Escalating Price Of Olive Oil

Based on the article ‘The soaring cost of dressing a salad’ from The Economist on 22^nd September 2012.

Ever thought of why salad cost so much? It is because of dressings such as thousand island, balsamic and of course olive oil! Yes! Olive oil played an important role in ancient mythology. In those days, it is used as skin emollient and as fuel for lighting. Today, olive oil is used in many different ways from cooking to skin care thanks to an ever-growing body of evidence that it can prevent everything from heart disease to cancer.

Because of its health benefits, consumption in Europe has peaked with the Germans consuming five times more and the British consuming ten times more olive oil in their food than in 1990. In addition, America, according to Rabobank has demand growing by almost 6% a year.

The more desirable the good for instance in this article is olive oil, the more consumers will demand. When the demand for a good increases, the demand will move rightward in a graph consisting a demand and supply curve. This will prompt an increase in the price of olive oil. According to the law of demand, when all other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.

This scenario can be resulted from either the substitution effect or income effect. The substitution effect is when the opportunity cost, which is the next best alternative forgone of a good rises, people seek substitutes for it, so the quantity demanded of the good decreases. Whereas the income effect is when the price of the good rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good decreases.

The Mediterranean, with its baking summers and warm, wet winters, usually provides an ideal climate for olive groves. But recently, a drought in Spain is having a dramatic impact on the market as this natural disaster will trigger a decrease in supply that shifts the supply curve of the olive oil leftwards. Such ‘random shocks’ affect the harvesting of olive oil hence unable to supply the goods to the market creating a shortage.

Spain is accounted nearly half of the global production of olive oil. The absence of rain in Spain might reduce the total global output by around 20% compared to last year, when the world was awash in over 3 million tones of olive oil. Before the drought happened, production was high, supply was increasing hence it pushed prices to a nine-year low. This time however, prices are sky rocketing high due to the shortage of supply. Even when stocks left over from last year’s bumper harvest are helping to keep price rises in check, it is still not enough to prevent drastic price hike.

When prices are too high, consumers will look for substitutes, as mentioned earlier, the substitution effect. Substitutes for olive oil are for example: other salad dressing such as mayonnaise, thousand island and vinegar. When there is a shortage of olive oil, other substitutes will experience an increase in demand. This can be proven in the cross elasticity of demand where it measures the responsiveness of a demand of a good to a change in price of a substitute or vice versa, other things remaining the same.

At the same time, since olive oil has many health benefits, it should fall under the category of merit goods as olive oil exhibits positive externalities and it gives the consumers benefits. However, it is very hard to determine whether it is a merit good to certain individual consumer as olive oil may be good for an individual but it may also not be a good product for another individual. As a whole, based on this article, olive oil is a merit good after all as it is highly sort after and brings benefits to the society or individual consuming it.

To counter the rising cost of olive oil, government intervention is said to be one of the solutions. As stated earlier, olive oil exhibits a positive externality. To make it simple, positive externality is when social benefits exceed private benefits. Since the social benefits exceed the private benefits, government should implement a financial intervention such as subsidies to the olive growers for the production of olives. In this case, the possibility to recover from the shortage will be higher thus increasing supply to the market and stabilizing the price of olive oil.

Moving on, price stabilization policies are relevant in helping to keep prices of olive oil from rising to an unexpected level. It is designed to lessen the effects of unplanned fluctuations in supply. For example in the earlier paragraphs, we talked about stocks left over from the previous year’s over-production being used to control prices. What the government can do is something similar to the example discussed earlier. The government can set up a marketing board that regulates supply by releasing buffer stocks on to the market in order to stabilize the olive growers’ income. By releasing buffer stocks at times of shortage or by purchasing excess stocks at times of surplus production, price can be stabilized at a predetermined level.

However, there are drawbacks on the government intervention mentioned above too. This is because government may not know the full costs and benefits of its policies. It may genuinely wish to pursue the interest of the consumers and yet may be unaware of people’s wishes or misinterpret their behavior. Also, if the government intervention removes market by the use of subsidies for example, it may remove certain useful incentives.

To sum it all up, we have discussed the reasons for the surplus and shortages of olive oil to the externalities it exhibits to the ways of countering its rising cost due to the drought that affected many. I hope that the major producers of olive oil will get help from their respective governments in view of recovering the industry and reduce the price of olive oil back to its equilibrium level for the good of all.

( Author : Student ID - 1101A13303 )