Price volatility and international trade: Some reflections for important commodity exporters

Introduction Commodity prices tend to be subject to high volatility. This high volatility tends to be explained mainly, but not only, by supply side effects such as climate in the case of agricultural products. However, this volatility can be also explained by Government measures or other international institutions (OPEP decisions in terms of supply of oil, for example). Moreover, demand side effects can be also found such as changes in the income and production structure of the important buyers, such as China and India in the last years. On the other hand, Governments can reduce or amplify this volatility with different policy measures (import and export tariffs, subsidies, buffers, etc). Since the volatility is transmitted between countries, international trade must be considered in the analysis. The effects of high volatility are greater the larger the share of the agricultural and mining activities in the economy or in exports but also the lower or weaker the market tools or institutional arrangements available to reduce them, such as future, assets and insurance markets. Moreover, high volatility could also affect the Governments budget as well as the current account of the balance of payments. It is well recognized in the literature and in the economic history the effects of phenomena such as the so-called Dutch Disease. However, continuously countries have been experiencing problems in dealing with this phenomenon. Sudden increases in commodity prices tend to reduce the relative profitability of other economic sectors, reducing its participation in the total product and consequently, making the economy even more vulnerable to the following reduction in the price. This phenomenon reinforces the observed volatility, increasing prices when they are already high and reducing them further when they are already low. On the other hand, Governments have been several times incapable of dealing with these problems. It is convenient to clarify what is the problem. At the end, developing countries have been always looking for higher prices for their exports and blaming developed countries about protectionist measures that reduce the international price, particularly in agricultural products. Since the 1950s and 1960s several economist have been warned about the declining price in the agricultural and mining products. Prebisch and other economist from the Structuralism School have been warning about this problem. However, they do not foresee that also industrial products would also fall, making the deterioration of the terms of trade not so important. Nevertheless, the bias against the agricultural production and pro industrialisation has been and it is present in the development literature. However, it seems that the problem is not the constant deterioration of the terms of trade or reduction for the prices of exports. The main problem is seems to be that commodities in general, even though could be facing a downward or upward trend; they are subject to sudden increases and decreases. In a nutshell, more than the trend, the problem is the variance. From 2003 until nowadays, prices for commodities have increased again. Whatever the causes behind these increases, the problem seems to appear again. Commodities producers are facing again extraordinary higher prices for their products and the possibility that problems could appear if prices fall is latent. Moreover, it seems that institutional capability to deal with these problems has not improved and the danger is still present. In some cases, countries are applying old recipes to deal with the problem and some questions raises about the efficiency and effectiveness of that measures. This is a problem particularly of economies in which the agricultural, mining and oil activities play an important part in the total economic activity or in countries in which their exports rely heavily on this kind of problems. If we accept that agents try to smooth their income and, specially, their consumption, price volatility constitutes an impediment to achieve that goal. This appears particularly

when agents do not count with appropriate market tools to hedge against this movements and transfer wealth and income from states of nature and across time, they are unable to smooth their consumption and are subject to the consequences of the price volatility. If the market tools are available, producers could reduce, in principle, their exposure to the high volatility prices, but also, they could reduce the volatility in itself. If insurance, futures and assets markets are available and their work efficiently, producers could transfer wealth between time and states of nature. This would contribute to reduce the price volatility and consequently, the economic cycle volatility and reduce the whole economy risk exposure. On the other hand, there is a policy dimension. Governments could reduce price volatility and smooth the economic cycle by using appropriately different policy instruments. However, the experience reveals that they could not achieve the stabilisation of price and sometimes, they have also worse the problem. One question to answer is that if their failure has been due to the tool chosen in it or due to an inappropriate use of it. Related to the previous point is the use of trade policy to deal with this phenomenon. In the case of Argentina, for example, being an important exporter of food products, the increase in the commodities prices adds another problem to the phenomenon, since it tends to increase prices for food in the domestic market. That means that since agricultural exports explain nearly 50% of total exports, increases in international prices tend to increase also the domestic price in sensitive products. The Government solution has passed to isolate the export market and the domestic market by the introduction of export taxes and export restrictions. On the other hand, countries facing low international prices tend to increase tariffs to protect local producers and increase their profitability1. This adds the main contribution of this paper: the international trade dimension. During the 1970s the Academia showed a renewed interest in the study of the price fluctuations determinants and the tools that agents can use to reduce or hedge from that volatility. Particularly, authors such as (QUOTE) developed different analysis tools However their analysis have focused on the analysis in a single market framework. In their analysis, there is only one good, homogenous suppliers and consumers. However, we see in the real world that more frictions are present. Tariffs, distances, transportation costs and tastes add different implications to the problem. This generates also the possibility of exchanging risk across suppliers and consumers in the form of the international trade. Producers facing low prices in their own market can increase the exports in order to smooth their incomes. This dimension must be considered in the analysis. The goal of this paper is to analyse how the international and the domestic prices behave when markets are subject to output shocks and when the economy is integrated in the world. This implies that rather one market for each good, we have national markets that are related each other in an international market. As consequence, the international trade constitutes another dimension that affects the international and domestic volatility. In order to achieve that goal, a dynamic model is presented in which we have two countries that are subject to different type of output shocks. The model relies on (Turnovsky S. J., 1983)s work in terms on how the production decisions are made under shocks. However, several authors before and later had been working in similar frameworks. Nevertheless, they did not consider, at least to some extension and to our knowledge, the international trade dimension that this paper includes. However, the research agenda for this topic is complicated. The introduction of international trade in this kind of model and the introduction of imperfect substitutability between origins of products (imported and domestically produced) complicates the mathematical solution since we are departing from the linear models utilised before. As a consequence, this paper more that clarifying the question seems to complicate more the analysis. The reader of this paper will have a bitter taste since a several
1

In fact, under the WTO agreements, countries can applied safeguard measures if import prices fall below a preestablished threshold or if there is an important import surge.

questions will be presented without almost any answer. The answers are expected to be present in further stages of this research. However, this paper highlights that the problem in question is more complicated and depends on several factors omitted before. However, the idea of this paper is not to analyse how volatility behaves in the presence of trade but given that trade exists, how the volatility changes when some elements that affect trade vary. It is also convenient to clarify that this paper is the first part of a long research agenda. Particularly, this paper does not include other important determinants of the volatility of prices that have been included before in this literature. They are expected to be part in further research stages that will integrate the international trade dimension with other features in the analysis of price volatility. Moreover, the model developed here has the flexibility to include additional considerations. These are expected to be present in later stages of this research. The first part of this paper will present the model that will be used to analyse the market behavior. From very simple assumptions, a very simple and clear model was developed that can be used to analyse any commodity market. However, due to incorporation of some non-linear functions necessary for the trade dimension, the mathematical solution is hard to achieve. As a consequence, we have decided to implement this model in standard mathematical software and allow it to speak. The second part of this paper presents the data and the calibration techniques used in the simulations. With very little quantity of data that reflects the international supply and demand conditions for three goods, we were able to implement this model and obtain interesting results. The third part of this paper presents some simulations and sensitivity analysis on three key parameters: the elasticity of demand, the coefficient of risk aversion and the elasticity of substitution between imports and domestic good. This exercise allows us to analyse how the model behaves under different structural parameters that will shed some light on how the price volatility is transmitted between countries. The final part will draw some conclusions and set the starting point for further research. An export country dynamic model During the 1970s and 1980s there was a bloom in the interest on the analysis of how markets behave under uncertainty. This literature, besides stochastic analysis elements, introduced definitely the dynamic analysis in economics. However, this literature basically continued a research avenue that had started several years before, particularly, in the discussion of expectations in economics. (Nerlove, 1958) and (Muth, 1961) constitutes two seminal works in the development of expectations and dynamics in economics. The dynamics and the expectations are clearly related concepts. Necessarily, expectations will affect the dynamic conditions. As (Muth, 1961) states: ...the character of dynamic processes is typically very sensitive to the way expectations are influenced by the actual course of events. As a consequence, different expectations will generate different type of dynamic phenomena. The literature that surged in the 1970s and 1980s was definitely based on the (Muth, 1961)s approach or rational expectations approach. The idea of that the expected price is an unbiased estimator of the price2 resulted extremely appealing and theoretically well founded. As a contrary, the adaptative expectations approach, typical of cob-web phenomena, was deemed as naive and it was considered that agents should make the most efficient use of the information and, in the case of adaptative expectations, of the previous prediction errors. (Muth, 1961) puts it very clearly ...dynamic economic models do not assume enough rationality From the rational expectations approach, a very rich literature appeared that try to analyse how markets behave under uncertainty and given the expectations what are the price and quantity dynamics. Given the high volatility in commodity prices during the 1970s, it was recognised the
2

