Diersen, Matthew A.

Taylor, Gary

English

Public Research Access Institutional Repository and Information Exchange

South Dakota State UniversityOpen PRAIRIE: Open Public Research Access InstitutionalRepository and Information ExchangeEconomics Commentator Department of Economics5-16-2001Power Deregulation: Blessing or Curse; SouthDakota's Hog MarketGary TaylorSouth Dakota State University, Gary.Taylor@sdstate.eduMatthew A. DiersenSouth Dakota State University, Matthew.Diersen@SDSTATE.EDUFollow this and additional works at: http://openprairie.sdstate.edu/econ_commPart of the Agricultural and Resource Economics Commons, and the Regional EconomicsCommonsThis Newsletter is brought to you for free and open access by the Department of Economics at Open PRAIRIE: Open Public Research AccessInstitutional Repository and Information Exchange. It has been accepted for inclusion in Economics Commentator by an authorized administrator ofOpen PRAIRIE: Open Public Research Access Institutional Repository and Information Exchange. For more information, please contactmichael.biondo@sdstate.edu.Recommended CitationTaylor, Gary and Diersen, Matthew A., "Power Deregulation: Blessing or Curse; South Dakota's Hog Market" (2001). EconomicsCommentator. Paper 412.http://openprairie.sdstate.edu/econ_comm/412ECONOMICSCOMMENTA TORSoiJth Dakota State UniversityPower Doregylatiofi:Blessing or CurseQary TaylorAssistant Professorof EconomicsThe plight of California has been a topic ofmuch discussion In the last few weeks. Theproblems there have become almost synonymouswith the evils of market deregulation. Is thiscomparison justified? Was the California powermarket truly deregulated or Is the current situation aresult of excessive government Intervention? Aclear understanding of the situation that exists InCalifornia is necessary to make an informeddecision regarding the future of power deregulationIn other parts of the U.S.Tbe California SituationThe problem In California was born In 1996when the state legislature enacted a regulatory planthat partially deregulated the price of electriolty.This process allowed consumers access to powerfrom out of area, and out of state, suppliers. Thispolicy change was forced by a demand Increase of30% over the last ten years while supply onlyincreased 6%. During this same time periodconsumer/ environmentalist activism prevented thebuilding of any new power generating facilities.These groups of activists were dubbed BANANAS -- Build Absolutely Nothing .Anywhere Near Anyone -" by former Delaware Govemor Pete du Font.This increase In competition should, Intbeoiy, drive prices down. The problem Is thatwhile wfiolesale electricity prices were allowed tofluctuate, consumer prices were frozen. Thismeant that while the producers of electricity wereallowed to pass along the Increases In their costs ofproduction, the prices that utilities were allowed to(Continued on p. 2)No, 420 Mav 16, 2001South Dakota'sHog MarketMafthaw A. DiersanAssistant Professor& Extension SpecialistProducers, lenders, and others haveexpressed Interest in the future profitability of hogsand In marketing Issues such as basis and hedgingeffectiveness. In this Commentator, a couple ofIssues related to South Dakota's hog market areexamined. Raising hogs and pigs Is generallySouth Dakota's second largest livestock enterprisebased on sales revenue, lagging behind raisingbeef cattle. The number of farms producing hogshas declined in recent years, but South Dakotaranked 11*' among U.S. states inhog Inventory andranked 12'^ In pig crop size In 2000.^Despite a decline In the number of sows InSouth Dakota, the number of hogs marketed hasIncreased. The pig crop declined, but Inshlpments,presumably of feeder pigs, have made up thedifference as shown In Figure 1, Tfie ability to useexisting facilities and relatively Inexpensive feed arepotential causes. An industry-wide trend towardspecialization Is perhaps another factor explainingthe trend. Is there room for growth in SouthDakota's hog markets? Recent growth fromInshlpments of feeder pigs implies that SouthDakota may have a comparative advantage wherefinishing hogs Is concerned. Feed cost should berelatively low, as the price of corn Is typically thelowest in the U.S. along the 1-29 corridor In SouthDakota.Another Issue Is basis, the differencebetween cash and futures prices. Basis IsImportant because It determines how the futuresprices should be adjusted for planning purposesand for comparing futures and options with any(Continued on p,3}(D^regul&tion contd. fromp,?jcharge consumers wore frozen for six years. Thislaw was written at a time when