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 produced 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 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.
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).
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.
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.”
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