If disturbances are normally distributed.

importance of designing tools to help to stabilise those prices. As a consequence, part of the academia focus on the analysis the implications of storage in rational expectations models (Wright & Williams, 1982) , (Wright & Williams, 1984) and (Scheinkman & Schechtman, 1983) , buffer mechanisms (Newbery & Stiglitz, 1979) and (Newbery & Stiglitz, 1981) and futures markets (Turnovsky S. J., 1979) and (Turnovsky S. J., 1983). However, despite the reduction on the interest in the research of this topic, several authors have been continuing this research avenue in the following years. (Deaton & Laroque, On the Behaviour of Commodity Prices, 1992) and (Deaton & Laroque, 1996) in partial equilibrium and (Hirshleifer, 1988) and (Hirshleifer, 1990) under a general equilibrium approach. Also, some developments departing from the rational expectation approach (Westerhoff & Wieland, 2004) and more applied to agricultural products and in general equilibrium framework, (Bourguignon & Sylvie Lambert, 2004) This literature shared several common features. As was mentioned, they made an extensive use of rational expectations. As a consequence, the profit maximising behaviour of producers was always present. 3 They tend also to be based in partial equilibrium frameworks and, as a consequence, they did not consider the effects that substitution across commodities in the production decision could have, particularly in the agricultural sector. The most relevant, in terms of this paper, was the omission of the effects that trade could have in the volatility of prices. This literature analysed the behaviour of markets without considering any interaction between similar markets in other countries and the effect on the international price. Since the trade dimension was not considered and only one market was considered, the interaction between domestic and international prices was omitted. As a consequence, there was not any distinction between foreign and domestic instabilities. It is interesting to see that the possibility of different paths and variation for domestic and international price was not considered in this literature, given the theory and evidence provided in the trade literature of a disconnection between both prices. Despite several seminal trade theories considered that domestic and foreign prices should converge, latter theory developments as well as the evidence suggest several departures from this idea, even for tradable goods. The most important consideration and relevance for this paper is the idea of imperfect substitution between domestic and imported goods (Armington, 1969) However, the possibility of imperfect substitution between domestic and imported good has been considered and analysed in more static type of analysis and, generally, in general equilibrium frameworks (Dervis, de Melo, & Robinson, 1982) and (Devarajan, Lewis, & Robinson, 1993). Furthermore, it is the objective of this paper to develop a model that tries to include trade and the imperfect substitution between domestic and imported goods as another dimension in the price volatility. Moreover, it will try to analyse how the markets behave when consumers or importers are more or less prone to substitute domestic goods and imports. We will use (Turnovsky S. J., 1983) framework and we will add the trade dimension to that development. The reason lays, basically, on the clarity of exposition and development of that work. Moreover, despite the analysis we are presenting here does not consider the existence of storage and futures markets4, (Turnovsky S. J., 1983) is originally intended to analyse, particularly, those features. As a consequence, it will be later easier to add them to this model.

However, some have claimed that farmers, instead of maximising profits, they could try to minimise risk (Newbery & Stiglitz, 1981). Storage and future markets will be considered in a later stage of this research.

Let us assume a producer that sells to the international and the domestic market. We assume that the producer operates under a quadratic cost function5. Its profit function in t can be represented by 1) =

Where q is the planned output chosen by the firm or producer, qt is the actual output of the firm and is the spot composite price for its output at time t. Note that the cost does not depend on the actual output but on the planned output. The idea is that this producer will decide how much he will produce; face the cost of producing that planned output but, the actual output is stochastic. We will assume that output is subject to an additive technological risk, where t is a stochastic disturbance with zero mean and known variance: 2) = +

The model could handle a multiplicative type of technological risk (with mean equal 1 and know variance). However, the introduction of multiplicative risk will complicate the analysis in later stages of this research. Particularly, when multiplicative risk is present, the hedging and output decisions cannot be separated or the Separation Theorem does it hold (Danthine, 1978). As a consequence, we decided to keep the additive risk specification despite it can be considered not the best option for agricultural goods (Newbery & Stiglitz, 1981). The main contribution in this model, as it was mentioned, is that now the producer can supply either the international or the domestic market. As a consequence, its planned output can be divided into planned exports and planned domestic supply. 3) = +

and are the planned exports and planned domestic supply. As a consequence, the export Where and domestic supply decisions are determined when the output decisions are taken. This can be explained for example by the existence of contracts for exports and domestic supply. Rather than decide how much to export and how much to sell domestically after they have decided how much to produce; the operation tend to be the opposite. The total output is defined by the commitments on exports and domestic supply. Of course, after the shock is revealed, the exports and the domestic supply could vary from his planned levels. We can define the average composite price as the weighted (by the planned supply levels) average of the international and the domestic prices. 4) =

Where Pt e is the international or World price and Pt d is the price in the domestic market. Both prices will be determined by the interaction of the domestic and the international demand. The firm makes its production decision at time t-1, before the prices are revealed. Furthermore, the profit function can be expressed as 5) = +

The possibility of more elaborated cost functions were not considered, however, a linear cost function will eventually generate an indetermination in the model.

The firm maximises the following one-period function of the expected profit and variance. This utility function depends positively on the expected profit and negatively on the variance of the profit. In this setting, the utility of the producer is reduced by the volatility of the profits.
2 6) t = * (t , t 1) 1 a (t , t 1)

Where, * (t , t 1) = E t 1 ( t ) is the conditional expectation of profit at time t formed at the previous

2 period; (t , t 1) = Et 1 ( t Et 1 ( t )) is the conditional variance of profit at time t formed at t-1. In this special form, a represents the producer risk aversion. When it equals zero, the producer is risk neutral and the variance term disappears from its expected profit function. If a is greater than zero, the producer is risk averse. The bigger is the coefficient of risk aversion, the more importance will be the variance of the profits in the producers utility function. The expected value of the profit and the expected variance6 can be expressed as 2

7) 8)

, 1 +2

Finally, replacing the expected profit and the expected variance in equation 6, we will get the producers utility function expressed in terms of the mean and the variance of the profits. 9) =
,