generation coats forelectricity were decreasing. The unforseenIncreases in the costs of producing electnolty couldnot be recouped by the utility companies, forcingthem to the verge of bankruptcy. State rules forcedcompanies to buy power at $.15 to $1.00 perkilowatt hour but retail prices were capped at $.067per kilowatt hour, (Taylor)The Theory of Deregulattonin most cases the local power companyoperates In a monopoly situation. Since they arettie oniy supplier of electricity, the usual marketresponse is to produce iess than the optimaiamount of electricity and charge a price higher thanthe tree market equilibrium. This misaiiocatlon ofresources arrd transfer of consumer surplus toproducers are the usual reasons for regulation.The job of the regulatory body is to try to balancethe Interests of the consumer (low prices, productvariety, and quality of service), while etillmaintaining the economic viabiiity of the producer,(Fisher and Dombusch) In order to satis% theseinterests some guidelines should be followed. First,marginal cost pricing should be followed as closelyas possible. Second, the pricing and servicerequirements should allow the utility to obtain a"normal" rate of return on the capital it hasInvested. Finally, power should be produced In anefficient manner. This rate of retum should beapproximately what could be earned by investingthe capital In the next most attractive alternative, Acompetitive rale of return is necessary to allowproducers to update generating facilities and linesand maintain a reasonable mtum to their investors.History shows that deregulation of a marketallows the influx of new compeHtors v/ho see anopportunity to reap profits and introduce a cxjnditionwhere the forces of supply and demand determineprices. As supplies increase, prices are drivendown and as consumer demand increases, pricesIncrease, Such an increase in competitton willforce utilities to t>ecome more efficient producersand reduce the prices customers pay. Freeing themarket in California would have initially resulted InIncreased consumer prices but it would have alsobrought consumer demand closer to actualsupplies, encouraging conservation measures andnew construction of power plants. As newparticipants enter the market, prices would havegone down and consumers would have gained newchoices for their power supply. The partialderegulation plan that was purmed In Californiaresulted in deteriorating service and rollingblackouts, and has caused severe economichardship to both businesses and private Individuals.Lessons for the FutyreAs we look at the problem of deregulationand its effect on markets, there are sortie lessonsto be learned. The results of the partialderegulation in California should be no surprise.We have seen the same results in the formerSoviet Union, yaintalning price controls In thedomestic market while paying free market prices forgoods and resources needed for production andconsumption drove the USSR Into bankruptcy. Weare seeing the same situation being replayed inCalifornia. Paying high prices for inputs and havingoutput prices capped is a recipe for failure. Thesecond thing to be learned here Is that givingconsumers what they want may be politicallyexpedient in the short run, but may be very costly inthe long run. Consumers In California havedemanded cheap electricity. However, at somepoint the bills for providing cheap power will comedue. The laws of economics cannot be suspended.We are seeing the results now. Consumers arefacing disruptions In power supplies as well as afuture of higher power prices as the state bails outthe floundering utility companies. The final lessonfrom this process is to take the lime to thoroughlyexamine a problem before proposing a solution andexamine both the intended and unintended resultsof the policy. The externalities created must alsobe accounted for. The intended result of the law,iow power prices for consumers, was achieved.However, the unintended resuits, utilities on theverge of banknjptcy and lack of generationfacilities, were not anticipated. This doesn't meanthat deregulation will not work; ItJust needs to becarefully evaluated on a case by case basis.Due to different resource allocations,managerial abilities, and consumer needs, whatfails in one situation may be a great successsomewhere else. Adequate study and analysisprior to implementation is much easier than tryingto solve a preventable problem later. The problemsfacing California should not deter other states.Including South Dakota, from pursuingderegulation. There are also examples ofsuccessful utility deregulation. Pennsylvania is agood example. By truly deregulating the electricitymarket In that state, consumers have been therecipients of lower prices and better service.Markets that are allowed to work freely do a betterJob of allocating resources and discovering pricesthan regulated ones. The key is to allov^ themsufficient freedom and time to achieve a stableequilibrium and to allow consumers to makeinformed decisions regarding their purchases.SooroesFischer, Stanley and Dombusch, Rudlgsr. Economics.McGraw-Hill, 1983. p, 279Taylor. Jerry. "California's 8urn-ouf, National ReviewOrrline, February 7, 2001.