by Tim Nadreau, Ph.D.
The Issue:
This week I wanted to highlight a post from a friend that I went to grad school with. Jadrian takes on the economics of the formula shortage HERE. Notice that the shortage of baby formula is a true shortage because retailers aren't allowing the price to rise. "Shortages occur when prices are below some equilibrium level in a market." Towards the end of his article, he mentions a few key issues. The first is timeliness: “…it would take about two weeks to restart the manufacturing process and still months before the baby formula is back on the shelves.” The second is excess demand: “Abbott said on Friday it has already shipped millions of cans of infant formula powder into the United States from its Ireland facility.”
The Theory:
Timeliness is an issue important in every industry. When a manufacturing plant shuts down, it isn't like flipping a switch to get it up and going again. If a farmers combine is too small, they may lose yield and quality from taking too long to harvest their crop. Potato processors need to process inventory quickly to avoid inventory losses. Time, as they say, is the only non-renewable resource and as such the economics of time is a critical area of research that gets little attention. Figure 1 shows how ownership costs rise with increasing size of equipment or facilities. Operating and timeliness costs tend to decrease with size or scale. The optimal scale of an operation is not always “bigger,” but neither is it always “smaller.” The goal is to minimize total costs, and timeliness is a key component of that. The FDA might be able to expedite the process to get us back on track more quickly in the case of baby formula.
Figure 1: Timeliness and Optimal Equipment Size
The more interesting comment Jadrian made was in references to imports. Excess demand occurs in an international trade context. When the world price of a good is below the domestic market price, domestic consumers have demand in excess of domestic supply. The international markets can often fill that excess demand, if they have available excess supply. See the figure below. A few things to note about Figure 2: 1) the graph assumes a free market with no trade frictions, 2) the country with the lower domestic price is the exporter— panel 1, 3) conversely, the country with the higher domestic price is the importer— panel 3, 4) producers in the importing nation lose welfare and consumers gain welfare, 5) producers in the exporting nation gain welfare and consumers lose welfare. The most important takeaway here is that both nations experience net gains.
Figure 2: International Trade and Net Welfare Gains
These three panel graphs are illustrative more than anything, but you can read them the way you read standard partial equilibrium graphs from Ec101. When the exporter has a surplus, i.e., quantity supplied exceeds quantity demanded, they sell that excess supply on the world market. That is the ES curve in the middle panel. Countries that have an excess demand, like the U.S. has for baby formula right now, are seeing quantity demanded exceed quantity supplied. So, in theory, they could go to the world market and buy the goods they need, hence the ED curve in the middle panel: that world market sets the world price for a good. (This is a great story about what happens when that process is curtailed).
Figure 3 shows how the gains and losses to producers and consumers occur in each nation. While I am going to leave it to the reader to calculate the changes in consumer and producer surpluses, it should be noted that the gains from such trades are positive for both countries! The gray triangle in the world market panel represents gains from trade. They can be seen in the “Total” row of Figure 3—both the exporting and importing nation realize positive net welfare changes from trade.
Figure 3:Welfare Analysis from Trade
| Exporting Country | Importing Country |
Change in Consumer Surplus | -ijbd | +hfol |
Change in Producer Surplus | +dikb | -hfml |
Total Change in Welfare | +jkb | +fom |
Our Take:
Our take is that, just as trade intranational trade is a good thing, international trade is a good thing also. It provides larger markets for our farmers, while consumer bases like Japan and South Korea benefit from not having to put scarce land into agricultural production. They can focus on producing the things they are good at; we can focus on producing the things we are good at, and we can trade.
In the case of baby formula, which we are good at producing, trade allows for diversification and risk mitigation. If a plant in the U.S. goes down, plants elsewhere still exist to provide the good or service. Trade inherently brings with it international risks—transportation losses, supply chain disruptions—but on net, it provides market stability and increases consumer wellbeing. Imagine if there were no trade, and you had to produce your own house, car, medical, and accounting services, etc. We would all be less productive.
Timeliness is improved by trade as well. How much time would it take you to do your taxes, paint your home, or replace your alternator? You trade, and a professional provides the good faster. One of the concerns with the baby formula is the lack of competition in the market. With only 5 producers—one with 43% of the market share—any disruption is a big disruption. I suspect that the FDA is the cause, not the solution, to this problem, as the regulatory environment has likely led to the oligopoly and high concentration in the first place.