, 1 +2

Again, if the producer is risk neutral, the variance term vanishes and only the expected value of the profits can alter the level of utility achieved. Continuing with (Turnovsky S. J., 1983) development, we will assume n identical firms or producers and each of them contributes equally to the total disturbance t ' , as a consequence, for the representative firm t = t ' n . Additionally, if we assume that the price responds proportionally to the total supply stochastic disturbance t ' , then cross moments formed at t-1 between , 1 = 1 1 = , 1 = , 1 = and t ' are finite and of order 1. Furthermore, we will have that 1 1

Where, O(*) denotes order. Assuming that the number of producers is large, the terms with order less than one will tend to vanish and a consequence and to the first order, we can express the one period mean and variance of profit by 10
6

See Annex I

11)

, 1

Replacing these two expressions in expression 6 we will get, for the representative producer that, 12) =
,

, 1

Now, we are in position of finding the export and the domestic product supply function. The planned exports can be found by differentiating equation 12 respects to , the planned exports. 13 = =
, ,

+ + +
,

, 1 +

From equation 4 we can clearly seen that

,

Where , and , are the conditional expectations for the international and the domestic prices formed at t-1, respectively. Taking its derivative respect to q is
,

Or

= +

+
,

+ =
, ,

14

Now, the variance of the composite price, expressed in terms of exported and domestic supplied quantities can be defined , 1 = + , 1 + + + , 1

Where, , 1 and , 1 are the conditional expected variances for the international and the domestic price formed at t-1. Its derivative respect to is , 1 = 2 + 2 , 1 + + + ,
2 2

+2

, 1 +2
2
2

, 1 +2

15)
2

Now, replacing equations 15 and 14 into equation 13 we get

, 1

, 1

= 2

2 2

+2

+2

16)

Where we have replaced the derivative respect to = =

,

, 1 by +
, ,

, to save notation. Working in the same way we can get

17)

As a consequence, the planned exports and domestic supply can be written as

18)
, ,

19)

The planned supply of exports and domestic product depend on the respective expected prices as it is expected. As it is also seen in similar developments, it also depends negatively on the variance of the price. i.e. a higher variance will reduce the supply of the product. The new element in this expression is the expected covariance between the two prices. In fact, the role of the covariance in this specification is extremely relevant. If the expected covariance is positive and the producer is risk averse (a is greater than zero), the producer will find profit maximising to increase its supply of the product in question since it cannot reduce their risk exposition by supplying the other product. On the other hand, if the expected covariance is negative, the producer will reduce its supply in the product in question since it will prefer to take a more diversified position. That implies that any increase in the expected price will not be translated into an increase in the supply of that product and would generate an increase in the supply in the other product by the action of the covariance. We need now to add over the total number of producers. Since we are assuming homogenous producers, we can multiply each supply function (equations 18 and 19) by the total number of firms or producers. We must consider that now, the supply of both exports and domestic supply will be affected by the total output disturbance, t ' . However, the total output disturbance affects the total output and we have divided the problem into two supply decisions. As a consequence, we need to assign how the total output disturbance will affect each supply decision. We will assume that the total output disturbance is split between both products (exports and domestic supply) by the share of the planned exports/domestic supply in the total planned output. 20) = = =
,

+
,

t '

21 Where

+ is the total supply of domestic product,

is the total supply of exports, .

and

We will not turn to the demand side. We will assume that the demand is supplied with domestic supply and imports. Moreover, we will further assume that the demand is completely deterministic and does not depend on any type of shock. This is also a common feature in this type of literature and despite some analysis on the effects of volatility in the demand (Newbery & Stiglitz, 1979), in general, the greatest sources of volatility tend to come from the supply side. We will use a nested structure to model the demand system. On the top of the nest, the total demand is determined by the composite price between the price of the domestic supply and the international price. 22) =

Ct , > 0

Where is the total demand for the product and is the composite demand price. As we mentioned, the total demand is composed of domestic supply and imports; as a consequence, we need a proper definition on how the consumer will allocate its demand of domestic supply and imports. We will use make use of the well known Armington assumption (Armington, 1969). The assumption basically establishes that consumers perceive imports and domestic supply as two goods with a limited degree of substitutability. This is specified through a Constant Elasticity of Substitution (CES) function. The composite price is defined as the weighted average of the domestic and the international price. 23) = = + 1 = 1

The Armington aggregator is defined as 24

Where G is the shift parameter, is the share parameter and is the elasticity of substitution between domestic produced demanded and imported products. The minimisation of the expenditure gives the following first order condition 25 =

We have almost all the equations necessary for our model. We need now to establish our equilibrium condition. Up to this point, we have developed our model without making any assumption about how many countries are in our world. We will assume that there are two countries: Home and the Rest of the World (ROW). The technology of production and the demand structure is similar across the two countries. However, we will assume that the two countries are subject to different shocks. In essence, the same type of additive shock will be applied; however, we assume that the standard deviation of the shock is different. This could be seen as, for example, both countries being subject to different weather shocks. We will assume also that the two shocks are not correlated. On the other hand, we will assume that the Home country is a pure exporter and it will not import from the ROW. As a consequence, the ROW imports all its exports plus the exports from HOME. This implies that we need two equilibrium conditions. On one side, the domestic demand and the domestic supply at Home must equal; and, on the other hand, the exports and imports must be cleared. These conditions are expressed as follows, where we have used the double superscript to distinguish HOME and ROW magnitudes. 26
,

27

In order to have a clear idea of how this model behaves, we have implemented it in GAMS. Furthermore, we present the Table 1 all the equations in the model as it was implemented in GAMS. We have also included as separate equations the expressions for the different expected values for prices, variances and covariance since they will be updated each period in the model solution. Table 1. Model equations
Q =n Q =n = P, q c aCOV c aCOV c + a c + a P ,P P ,P = = 1 + 1

P,

+ +

t '

= = , 1 =

=
,

1 1 1

= = ,
,

=
,

, 1 =

t1

The behaviour In this section, we will explain what would be the sequence of effects after a once increase in the supply of the commodity in both HOME and ROW. The idea of this exercise is try to capture the intuition behind the model and later, we will present the results of the simulations performed. We will assume that there is a single shock in a given period and we will explain how the model behaves after that shock. Suppose that in a given period, due to an extraordinary benign weather conditions, there is an increase in the supply of any of the commodities at ROW. As a consequence of the shock the supply of exports and domestic product at ROW increase by equations 20 and 21. The distribution of the effects in both supplies is determined by the variable that captures the share of exports or domestic supply in total output. The increase in the supply generates an immediate reduction in the domestic price at ROW and in the world price for this product. What is the effect at HOME? When HOME producers decided their output and supply, they did not foresee the shock. Furthermore, their level of output in the period of the shock is equal to the equilibrium or previous level. Moreover, the domestic and export supply decisions were made without the shock. As a consequence, they do not change in this period. HOME producers behave as the shock would not have existed. One can think that there were supply contracts in place at the time of make their decisions that cannot be broken when the international price falls. Furthermore, there is no effect in the period of the shock at ROW for HOME. However, the international price has fallen revealing the increase in the availability of product. The increased supply of exports made by ROW is entirely absorbed by ROW as imports. As a consequence, the total demand at ROW increase strongly (by the increase in the domestic supply and the increase in imports) In the following period, both HOME and ROW producers include the previous period information in their price expectations (and expected variance) formation in order to make their output decisions for the current period. Since the previous international and ROW domestic price have fallen, the expected prices have also fallen. Moreover, the expected variances of both prices are positive now at ROW. The expected covariance between the domestic price and the world price at ROW is now positive but remains zero for HOME (this is because, the domestic price at HOME did not change) Furthermore,