(SD's Hog Market ... contimied frwi p.1}forward prices. The difference between cash pricescan also be compared, giving a location basis. Theweekly average price for market hogs in SiouxFalls, reported by USDA-AMS, was compared tothe CME Lean Hog index on expiration dates from1997 to 2000 For months without a contract, theindex value was from the business day of themonth, the day futures contracts typically expire.As shown In Table 1, the basis in Sioux Fails wasusualiy negative, but ranged from ~$7.27 to $4.22.A basis level of -$2.00 Implies that for any observedfutures price, the implied Sioux Fails' cash price isobtained by subtracting $2.00, then converting to acash price by multiplying the result by 0.74. (TheIndex is on a dressed basis and the dressingpercer^tage for butcher hogs Is about 74 percent ofits live weight).Sales revenue from hogs In South Dakotaclimbed back to around $280 million in 2000. Whatthat means In terms of future profitability is difficultto assess, given the equity-draining prices of late1998, Tfie prospects seem to raise as manyquestions as answers.^ However, given the movetoward year-round, continuous operations, there Ispossibly a niche to exploit given the continuedseasonal demand fluctuation (and higher prices) forpork.' USDA-NASS annually rspoUs numbers such as inshlpmefXs,farm slaughta~, and deaths in the Msat Animals Productbn,Dispo$itk>rs. and Inaome report,^For a morederailed discus$ior> see Oiersen, M.A. SouthDakota 's Hog Market: Qavatogn^nta and Prospects.Ecx»nomiGs Staff Paper 2001-2, Economics Department SouthDakota State University, Brookings, South Dakota, March2001.O Fig Crop ^ foshipisiessfe3,5083,0002^00"HI 2,000o 1300♦1,00050001095Source: USDA-NASS1990 1997 1998Figure L Soelh Dakota marketable bogs fey year1999 2000Table L Basis at Esplratloa for Sloax Falls' C^^asli and CME LH indexfun($/c\vt. lean)-7.27 3.17-4.62 -3.63-4.20 -3.93-3.12 -4.46Ang Sep Oct Nov DecYear Jan1997199819992000-2.11-0.83o •^'*5-3./5-2.43-5.81-2.87-3.71-0.40-1.68-4.20-1.95-0.60-0.51-4.23-2.37-0.43-1.92-3.99-3.28-2 364.22-3.42-5.13-3.892.300.09-3.12-1.01-5.40-2.52-0.83-1.55-4.21-0.14-2.57Note: Cash is lean equivalent of D.S, 1-2,230-250# slaughter barrows and gilts price.Ecommcs commENTATORrXY.)NOMiC:S DEF/WrMfiNTSouth Dakc'ta Stete UnivsrsityBox 504Brortkingfi, SO 5700?4>S95Phooe. (605)688-045Pb>;; (605 ?6S8-&.t86F-nmi!; Siover_rvnny.@s(55iat£,e<iuSOUTH DAKOTA STATE UNIVERSITYEconomics DepartmentBox .504Brookings, SD 57007-0895Change Service Requested-3.74-7.21-1.88-1.26N'on Profit Off.IJ, S- PostagePAIDBrookings, S. O.Permit 24

Power Deregulation: Blessing or Curse; South Dakota\u27s Hog Market

South Dakota State UniversityOpen PRAIRIE: Open Public Research Access InstitutionalRepository and Information ExchangeEconomics Commentator Economics5-16-2001Power Deregulation: Blessing or Curse; SouthDakota's Hog MarketGary TaylorSouth Dakota State UniversityMatthew A. DiersenSouth Dakota State University, Matthew.Diersen@SDSTATE.EDUFollow this and additional works at: http://openprairie.sdstate.edu/econ_commPart of the Agricultural and Resource Economics Commons, and the Regional EconomicsCommonsThis Newsletter is brought to you for free and open access by the Economics at Open PRAIRIE: Open Public Research Access Institutional Repositoryand Information Exchange. It has been accepted for inclusion in Economics Commentator by an authorized administrator of Open PRAIRIE: OpenPublic Research Access Institutional Repository and Information Exchange. For more information, please contact michael.biondo@sdstate.edu.Recommended CitationTaylor, Gary and Diersen, Matthew A., "Power Deregulation: Blessing or Curse; South Dakota's Hog Market" (2001). EconomicsCommentator. Paper 388.http://openprairie.sdstate.edu/econ_comm/388ECONOMICSCOMMENTA TORSoiJth Dakota State UniversityPower Doregylatiofi:Blessing or CurseQary TaylorAssistant Professorof EconomicsThe plight of California has been a topic ofmuch discussion In the last few weeks. Theproblems there have become almost synonymouswith the evils