The effect of a poor crop, applying demand, supply and elasticity

It will surprise many to learn that the second most expensive spice by weight in the world is Vanilla (Saffron is the most expensive). And there was a poor crop of vanilla last year.

The article linked below shows that in Madagascar the vanilla crop has fallen by up to 700 tonnes from 2000 tonnes a year. Madagascar produces the best vanilla and is favoured by ice cream makers.

The result has been a rise in price from £59 to £144 a tonne and this is being passed on to ice cream makers. While your favorite ice cream flavour might not be vanilla it is the biggest selling ice cream.

The diagram below shows the effect on the vanilla market.

Although the fall in vanilla production is 35% the rise in price is 144%. This gives us a Price Elasticity of Demand (PED) of (-) 0.24. That is very inelastic. Should we be surprised by the result? Well not really, vanilla has few substitutes and those that exist are regarded as being of lower quality. Also vanilla represents a fairly small proportion of household expenditure, despite it's high price per kg. Could we regard it as a necessity? Well for some products yes, although this argument isn't as clear cut. Whatever the PED tells us demand is inelastic!

Notice also that the income of vanilla farmers has shot up, from £118,000 to £187,200. This is what we expect to see in primary product markets and inelastic demand.

What will be the consequence for ice cream prices? Well not as big a price hike as there was for vanilla. The article tells us that 'customers would notice' a rise in vanilla ice cream prices compared to other ice cream. This is suggesting that ice cream flavours are substitutes for each other (they have a high cross-price elasticity of demand, XPED) and there are also alternatives to icecream. So manufacturers are likely to absorb the rise in vanilla price this year and hope for a larger crop in 2016.

The diagram below shows what happens if the ice cream manufacturers passed on the full rise in vanilla prices. Because demand for vanilla ice cream is elastic the price rises from 0P1 to 0P2, but there is a large fall in quantity demanded (Q1 - Q2). So we are likely to see a smaller rise in ice cream price than (P2 - P1) due to competition between ice cream makers and the high XPED between ice cream flavours.

The Guardian article is here

IB students will be able to apply elasticity concepts to this article and use it as an example of primary product markets. It is th stuff good IA's are made of. VCE students will see it as an application of demand and supply analysis and PED.