ROW producers reduce their supply of both, exports and domestic products. This holds except for HOME. The HOME producer includes the new international price information in its price formation which makes the expected price to fall and their expected variance to rise. However, the domestic price at HOME did change in the previous period and, consequently, neither the variance nor the expected domestic price change. Furthermore, at HOME all the adjustment is made by reducing the supply of exports rather than reducing the supply of the domestic product. As a consequence, the ROW producers adjust down the supply for exports and domestic product while HOME producers only adjust the supply for exports. Furthermore, the international and the ROW domestic spot price rise. In the third period (counting from the shock), the new price information of the second period is included in the price and the variance expectation of the producers. At ROW, the supply is increased because the expected price of both, exports and domestic product has risen. At HOME the exports supply is increased but also the domestic supply is increased. This occurs basically because the substitution between domestic and export market is not perfect and part of the extra output is allocated also in HOME market. Moreover, the covariance between both prices has also changed and also the expected output of the exported product has also changed and this affects also the supply of the domestic product. Furthermore, the producer decides to hedge against the fluctuations in the international market by increasing it supply in the domestic market. As a consequence, the spot price in the third period in the domestic market at HOME is reduced. Furthermore, the adjustment in the domestic market at home begins three periods after the shock. In the fourth period after the shock, again the previous prices are included in the price expectation formation. Now, the expected domestic prices and the international price have fallen , as a consequence, the supply of exports and domestic product in both, HOME and ROW is reduced, bringing the spots domestic and international prices up. Since the domestic price at HOME has fallen in the domestic market in the previous period, it will affect the price expectation for the domestic price for this period and the expected variance. This sequence of adjustment continues in further periods. However, every period the adjustment is smaller until the variables will converge eventually to the new equilibrium values when the initial shock is washed in the history. A similar process occurs when the shock is originated at HOME, however, in the ROW both exports and the domestic supply response are lagged one period. However, the domestic price at ROW will be affected in the first period. Since ROW is the only importer in this model, the extra export supply of HOME is absorbed by ROW and as a consequence, the supply is increased at ROW generating a decrease in the domestic price. The size, speed and type of adjustment depend on several factors. First, it is important the relative size of each country in the commodity market analysed. If the shocked country is a small supplier, the shock will have little incidence in the world market and will not affect substantially the other country domestic market. Moreover, it will also affect the importance of the exports in the countrys supply scheme. Products that are heavily exported will have a different effect if they are mostly consumed domestically. On the other hand, the effect could be different if the country is an important producer but also an important consumer, since any decrease in the domestic demand could have important effects in the international market. Second, the demand will also play an important role. In the case of very inelastic demand functions the price in the domestic market, the quantity demanded will change very little. In that case, we should expect, a priori, that the volatility of the international price must be increased because the domestic market is not adjusting enough and any excess of supply will be transferred to the internal market. Third, the risk aversion of producers will also affect the supply response. When the producer is extremely risk averse, he will make a lower adjustment of the supply since the supply depends

negatively on the variance of the price. If this is increasing, a risk averse producer will react strongly compared to a risk lover. Finally, the adjustment will also depend on the flexibility by which the consumers in ROW can substitute the domestic and imported product. If the consumers consider both products (the domestic and the imported) as not substitutable, it will not be possible to switch output from one market to the other in order to reduce the volatility of the producers income. On the other hand, if the importers consider both products as perfect substitutes, the volatility of the domestic and the international price will be similar. Given the non-linearity of some functions, it is hard to find an analytical solution to the model that could shed some light on the behaviour of the model. As a consequence, we have decided to let the model speak by making simulations of it using GAMS. We will simulate later how this model behaves under different values for the elasticity of demand, the coefficient of risk aversion and the elasticity of substitution between domestic product and imports when there are shocks coming from HOME and the ROW. Before, we will present the main data values used in the simulations. Data and calibration In order to simulate this model we have used real data on output to calibrate the parameters for the distribution of the shocks. We have simulated this model using data for soybeans, maize and wheat. In this model, Argentina is represented by HOME. We have used Argentina as a case since it is an important producer and exporter in some commodities. However, the model could replicate the situation of other country. The model implementation requires data to serve as a solution baseline. As a consequence, data on output, exports, imports and domestic consumption as well as the number of producers were obtained to form a solution baseline. In the case of HOME, we have collected data on the commodity balances for the 2006/2007 Argentine campaign. The ROW data was taken from FAO FAOSTAT. In the case of the number of producers, we have assumed homogenous producers. Furthermore, we proxy the number of producers by the number of hectares harvested. This implies that in this framework, the quantity of producers is represented by the number of hectares. We have calculated all the data for the individual producer. Since producers are homogenous, we assume that each of them exports the same average quantity. As a consequence, we have calculated the export and domestic supply yield by the total yield multiplied by the share of exports and domestic supply in total output. The total HOME exports, for example, can be calculated by multiplying the export yield by the number of producers. Since we are assuming that the Home country does not export, the sum of total exports of both countries, HOME and ROW, must be equal to the ROWs total imports. The domestic demand must be equal to the domestic supply at HOME; and in the ROW the domestic demand is equal to the sum of the imports and the domestic supply. We are not considering any other use (stocks, seeds, feeding, etc.). In Table 2 we present the quantities data used. From this very basic data, we construct all the quantities variables in the model. Table 2 also have relevant information that can help to interpret the results. It can be seen that at HOME, Maize is the most exported product with nearly 63% of the output exported. On the other extreme, Soybeans is a product that is the less exported (21%). In fact, in Argentina, the soybeans output is mostly used to produce oils and meals that are latter exported. However, we are not considering other use than exports and domestic demand, that could be final consumption or industrial use. On the other hand, we can see that the opposite occurs in ROW where the majority of the output is domestically demanded. It can be seen, that HOME in maize supplies the 18% of the World exports, 15% in soybeans and 6% in wheat. On the other hand, HOMEs production on maize

represents 3% of the World production, 22% of the total production of soybeans and 2% of the total production of wheat. Table 2. Quantity data used in baseline
Variable Total Yield Export yield Domestic supply yield Number of producers Total Yield Export yield Domestic supply yield Number of producers Total Yield Export yield Domestic supply yield Number of producers Unit Maize Metric tonnes/hectare Metric tonnes/hectare Metric tonnes/hectare thousands Soybeans Metric tonnes/hectare Metric tonnes/hectare Metric tonnes/hectare thousands Wheat Metric tonnes/hectare Metric tonnes/hectare Metric tonnes/hectare thousands 2.625 1.300 1.325 5,540.405 2.845 0.5087 2.3363 215,897.814 2.971 0.640 2.331 15,981.264 2.163 0.7061 1.4569 77,412.175 7.665 4.880 2.785 2,838.072 4.844 0.4347 4.4093 142,660.835 Home ROW

Source: Author calculations based on FAO FAOSTAT and Rodolfo Franks database and the Secretariat of Agriculture, Livestock, Fisheries and Food Industry.

