the price elasticity of demand for processing potatoes is close to that for retail potatoes. However, data issues for processing potatoes make the elasticity more difficult to estimate for that segment. USDA National Agricultural Statistics Service (NASS) data show that, for potatoes, processing sales are more stable than fresh sales. This is explained by some structural characteristics of the processing versus the fresh markets. Potato processing capacity is relatively fixed from year to year, with more capacity coming online after an investment over several years. Thus, with relatively fixed capacity, it is expected that processing demand remains relatively steady even if prices fluctuate. This is consistent with inelastic demand.

Fresh potato sales are influenced by the relative prices of substitute vegetables and general consumer demand-related factors such as consumer income and population. Since income and population, and hence retail fresh potato sales, can change year-to-year to a higher degree than processing capacity, it may be likely that fresh potato retail demand is more price elastic than that for processing potatoes. Despite differences across market segments, since potatoes are the most consumed vegetable in the U.S., the nature of generally price inelastic demand is unlikely to change in the near term.

Farm Profitability

With this context of price inelastic demand, the next important component for 2022 profitability is the behavior of potato prices. A key aspect of potato prices in the U.S. is the level of potato production. This is in large part due to it being costly to transport potatoes from production to processing regions, which means that production in other potato-producing regions (even in Canada) cannot be cheaply substituted for local production. Thus, with price inelastic demand and few substitutable supplies, reductions in U.S. production tends to correspond with higher prices. Since NASS is estimating lower production in 2021 relative to 2020, it is likely the case that prices in 2022 will be higher than 2021. Price data from the USDA Agricultural Marketing Service (AMS) show that U.S. potato prices were increasing from November to December 2021. An index of historical prices shows that prices tend to, on average, increase from January to April. Thus, potato producers may expect higher prices for at least the first few months of 2022. Risk for downward price movements will arise around April when area-planted estimates for potatoes and other crops become known.

Will your operation realize profits in 2022? This question is largely determined by your operation’s position in the potato supply chain, and whether you sell to retailers, foodservice or processors. Each of the segments has its own return and risk profile. Selection among varieties such as Burbank versus Norkotah, and the associated ability to sell each type in each segment of the potato supply chain, can also influence the ability to successfully market potatoes at a desired price. Another key factor is the extent to which and the type of contracts that are used. Sales contracts that have a fixed sales price reduce the risk of selling when non-contract market prices decline. However, in this period of higher input costs, locking in only sales prices can ultimately lead to lower profits.

Thus, we recommend that potato producers use this period of substantial increase in input costs as a time to take stock of current business operations. Is your marketing arrangement providing you your desired return and risk profile? Are there any adjustments you can make to your production plans to make it less at risk of lower profits if costs increase in the future? Are the risk management tools (e.g., contracts) currently being used sufficiently lowering risk and providing enough returns? We hope this period of change can be an opportunity to make or at least consider worthwhile adjustments.

 

This article is based on a presentation by the authors at Potato Expo 2022 in Anaheim, California, on Jan. 6.

Patrick Hatzenbuehler is a crops economics extension specialist at the University of Idaho’s Twin Falls Research & Extension Center. He can be reached at phatzenbuehler@uidaho.edu.

Liang “Jimmy” Lu (llu@uidaho.edu) is a UI assistant professor of agricultural economics.

References are available upon request.