266 – Supply and demand: The wool crisis

The wool crisis of 1990-91 was a spectacular case of economic mismanagement, where an industry inflicted massive costs on itself (and others) through acts of obvious and determined stupidity. Industry leaders convinced Australian wool producers to endorse a strategy that was completely devoid of economic sense. The aim was to make producers rich, but the result was that they lost billions of dollars.

What they did was establish a reserve price, below which they would not allow wool to be sold. That needn’t have been disastrous, except that they set the reserve price optimistically during a period of booming demand, and then refused to lower the price when demand cooled. Farmers kept receiving the artificially high price and so sheepproduced huge volumes of wool – much more than they would have done at the real market price. At the same time, wool buyers responded to the high price by reducing their purchases of wool and switching to other textiles. The predictable result was a huge stockpile of unsold wool.

The industry borrowed billions of dollars to pay itself inflated prices for its own wool, put it in sheds and pay storage and interest costs, hoping that the price would rise again, but actually creating ever-increasing pressure for it to fall. It really was as ridiculous as that sounds. It’s hard to imagine how anybody involved could not see the folly in this, but somehow wool-industry leaders convinced themselves and most wool growers that it was a good strategy.

Figures 1, 2 and 3 illustrate what was happening, in a simple supply and demand model. Figure 1 shows what the price and quantity would have been in a free market: a price of 555 c/kg, resulting in a balance between supply and demand, at 44 units. (These are not the real numbers – they are just for illustration).

Figure 1

Figure 1

Figure 2 shows what happened when the Australian Wool Corporation (AWC) set a high reserve price (of 870 c/kg), and passed that price on to farmers. Because of the artificially high price, demand for wool was reduced (to 13 units in this illustration) while production of wool was increased (to 84 units). The wool that wasn’t bought (71 units – the difference between production and sales) was acquired by the AWC and stored indefinitely.

Figure 2

Figure 2

Just as in Figure 2, the AWC found itself having to acquire most of the wool being offered to the market. By the end of the scheme, the amount of wool being stored reached extraordinary levels (4.8 million bales, approaching a billion kilograms), and it was incurring around $3 million per day (over $1 billion per year) in costs of storage and interest.

The sensible way to get rid of over-production would have been to abandon the reserve-price scheme, but instead the AWC decided to tax the price received by wool producers. Presumably, the aim was to bring the amount of production down to about the volume of wool being purchased. Figure 3 illustrates this outcome. In this figure, wool buyers are still being charged 870c, so they are still only purchasing 13 units. Wool producers are being taxed 566c, so the price they receive is only 304c, resulting in production of 13 units (matching demand).

Figure 3

Figure 3

If the original reserve price system was stupid, this system of taxing producers was stupid squared. For it to eliminate surplus production, wool producers would have had to receive a lower price, and produce less wool, than in a free market. And this was a system that was intended to benefit wool producers!

Throughout the drawn-out crisis, proponents of the scheme argued that the shortfall in demand could be overcome through market promotion, and a big chunk of the wool tax was spent on this. A tenacious faith in this idea was partly what drove them to stick with the scheme long after it was clearly a disaster. If the experience proved anything, it’s that this faith was unjustified.

Another factor driving them to stick doggedly with the scheme was an apparent unwillingness of the decision makers to admit that they had made mistakes. The delays in shutting it down greatly escalated the costs.

Eventually (much later than it should have) the Australian Government exercised its power to force the AWC to lower the price and later shut down the scheme. The AWC fought it all the way.

Wool producers, processors, traders and Australian taxpayers all lost money in this scheme. Charles Massy in his excellent book “Breaking the Sheep’s Back” estimates that the total cost was at least $12 billion in 2011 terms (and probably much more), making it “the biggest corporate disaster in Australian history in terms of losses generated by a single corporate or statutory business entity” (Massy, 2011, p.382).

At the time of the crisis, I was living out in the wheat-sheep belt of Western Australia, so I got to hear much of the debate at the grass-roots level. Some farmers could see that the industry was making a massive mistake, but most were following the lead set by industry leaders and blaming the scheme’s problems on everybody else: politicians, economists, wool customers.

It would be hard to imagine a more incompetent and irresponsible set of decisions than those of the AWC board and management throughout this episode. As a result they caused untold human misery. We can count the billions of dollars lost, but we don’t have statistics for the depression, the suicides, the fractured families or the agony caused to farmers by having to shoot and bury thousands of worthless sheep. I don’t think those responsible for this misery have ever been adequately held to account.

The wool industry has never recovered. It remains a shadow of its former self.

A really basic understanding of economics would have avoided all of this. Not only did the industry leaders lack this understanding, but, as Massy reveals, they actively resisted and rejected advice from competent economists when they received it, including economists who worked for them.