As a consequence, the baseline value for the total expected supply of maize, for example, can be calculated as Export yield times the number of producers. In the baseline, the domestic prices and the international price are equal and set to unity. This is allows an easier interpretation of the results and facilitates the calibration of the model. The elasticities of demand, substitution between imports and domestic product at ROW and the coefficient of risk aversion play an important role in this model. We do not have accurate estimations for them. However, we have decided to play with them in order to analyse the model properties under different values of these. They will also play an important role in the calibration of the model. For example, the share parameter in the CES function is calibrated using a given value of the elasticity of substitution. As a consequence, each time one of this parameter is changed, there is a correspondent change in another parameter. Results The simulations of the model were made using GAMS. We have simulated a 25% increase in the output for each product in both, HOME and ROW in the 5th period. However, the shock applied to each country is considered an independent exercise. The model can be solved for several periods, however, for the sake of the exposition we limited the time periods to 20. This is basically due to the fact that as more periods are included, it is hard to see the effects since the effects as washed away in so many periods and also, because the computing time increases. As a consequence, in this time frame, variables will not reach completely their new equilibria. We will present the results under different elasticities of demand, different coefficient of risk aversion and different elasticities of substitution between domestic products and imports. In the Annex II we present the description of the exercises performed. Elasticity of demand In this exercise we have simulated the model using different elasticities of demand at HOME but keeping fixed the ROWs elasticity of demand across simulations. Moreover, we have performed to separate sets of simulations: one for shocks that are originated at ROW and one for shocks that are

originated at HOME. The solution found by (Turnovsky S. J., 1983), which is analogous to the solution found by (Turnovsky S. J., 1979), (Kawai, 1983) and (Muth, 1961) is that we should expect that a high demand elasticity reduces the price volatility (expressed as the variance of the spot price). Table 3 presents the coefficient of variation of the domestic price in both countries for every scenario considered when the shock is generated in ROW. As it is expected, different elasticities of demand at HOME has very little effect in the volatility of the domestic price in ROW. However in HOME the picture changes dramatically. As we increase the value of the elasticity of demand (from inelastic to elastic values) the volatility of the domestic price is substantially reduced. For example, doubling the elasticity of demand from 0.6 to 1.2 will reduce the coefficient of variation of the domestic price by a 25% in the case of wheat (compare 0.466 and 0.354), by 48% in the case of soybeans and by 40% in the case of maize. We have also made a similar exercise but simulating an increase of the 25% in the output at HOME. It is expected that the effects will be bigger at HOME than in the ROWs domestic market. Table 4 presents the results. As we increase the elasticity of demand, the coefficient of variation of the domestic price at HOME is reduced in all cases. If we double the elasticity of demand from 0.6 to 1.2, for example, the volatility of the domestic price is reduced by 60% in the case of wheat. These results, furthermore, do not differ from the ones we obtained when we simulated a shock coming from ROW. There are not important changes in the coefficient of variation of the domestic price in ROW for wheat and maize, but the coefficient of variation for the domestic price of soybeans change as we change the elasticity of demand at HOME. Moreover, from Table 5, we see that the World price is affected differently according to the elasticity of demand at HOME. This is a very interesting result. By looking in the data values we have used, we can realise that soybeans is a product that is largely consumed domestically7 and given that HOME is an important producer, any change in the domestic market will have important effects in the international market and, consequently, in the domestic price at ROW. What is also very interesting is the U-shape behaviour. Initially, when the elasticity of demand at HOME is increased, the domestic demand at home adjusts faster to the price. This helps to stabilise the domestic price at ROW since HOME can easily reallocate any surplus into their domestic market. However, when the elasticity of demand is big enough (particularly when is bigger than one), the higher elasticity in the demand at HOME generates substantial swings of supply from the export market to the domestic market, generating an increase in the volatility of the international price and the volatility of the domestic price at ROW. This contradicts the results found by (Turnovsky S. J., 1983) since now; there are other factors that could be affecting the volatility in the price. In this case, the volatility of the domestic price at ROW is being affected by the elasticity of demand at HOME. Finally, in Table 5 we present the volatility of the international price for each scenario. When the shock is generated in the ROW, it does not have substantial influence the size of the elasticity of demand at HOME, even if HOME is an important player in the market. This is also explained by the fact that ROW can absorb any increase in the supply in their market. We must remember in this case, that ROW is the only importer in this model and is the only one that imports their exports. As a consequence, any sudden increase in the supply is almost completely absorbed in ROW. If the shock is generated at HOME, we see that there are not important changes in the coefficient of variation of the International price in both, wheat and maize. However, as the elasticity of demand at HOME is increased, the volatility of the international price of soybeans also increases. This behaviour is similar to the domestic price at ROW that exhibits a similar pattern. As a consequence, the unambiguous reduction in the volatility when the elasticity of demand is increased seems to be challenged when countries are allowed to trade. It seems that in goods where one of the countries is an important producer but it consumes largely their production, very high as well as very low elasticities of demand, could generate important volatility in the World price. This could be explained by the fact that when the elasticity of demand is very low at HOME and there is a shock in that country; the international market suffers since HOME producers reduce their export
In the case of Argentina, soybeans are used in the production of oils and meals that are later exported, but in the case of unprocessed soybeans, the share of exports is smaller.
7

supply in order to satisfy the inelastic and important HOME demand. However, when the elasticity of demand is very high at HOME, the high volatility in the domestic demand is transferred to the World market and since HOME is an important producer and consumer, a reduction in the domestic demand will generate an important export surplus that will eventually increase the volatility in the World market. The relationship between the supply and demand composition and the volatility is expected to be analysed analytically in a later stage of this research. Table 3. Coefficient of variation of the domestic price at HOME and ROW under different values of elasticity of demand at HOME when shocks are generated in ROW
Wheat Simulation beta06row beta07row beta08row beta09row beta10row beta11row beta12row beta13row beta14row beta15row beta20row beta30row beta40row beta50row beta60row beta120row beta240row HOME 0.466 0.444 0.423 0.404 0.386 0.370 0.354 0.340 0.327 0.314 0.263 0.198 0.158 0.131 0.112 0.060 0.031 ROW 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 HOME 0.107 0.094 0.084 0.076 0.070 0.064 0.059 0.055 0.052 0.049 0.038 0.026 0.019 0.016 0.013 0.007 0.003 Soybeans ROW 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 HOME 2.103 1.919 1.762 1.627 1.510 1.410 1.321 1.244 1.176 1.115 0.888 0.637 0.499 0.411 0.350 0.185 0.095 Maize ROW 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207 2.207

Table 4. Coefficient of variation of the domestic price at HOME and ROW under different values of elasticity of demand at HOME when shocks are generated in HOME
Wheat Simulation beta06home beta07home beta08home beta09home beta10home beta11home beta12home beta13home beta14home beta15home beta20home beta30home beta40home beta50home beta60home beta120home beta240home HOME 12.055 9.561 7.956 6.836 6.006 5.364 4.852 4.432 4.082 3.784 2.781 1.824 1.358 1.082 0.899 0.446 0.222 ROW 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 HOME 13.522 9.515 7.575 6.374 5.539 4.916 4.429 4.036 3.711 3.437 2.522 1.655 1.234 0.984 0.818 0.408 0.203 Soybeans ROW 0.215 0.204 0.200 0.199 0.198 0.198 0.198 0.198 0.199 0.199 0.200 0.201 0.202 0.202 0.203 0.204 0.204 HOME 17.117 12.924 10.344 8.626 7.410 6.506 5.809 5.253 4.800 4.422 3.193 2.072 1.540 1.226 1.020 0.508 0.253 Maize ROW 0.095 0.095 0.095 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094

Table 5. Coefficient of variation of the international price under shocks at ROW and at HOME
ROW SHOCK SIMULATION beta06row beta07row beta08row beta09row beta10row beta11row beta12row beta13row beta14row beta15row beta20row beta30row beta40row beta50row beta60row beta120row beta240row WHEAT 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 SOYBEANS 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 MAIZE 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.24 22.23 SIMULATION beta06home beta07home beta08home beta09home beta10home beta11home beta12home beta13home beta14home beta15home beta20home beta30home beta40home beta50home beta60home beta120home beta240home WHEAT 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 HOME SHOCK SOYBEANS 1.65 1.60 1.59 1.60 1.61 1.62 1.62 1.63 1.64 1.65 1.67 1.70 1.71 1.72 1.72 1.73 1.74 MAIZE 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36

Coefficient of risk aversion

The coefficient of risk aversion plays an important role in the supply decisions in this framework. By looking into equations 20 or 21 it can be seen that the higher is the coefficient of risk aversion, the higher will be the weight the producer will give to the variation and the co-variation of the prices in their supply decisions. In order to see if effectively in our model the volatility of the price depends on the coefficient of risk aversion, we have performed a similar exercise as in the previous section. We have performed two sets of simulations altering the value of the coefficient of risk aversion at HOME. One for shocks generated in the ROW and one for shocks generated at HOME. Table 6 presents the results for the coefficient of variation in the domestic price under different values of the coefficient of risk aversion when the shock is generated at ROW. The model behaves differently according to the product considered. In the case of wheat (first column of Table 6), risk lovers producers generate lower domestic price volatility at HOME. As the variance of the domestic price changed, risk lover producers adjust more their supply than more risk averse producers, furthermore, the fluctuations in the domestic price tends to be reduced. In the case of Soybeans, where HOME is an important producer but a comparatively modest exporter, the volatility tends to be decreased as producers become more risk averse. However, at extremely high values of the coefficient of risk aversion, the coefficient of variation is increased. In the case of maize, where HOME is an important supplier of the world market, we see that when producers are risk lovers the volatility is high in the domestic price but also this holds if producers are extremely risk averse. As a consequence, the volatility seems to be minimised when the coefficient of risk aversion is around one. Moreover, in the case of maize, the different scenarios also generate changes in the volatility of the domestic price at ROW since HOME is an important supplier of ROW (column 6 of Table 6). When the shock comes from HOME, its producers are the first to receive the shock and observe the price volatility. It can be seen in Table 7 that when the coefficient of risk aversion is increased, the volatility of the domestic price at HOME is increased in the case of wheat and soybeans (columns 1 and 3 of Table 7). However, it applies the opposite in the case of maize where HOME is an important supplier of the World demand. In the case of wheat and soybeans, the shock has small effects in the international market and, as a consequence, lower coefficient of risk aversion generates lower price volatility as the shock is mainly absorbed in the domestic market. In the case of Maize, HOME is an important producer and a more important exporter. A large share of the total production is exported. When the shock is received, it has immediate effects also in the international market. A risk lover producer will react strongly in both markets but with their reaction will also affect the volatility in both markets. This effect in the international market affects also the volatility at HOME. If the producer is risk averse, the reaction will be small in both markets. The international price will change little and the domestic price volatility will be smaller than under higher coefficient of risk aversion. An important result is that, with the exception of soybeans, the domestic price volatility in ROW does not change substantially with changes in the coefficient of risk aversion at HOME. In the case of soybeans, the lower is the coefficient of risk aversion at HOME; the lower is the volatility of the domestic price at ROW. As the volatility of the domestic price increase, risk averse producers substitute domestic supply by exports generating a bigger supply at the World market that helps to reduce the volatility in the domestic market at ROW. In the case of Maize and Wheat, this cannot be seen because their exports are already high and the marginal contribution of more exports does not change substantially the picture. Table .8 sheds some light on the effects on the international price and helps to understand the effects on the domestic prices mentioned before when the coefficient of risk aversion is altered. Shocks in the ROW generate, by the size of the markets, higher shocks than HOME shocks. However, when we consider different type of attitudes to risk at HOME, we have different effects depending on where the shock comes from. When the shock comes from ROW, the volatility of the international price is increased as we have more risk averse producers at HOME. The effect is very small in wheat and soybeans, but it is relevant in the case of maize, the heavily exported product where HOME has an important share of the World market. Risks averse producers return the volatility created in ROW with a bigger volatility in the international price.

When the shocks are generated at HOME, the domestic price volatility is not so easily transmitted to the international price. As a consequence, the volatility of this does not change substantially. However, in the case of soybeans, a lower coefficient of risk aversion at HOME can reduce the volatility of the international price. This is because being HOME and important producer but also an important consumer, any substitution between domestic supply and exports made by the producers will have substantial effects in the international markets. Facing high volatility in the domestic market, risk averse producers, increase the supply in the international market that is showing a lower volatility. As a consequence, we have found that there are potential cross effects between the attitude to risk of producers in HOME and the volatility in the World price that would eventually affect the volatility of the domestic price at ROW. Table 6. Coefficient of variation of the domestic price at HOME and ROW under different values of coefficient of risk aversion at HOME when shocks are generated in ROW
Wheat Simulation cra_04row cra_03row cra_02row cra_01row cra01row cra02row cra03row cra04row cra05row cra06row cra07row cra08row cra09row cra10row cra11row cra12row cra13row cra14row cra15row cra20row cra30row cra60row cra120row HOME 0.163 0.166 0.168 0.171 0.176 0.178 0.181 0.183 0.186 0.188 0.190 0.193 0.195 0.198 0.200 0.203 0.205 0.208 0.210 0.222 0.247 0.320 0.463 ROW 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.924 1.925 1.925 HOME 0.036 0.035 0.034 0.034 0.032 0.031 0.031 0.030 0.029 0.028 0.028 0.027 0.026 0.026 0.025 0.024 0.024 0.023 0.022 0.020 0.017 0.030 0.081 Soybeans ROW 1.696 1.697 1.697 1.697 1.697 1.697 1.697 1.697 1.697 1.697 1.697 1.697 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.698 1.699 1.702 1.707 HOME 3.580 3.231 2.898 2.580 1.989 1.715 1.458 1.218 0.999 0.808 0.659 0.574 0.569 0.637 0.753 0.893 1.044 1.197 1.350 2.061 3.144 4.572 4.603 Maize ROW 2.175 2.178 2.180 2.182 2.187 2.189 2.192 2.194 2.196 2.198 2.201 2.203 2.205 2.207 2.209 2.211 2.213 2.215 2.217 2.226 2.242 2.277 2.318

Table 7. Coefficient of variation of the domestic price at HOME and ROW under different values of coefficient of risk aversion at HOME when shocks are generated in HOME
Wheat Simulation cra_04home cra_03home cra_02home cra_01home cra01home cra02home cra03home cra04home cra05home cra06home cra07home cra08home cra09home cra10home cra11home cra12home cra13home cra14home cra15home cra20home cra30home cra60home cra120home HOME 1.814 1.815 1.815 1.816 1.817 1.818 1.819 1.819 1.820 1.821 1.821 1.822 1.823 1.824 1.824 1.825 1.826 1.826 1.827 1.831 1.838 1.860 1.907 ROW 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.039 0.038 HOME 1.629 1.631 1.632 1.634 1.638 1.640 1.642 1.643 1.645 1.647 1.649 1.651 1.653 1.655 1.657 1.659 1.661 1.663 1.665 1.676 1.698 1.775 1.995 Soybeans ROW 0.206 0.205 0.205 0.205 0.204 0.204 0.203 0.203 0.203 0.202 0.202 0.202 0.201 0.201 0.201 0.200 0.200 0.200 0.199 0.198 0.195 0.186 0.174 HOME 2.090 2.089 2.088 2.086 2.084 2.083 2.081 2.080 2.079 2.077 2.076 2.075 2.073 2.072 2.071 2.070 2.068 2.067 2.066 2.060 2.047 2.014 1.961 Maize ROW 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.094 0.093