An online review of Massy’s book sums up one of the key lessons very well: “Those who defy the markets will eventually lose. They may lose slowly, or lose in a spectacular collapse, but they will lose.”

Further reading

Bardley, P. (1994). The collapse of the Australian Wool Reserve Price Scheme, The Economic Journal 104(426), 1087-1105. IDEAS page

Massy, C. (2011). Breaking the Sheep’s Back, University of Queensland Press. Here

Richardson, B. (2002). The politics and economics of wool marketing, 1950–2000, Australian Journal of Agricultural and Resource Economics 45(1), 95-115. Journal page here

38 Comments

  • Neil
    6 May, 2014 - 10:40 pm | link

    Is today’s situation with rice in Thailand the same, if not worse?

    • 7 May, 2014 - 7:07 am | link

      Hi Neil. Current Thai rice policy does have some key things in common with Australian wool policy in the 1980s-90s. The Thai government has set a price for farmers that is about double the market price. As a result, production has boomed. A big stockpile of unsold rice has built up. And yes, the costs look like they are roughly similar in magnitude, and perhaps even bigger.

      There are some differences too. In Thailand it was a government decision (for electoral advantage) rather than a decision of the industry. It is mainly the government that is bearing the cost (billions of dollars per year), rather than the farmers. It doesn’t pose a threat to the long-term prospects of the Thai rice industry. Thai rice is a much smaller percentage of world production, so the scheme is having a smaller impact on traders, processors and other producers around the world. Once they abandon the scheme (as they will have to sooner or later), they should be able to return to more-or-less where they would have been without the scheme, whereas for wool there had been irreversible substitution away to other fibres. The Thai situation is made worse by corrupt officials, and by people bringing in rice from neighbouring countries to sell at the inflated prices.

      http://www.economist.com/news/asia/21583281-increasingly-unpopular-government-sticks-its-worst-and-most-costly-policy-rice-mountain

    • Mamadou Diallo
      11 September, 2016 - 6:21 am | link

      The situation that you describe has been seen in Mali it 8 years ago. With the higher prices of the products especially rice in 2008 which caused strikes in diverse Sahel countries including Mali, the Government has subsidizing agricultural inputs such as seeds and fertilizers which contributed to boost rice production. At the same time, the Government has reduced the taxes of rice and traders enjoy to export thousands of tons coming competition with local rice. Malian consumers who have a low very purchasing power are turned to the imported rice who cost 2 times cheaper than local rice. Rice farmers could not repay inputs subsidized price credit have sell off their production and most especially small producers have quit the countryside for the city looking for other opportunities.

  • 12 May, 2014 - 8:23 pm | link

    David, I have to admit that I was only a kid when I was dragged along to a wool scheme rally at the height of the issue. But I still remember that the issue was very much irrational and emotive. A lot of farmers were all about getting paid to produce, it was someone else’s problem to sell the stuff.

    To some extent there is a lot of that in all the pooled ag commodities. You only have to look at the way people reacted to the wheat board changes. Many regard themselves only as growers and don’t care about the end market, demand or, surprisingly, the price. The last point caught me off guard, but it was front page of the FarmWeekly (the season after the peak in wheat prices), with a farmer standing in a crop in spring saying he needed $300/t to break even, that made me realise how unresponsive farmers are to change, especially in their produce markets.

    Thus, they loved the floor price, it made everything easy.

  • Bingo
    2 February, 2015 - 4:15 pm | link

    So, market economy should manage the price, then it’s good if a grower could predict the price then decide which to transplant? 😀

  • Tom
    3 February, 2015 - 9:32 am | link

    David.
    The most significant damage to the wool industry was from the existence of the stockpile even after the scheme was abandoned. In effect it meant that there was an unlimited supply of wool overhanging the market, and of course the supply/ demand relationship is really a psychological one. It is a perception.
    At that time I suggested that the entire stockpile should be destroyed…..dumped and buried in the Kalgoorlie super pit. While that was the equivalent of tearing up billions of dollars, producers would still have been better off overa period of years. One of the replies I got was, “I have too much money invested in the stockpile.”

    • 13 February, 2015 - 3:00 am | link

      That was one of the options on the table. A lot of analysis was done to identify the best strategy overall. From memory, I don’t think destroying it came out best.

  • Sam
    3 February, 2015 - 4:30 pm | link

    What happened to ask that wool? I can imagine so many businesses benefiting from that huge stockpile, and the blight of the AWC, and make millions by producing and selling innovative and probably not so cheap wool based products.
    There ought to have been done savvy business man or other getting rich during this crisis?
    In Farsi, we’d say “catch fish from murky waters”.