Table .8. Coefficient of variation of the international price under shocks at ROW and at HOME and different values of the coefficient of risk aversion
ROW SHOCK SIMULATION cra_04row cra_03row cra_02row cra_01row cra01row cra02row cra03row cra04row cra05row cra06row cra07row cra08row cra09row cra10row cra11row cra12row cra13row cra14row cra15row cra20row cra30row cra60row cra120row WHEAT 3.57 3.57 3.57 3.57 3.57 3.57 3.57 3.57 3.57 3.57 3.57 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.58 3.59 3.61 SOYBEANS 1.94 1.94 1.94 1.94 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.95 1.96 1.96 1.97 1.99 2.04 MAIZE 21.30 21.36 21.43 21.49 21.62 21.69 21.76 21.83 21.90 21.96 22.03 22.10 22.17 22.24 22.31 22.37 22.44 22.51 22.58 22.91 23.56 25.35 28.45 SIMULATION cra_04home cra_03home cra_02home cra_01home cra01home cra02home cra03home cra04home cra05home cra06home cra07home cra08home cra09home cra10home cra11home cra12home cra13home cra14home cra15home cra20home cra30home cra60home cra120home WHEAT 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 0.57 HOME SHOCK SOYBEANS 1.75 1.74 1.74 1.74 1.73 1.73 1.72 1.72 1.71 1.71 1.71 1.70 1.70 1.70 1.69 1.69 1.69 1.68 1.68 1.66 1.63 1.52 1.35 MAIZE 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.36 2.35 2.35

Elasticity of substitution between domestic product and imports In (Turnovsky S. J., 1983) and other authors analysed, the international trade dimension is not included in their analytical frameworks. They considered in their analysis only individual markets without making any distinction between domestic and export markets. As a consequence, they did not consider the effects that the substitution across sources of imports could have on the volatility of domestic and world prices. The model that is presented here includes that dimension and we have made a final exercise where we try to analyse how the model behaves under different elasticities of substitution between domestic product and imports at ROW. Since in our framework we have modelled HOME as a pure exporter, only will be changed the elasticity of substitution for the ROWs imports. Again, we have made two sets of simulations, one for shocks coming from HOME and one for shocks coming from ROW. The elasticity of substitution will play a central role in the domestic and in the international volatility. If consumers perceive the domestic and the imported goods as highly substitutable, it is expected that the evolution of the domestic price and the international price will be similar. Since consumers do not consider the price volatility in their decisions, they will substitute away from the more expensive domestic product, for example, to the cheaper import. As a consequence, that substitution will exercise a pressure in the domestic market that will bring the prices down. If the consumer cannot easily substitute one product for the other, it is expected that the volatility will be higher since the demand only adjusts through the domestic market

When the shock is coming from ROW and we increase the elasticity of substitution, we see different behaviours according to the commodity considered (Table 9). In the case of wheat, we see that the volatility of the domestic price at ROW is reduced when the elasticity of substitution is increased. However, at HOME, the volatility seems to increase at very low values of the elasticity of substitution but it tends to decrease as we continue increasing its value, describing an inverted U. In the case of the international price, the higher is the elasticity of substitution at HOME; the lower is the price volatility (Table 11). In the case of Soybeans, we see that the volatility of the domestic price at HOME and at ROW is increased when the coefficient of substitution is increased; and in the case of Maize, both volatilities are reduced when the coefficient of substitution is increased. As a consequence, there seem to be different behaviour in the domestic price according to the commodity considered. Table 9. Coefficient of variation of the domestic price at HOME and ROW under different values of the elasticity of substitution at ROW when shocks are generated in ROW
Wheat Simulation sigmaq09row sigmaq11row sigmaq12row sigmaq13row sigmaq14row sigmaq15row sigmaq20row sigmaq30row sigmaq40row sigmaq80row sigmaq160row sigmaq320row HOME 0.136 0.198 0.228 0.242 0.250 0.253 0.250 0.227 0.204 0.150 0.114 0.096 ROW 1.970 1.924 1.914 1.906 1.900 1.894 1.873 1.847 1.831 1.804 1.789 1.782 HOME 0.028 0.026 0.025 0.025 0.024 0.024 0.025 0.029 0.033 0.040 0.046 0.050 Soybeans ROW 1.6962 1.6976 1.6984 1.6992 1.7000 1.7008 1.7045 1.7099 1.7135 1.7204 1.7246 1.7269 HOME 0.977 0.637 0.450 0.359 0.353 0.374 0.397 0.375 0.357 0.286 0.208 0.157 Maize ROW 2.243 2.207 2.164 2.120 2.083 2.055 1.984 1.933 1.904 1.842 1.802 1.781

Table 10. Coefficient of variation of the domestic price at HOME and ROW under different values of the elasticity of substitution at ROW when shocks are generated in HOME
Wheat Simulation sigmaq09row sigmaq11row sigmaq12row sigmaq13row sigmaq14row sigmaq15row sigmaq20row sigmaq30row sigmaq40row sigmaq80row sigmaq160row sigmaq320row HOME 1.824 1.824 1.824 1.824 1.824 1.824 1.824 1.825 1.825 1.826 1.826 1.826 ROW 0.044 0.039 0.037 0.035 0.034 0.033 0.030 0.027 0.026 0.025 0.024 0.024 HOME 1.658 1.655 1.654 1.654 1.654 1.653 1.653 1.652 1.652 1.652 1.652 1.652 Soybeans ROW 0.2188 0.2011 0.1953 0.1907 0.1871 0.1841 0.1748 0.1675 0.1645 0.1608 0.1593 0.1586 HOME 2.074 2.072 2.074 2.075 2.077 2.078 2.084 2.089 2.092 2.097 2.099 2.100 Maize ROW 0.116 0.094 0.087 0.081 0.076 0.072 0.059 0.049 0.045 0.041 0.040 0.039

Table 11. Coefficient of variation of the international price under shocks at ROW and at HOME and different values of the elasticity of substitution between domestic and imported products
ROW SHOCK SIMULATION sigmaq09r sigmaq11r sigmaq12r sigmaq13r sigmaq14r sigmaq15r sigmaq20r sigmaq30r sigmaq40r sigmaq80r sigmaq160r sigmaq320r WHEAT 6.59 3.58 2.98 2.59 2.35 2.19 1.88 1.76 1.72 1.69 1.70 1.72 SOYBEANS 2.01 1.95 1.93 1.91 1.89 1.88 1.83 1.79 1.77 1.75 1.74 1.73 MAIZE 28.09 22.24 18.58 15.16 12.26 9.97 4.23 2.05 1.80 1.67 1.64 1.66 SIMULATION sigmaq09h sigmaq11h sigmaq12h sigmaq13h sigmaq14h sigmaq15h sigmaq20h sigmaq30h sigmaq40h sigmaq80h sigmaq160h sigmaq320h WHEAT 0.78 0.57 0.50 0.45 0.40 0.37 0.26 0.17 0.13 0.07 0.05 0.04 HOME SHOCK SOYBEANS 2.20 1.70 1.53 1.39 1.28 1.19 0.89 0.62 0.50 0.32 0.24 0.20 MAIZE 3.54 2.36 2.01 1.73 1.52 1.34 0.84 0.49 0.35 0.18 0.11 0.07

When the shock comes from HOME, we see a reduction in the volatility of the domestic price at ROW in all cases (Table 10). Again, being consumers able to substitute domestic by imported products help to stabilise the price at ROW. However, the response at HOME depends on the product considered. In the case of wheat, we see a marginal increase in the coefficient of variation at the ROW is more able to substitute products. In the case of soybeans, the volatility is marginally reduced as the elasticity of substitution at HOME is increased. In the case of maize, on the other hand, the volatility of the domestic price at HOME is increased when the ROW substitutes more easily domestic and imported products. Finally, from Table 11 we see that the higher is the elasticity of substitution between domestic and imported products at ROW; the lower is the volatility of the World price. As a consequence, the more flexible are consumers in terms of their preferences for the domestic and the imported good, the less volatile is the domestic price at ROW and the international price. The only exception is again, soybeans, where HOME is an important supplier but also an important consumer. However, at HOME the volatility varies according to the commodity analysed. In the case of maize the volatility tends to increase when the shock comes from HOME and decrease when the shock comes from ROW. This implies that HOME cannot send to the World market the internal volatility but also it will not receive the volatility generated abroad. The fact that the volatility of the world price is reduced when consumers at ROW are more flexible in their demand decisions does not seem to help to stabilise the domestic price at HOME. These results are very sensitive to the demand structure chosen for ROW. When the shock is generated, the extra exports supplied by ROW can only be absorbed by the domestic market at ROW (through their imports). As a consequence, the ROWs exports have an additional destabilisation factor in the domestic market at ROW, not present at HOME. If there is a shock at HOME, on the contrary, and the elasticity of substitution at ROW is high, HOME can easily reallocate the extra supply in ROWs domestic market. Finally, the ambiguous domestic volatility effects at HOME require a better understanding of the behaviour of the model. We have seen that the volatility of the World price is reduced when the elasticity of substitution is increased; however, the volatility in the domestic price at HOME has not a very clear pattern. The results seem to depend on the characteristics of the commodity. However, the unambiguous reduction in the volatility in the World price as the elasticity of substitution is increased, as the theory and intuition suggests, presents an interesting dimension to analyse that could present

important policy and practical consequences. Again, this requires further analysis and research that it is expected to be covered in the future. Final comments From very simple assumptions, this paper developed a model to analyse the behaviour and volatility commodity prices produced in multiple countries and when countries are allowed to trade. As a consequence, this model includes a dimension that had not been extensively or explicitly covered before. Using real commodity data, it was possible to simulate the behaviour of the model when key parameters change. In particular, the situation of a pure exporter country was analysed. In these exercises, it was made a distinction between the origin of the shock (local or foreign) and three different commodities were analysed. The commodities analysed allowed to considered different supply conditions for this exporter country. The addition of the international trade dimension complicates the analysis and the conclusions found before by other authors seem to be altered. From the local perspective, there is now a clear distinction to make in terms of the origin of shock since the volatility of the domestic price differs if the shocks are locally or foreign generated. On the other hand, the model behaves different in terms of the commodity analysed. It is not irrelevant the relative position of the considered country in terms of its share of exports. In this sense, it is important to make the distinction between a relevant exporter country in the World of a commodity and a commodity that is largely exported by some country. The fact that the results depend on the commodity and particularly, on the supply and demand characteristic of each them, calls for interesting empirical applications. However, it could be seen that when the Rest of the World is flexible in terms of their preferences between domestic and imported goods, the volatility of the domestic prices in the Rest of the World and the world price is reduced. However, the volatility of the domestic price in the exporter country depends on the commodity considered. Despite this results being sensitive on the way the demand in the rest of the world has been modelled, it presents interesting characteristics to analyse respect to how the volatility is transferred between countries and could call for interesting policy dimensions. This paper could not explain the conditions under why these effects occur. The analytical solution, given the non-linearity of the model, impedes it. However, it opens the door for a following research that is undergoing indeed. Moreover, the results presented here could be significantly influenced by the inclusion of storage, futures markets and the Government action. This is also another avenue of research that departs from this first paper.

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ANNEX I Expected profit and variance The expected profit can be calculated as

The conditional variance of the profit is , 1 = 1 , 1 = + 2 +2 = 2

,

1 2

+ 1 2 2 +2
,

1 2

2
,

Where, for simplicity, we have replaced , 1 = Now, given that = + +2 2 +2

+ ,

+ 2
,

2 + , 1

+2

And = , 1 = , 1 +2

, 1 ,

= , 1

, 1

Then, the expression can be reduced after making the correspondent replacements and substitutions in +

ANNEX II

Elasticity of demand There are two sets of simulations. Those named betaXXhom analyse how the model behaves under shocks given to the HOME output under different elasticities of demand at HOME. Those scenarios labelled betaXXrow analyse how the model behaves under shocks given to the ROW output under different demand elasticities at home Shocks
WHEAT SOYBEANS MAIZE HOME +25% of output (+0.36) in year 5 +25% of output (+1.18) in year 5 +25% of output (+0.54) in year 5 ROW +25% of output (+15.35) in year 5 +25% of output (+4.186) in year 5 +25% of output (+17.27) in year 5

Beta values
beta06hom/row beta07hom/row beta08hom /row beta09HOM /row beta10HOM /row beta11HOM /row beta12HOM/row beta13HOM/row beta14HOM /row beta15HOM /row beta20HOM/row beta30HOM /row beta40HOM/row beta50HOM/row beta60HOM/row beta120HOM/row beta240HOM /row HOME 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 2 3 4 5 6 12 24 ROW 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3

Coefficient of risk aversion= 1 Armington elasticity (sigmaq)=2 Elasticity of substitution between domestic product and imports There are two sets of simulations. Those named sigmaXXh analise how the model reacts under different Armington elasticities under shocks generated at HOME. Those shocks labelled sigmaXXr looks into how the model behaves under different Armington elasticities when the model is shock in the ROW. Shocks
WHEAT SOYBEANS MAIZE HOME +25% of output (+0.36) in year 5 +25% of output (+1.18) in year 5 +25% of output (+0.54) in year 5 ROW +25% of output (+15.35) in year 5 +25% of output (+4.186) in year 5 +25% of output (+17.27) in year 5

Sigmaq values
sigmaq09h sigmaq11h sigmaq12h sigmaq13h sigmaq14h sigmaq15h sigmaq20h/r sigmaq30h/r sigmaq40h/r sigmaq80h/r sigmaq160h/r sigmaq320h/r ROW 0.9 1.1 1.2 1.3 1.4 1.5 2 3 4 8 16 32 HOME N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Coefficient of risk aversion There are two sets of simulations. Scenarios name craXXr analyse how the model behaves under different values of the coefficient of risk aversion when the shock comes from HOME. Scenarios named cra XXh analyse it when the shock comes from HOME. For some reason, the model could not be solved at the same time for the three commodities. As a consequence, there are separate files for the simulations on wheat and the simulations on soybeans and maize.
WHEAT SOYBEANS MAIZE HOME +25% of output (+0.36) in year 5 +25% of output (+1.18) in year 5 +25% of output (+0.54) in year 5 ROW +25% of output (+15.35) in year 5 +25% of output (+4.186) in year 5 +25% of output (+17.27) in year 5

Sigmaq values
cra_04h/r cra_03h/r cra_02h/r cra_01h/r cra01h/r cra02h/r cra03h/r cra04h/r cra05h/r cra06h/r cra07h/r cra08h/r cra09h /r cra10h/r cra11h/r cra12h/r cra13h/r cra14h/r cra15h/r cra20h/r cra30h/r cra60h/r cra120h/r ROW 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 HOME -0.4 -0.3 -0.2 -0.1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 2 3 6 12