  • Sajid Mahmood
    3 February, 2015 - 7:23 pm | link

    Situation is even more worst in my country Pakistan. Now the potato harvesting season is going on here in Pakistan and Govt do not set any price for potato to benefit the formers and today’s price for potato in local market is US $ 10/100 kg.

  • Edward
    4 February, 2015 - 10:11 pm | link

    Thanks for offering this course on line, who said there is no free lunch.
    Kindly shed some light on minimum wage in the context of food security. Thanks

  • Farman Ali
    9 February, 2015 - 10:17 pm | link

    Dear David Pannell
    What would you say about the prices of cotton in Pakistan?
    Where India and china is giving subsidy to their farmers in cotton production (violating the WTO rules) and Pakistan dont give any subsidy. And poor farmers are suffering.

    • 11 February, 2015 - 5:21 pm | link

      I don’t know what Pakistan is doing with cotton prices. In general, my starting point is that any assistance provided to farmers should not be built into prices. If the government wants to give assistance, it should be by some other way, such as by a payment that isn’t built into prices.

  • Tham
    16 February, 2015 - 10:24 pm | link

    In Vietnam, the government set the price rice is too low. Then the middlemen (collectors) buy rice from farmers to low then middlemen and exporters got most of benefit, farmers (producers) get too little benefit from the rice value chain and have very low power to make decision on price

    • 21 February, 2015 - 8:03 am | link

      In some situations large companies (or governments) in the supply chain have market power and can reduce prices to farmers below a competitive level. There can be a role for government intervention in this case. I would be regulating the supply chain, rather than subsidising farmers.

  • 17 February, 2015 - 10:58 pm | link

    Dear Dave,

    Thanks for the educative piece on the importance of Demand and Supply.

    In my country Nigeria, the impact of Nigerian government is not felt much by the farmers; hence farmers are on their own. On many occasions, there are gluts in the markets and farmers are losers because they will have to sell at ridiculous prices which will lead to loss.

    It is my prayer that government in Nigeria will have strong policy and financial assistance for farmers so that many people will develop interest in farming which is the mainstay of the economy.

    Best regards,

    M.O. Falola

    • 21 February, 2015 - 8:05 am | link

      I don’t know about Nigerian agricultural policy, but it is true that historically many developing countries have had policies in place that favoured urban dwellers and penalised farmers. This is really not a good idea, especially given the large numbers of farmers.

  • Rupananda
    18 February, 2015 - 5:15 am | link

    Hi David

    You said that government assistance to farmers should not be built into prices. As you are aware that agricultural crop cultivation is not a profitable activity in developing countries. Given that do you advocate producer subsidies are as good policy tools to assist farmers in developing countries? I know that Sri Lankan government use the fertiliser subsidy to assist farmers.

    Thank you
    Rupe

    • 21 February, 2015 - 7:49 am | link

      Building assistance into input prices is usually not quite as bad as building it into output prices, but it is still not a good idea. Subsidising inputs leads to over-use of those inputs, and can create problems such as water pollution or simply waste. If assistance is to be provided, it should preferably be provided as a direct payment to farmers that doesn’t affect input costs or output prices. An exception could be where an input creates external benefits.

      • RichardU
        12 November, 2015 - 7:22 am | link

        I think the best assistance is educational subsidies for farmers’ children (and even farmers themselves) so they don’t keep making these mistakes and supporting policies which are against their interest.

  • Wandera peter
    26 February, 2015 - 12:43 am | link

    Hi about the falling of the wool industry is the major focus by the economy was to see that it increases the demand of wool in form of raw materials to factories thanks

  • A.Vidhyavathi
    11 March, 2015 - 4:57 pm | link

    In India still fertilizer subsidy is not streamlined. But government has started giving direct subsidy /cost to the LPG consumers. Instead of giving subsidized LPG the subsidy amount is directly credited into consumers bank account.

    • 11 March, 2015 - 8:50 pm | link

      Putting a subsidy straight into a bank account sounds better than building it into the price. It avoids distorting demand for the product or input.

  • Sox
    15 March, 2015 - 12:50 pm | link

    This is certainly an eye opener into economy of the Wool Industry for me. I never knew this and am pretty sure there are other industries facing this dire situation with leaders who only wants to make money.

  • Faisal Shahzad
    17 March, 2015 - 4:39 am | link

    Hello David
    I regret to say that the same manipulation is being done by the Pakistan Government for the production of wheat.
    Firstly they declared that the production is going to be less and market price will be high in this year.Mostly people changed their cropping pattern and focus on the major wheat crop as well. But in vain farmers have to survive at he last.
    Govt has declined the prices upto 40 %.
    Farmers are not subsidize with the conditions relating to issue and also not legislation for the cropping pattern so that analysis can e done and further evaluation can be possible. What is your suggestion if govt does not co-operate and we have to survive it on our self
    Regards
    Faisal

  • 22 August, 2015 - 8:14 am | link

    Hi David,

    Like your article on 1990s Wool crisis remember it well – been in mkts 25yrs & as per current Chinese Stockmkt crash no one seems to learn about damage done from trying to fix prices – certainly makes it interesting – I call it the “gold fish theory” mkt can’t remember what happened 24hrs ago let alone 20yrs.

    Cheer Ross McInnes

  • Puruswattam Rauniyar
    16 July, 2016 - 6:32 pm | link

    What will be if Producers and Sellers will know how make supply curve, demand curve and to find our Market equilibrium price and Market quantity.

  • juan
    8 October, 2016 - 3:39 am | link

    A great article, knowing this, agroindustry in many countries would act more logically in markets; the problem with taxes and protectionism causes more costs in markets, then countries need to set up different ways to stablish trade barriers for imports and protect local farmers.

  • Manuel Camacho
    8 October, 2016 - 5:39 pm | link

    Hi David, thanks for offering this course. I am beginning to be part of the international coffee trade and currently Climate Change, industry consolidations and producer poverty are pushing new conversations into alternative price mechanisms that can reflect changing cost of production and keep famers motivated to stay in coffee. Are there lessons from other industries and/or further reading you could recommend to be personally better prepared to understand this through a wider agricultural context? Thank you

    • 9 October, 2016 - 7:10 am | link

      In my view, one of the key lessons from experiences like this is that you should not be looking for alternative price mechanisms to keep any farmers in any particular product. The risks in trying to do so are too large. A better strategy would probably be to invest in research and development to create production systems that are more efficient or more productive.

  • Elias John
    25 October, 2016 - 9:46 am | link

    I support David Pannell because strategy is the key in any organization which provides proper directions and success and therefore would also reckon that better strategy would also be to invest in research and development. This will enhance and create productive systems which are efficient and more productive.

  • Puneeth Chengappa
    24 November, 2016 - 12:33 pm | link

    Dear David,
    The same situation except that there was no reserve price for silk in southern states(provinces) in India . The price for silk cocoons was very high during 2011 this promoted the farmers to take up Sericulture in non conventional areas, but now due to increase in supply the Government has taken measures like reducing the import duty of silk. So now since import duty is less textile industries started buying silk from Chinese, this made the the producer get less price hence growers uprooted the plants and this policy made a balance in demand and supply. This is just one side of coin.
    But the real problem is majority farmers here own land only for subsistence living so what to do with such consequences?

  • Awoyele Adebayo Adedamola
    8 December, 2016 - 2:22 am | link

    Dear David,

    The price management of staple crops in Nigeria is yet to to standardised, however, the improved value chain management of some few staple products e.g rice and cassava has helped stabilize the prices. Presently the Rice anchour project in Nigeria is producing more rice for sale (a good business synergy between the small and medium contract farmers , Big Rice Millers and corporate Organisations). Prices are still high yet stable.
    I believe in no distance future in Nigeria, the market equilibrium for most staple food will be at relatively lower price.

  • Opoku-Agyei Isaac
    26 January, 2017 - 7:03 am | link

    Hello David,
    This course has really enlightened me in the economic and social consequencies of government and other board policies which may be overlooked at the time of planning and implementation. Thank you very much. In Ghana, it is only cocoa that the government through a board regulates the prices. For some time now, there hasn’t be any challenge probably because about 75 percent of raw cocoa beans is exported. I am also informed that the selling price of cocoa by the board is hedged on the international market. Coordination along the cocoa value chain cannot also be underestimated. I think they have achieved a lot.

  • Andrew
    19 February, 2017 - 10:17 am | link

    David,

    I was a teenager being raised on a sheep farm and lived through this crisis.

    This article certainly brought back memories. Shooting sheep and throwing them in a pit is an awful memory that has never left me.

    I recall in our area that all the blame was with the Japanese. What was the rationale behind this?

    • 7 March, 2017 - 9:23 pm | link

      Yes, I never witnessed it, but I certainly talked to farmers who were deeply affected by having to shoot their sheep.

      There were wool processors in Japan. Blaming them was completely nuts. They problem was entirely created by the Australian industry.

  • Eric Doe
    24 February, 2017 - 3:40 am | link

    I am following the discussion.

  • 24 July, 2017 - 10:39 pm | link

    This is excellent

  • J
    14 September, 2017 - 4:32 pm | link

    Excellent example. Thanks!!

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