of market deregulation. Is thiscomparison justified? Was the California powermarket truly deregulated or Is the current situation aresult of excessive government Intervention? Aclear understanding of the situation that exists InCalifornia is necessary to make an informeddecision regarding the future of power deregulationIn other parts of the U.S.Tbe California SituationThe problem In California was born In 1996when the state legislature enacted a regulatory planthat partially deregulated the price of electriolty.This process allowed consumers access to powerfrom out of area, and out of state, suppliers. Thispolicy change was forced by a demand Increase of30% over the last ten years while supply onlyincreased 6%. During this same time periodconsumer/ environmentalist activism prevented thebuilding of any new power generating facilities.These groups of activists were dubbed BANANAS -- Build Absolutely Nothing .Anywhere Near Anyone -" by former Delaware Govemor Pete du Font.This increase In competition should, Intbeoiy, drive prices down. The problem Is thatwhile wfiolesale electricity prices were allowed tofluctuate, consumer prices were frozen. Thismeant that while the producers of electricity wereallowed to pass along the Increases In their costs ofproduction, the prices that utilities were allowed to(Continued on p. 2)No, 420 Mav 16, 2001South Dakota'sHog MarketMafthaw A. DiersanAssistant Professor& Extension SpecialistProducers, lenders, and others haveexpressed Interest in the future profitability of hogsand In marketing Issues such as basis and hedgingeffectiveness. In this Commentator, a couple ofIssues related to South Dakota's hog market areexamined. Raising hogs and pigs Is generallySouth Dakota's second largest livestock enterprisebased on sales revenue, lagging behind raisingbeef cattle. The number of farms producing hogshas declined in recent years, but South Dakotaranked 11*' among U.S. states inhog Inventory andranked 12'̂ In pig crop size In 2000.^Despite a decline In the number of sows InSouth Dakota, the number of hogs marketed hasIncreased. The pig crop declined, but Inshlpments,presumably of feeder pigs, have made up thedifference as shown In Figure 1, Tfie ability to useexisting facilities and relatively Inexpensive feed arepotential causes. An industry-wide trend towardspecialization Is perhaps another factor explainingthe trend. Is there room for growth in SouthDakota's hog markets? Recent growth fromInshlpments of feeder pigs implies that SouthDakota may have a comparative advantage wherefinishing hogs Is concerned. Feed cost should berelatively low, as the price of corn Is typically thelowest in the U.S. along the 1-29 corridor In SouthDakota.Another Issue Is basis, the differencebetween cash and futures prices. Basis IsImportant because It determines how the futuresprices should be adjusted for planning purposesand for comparing futures and options with any(Continued on p,3}(D^regul&tion contd. fromp,?jcharge consumers wore frozen for six years. Thislaw was written at a time when generation coats forelectricity were decreasing. The unforseenIncreases in the costs of producing electnolty couldnot be recouped by the utility companies, forcingthem to the verge of bankruptcy. State rules forcedcompanies to buy power at $.15 to $1.00 perkilowatt hour but retail prices were capped at $.067per kilowatt hour, (Taylor)The Theory of Deregulattonin most cases the local power companyoperates In a monopoly situation. Since they arettie oniy supplier of electricity, the usual marketresponse is to produce iess than the optimaiamount of electricity and charge a price higher thanthe tree market equilibrium. This misaiiocatlon ofresources arrd transfer of consumer surplus toproducers are the usual reasons for regulation.The job of the regulatory body is to try to balancethe Interests of the consumer (low prices, productvariety, and quality of service), while etillmaintaining the economic viabiiity of the producer,(Fisher and Dombusch) In order to satis% theseinterests some guidelines should be followed. First,marginal cost pricing should be followed as closelyas possible. Second, the pricing and servicerequirements should allow the utility to obtain a"normal" rate of return on the capital it hasInvested. Finally, power should be produced In anefficient manner. This rate of retum should beapproximately what could be earned by investingthe capital In the next most attractive alternative, Acompetitive rale of return is necessary to allowproducers to update generating facilities and linesand maintain a reasonable mtum to their investors.History shows that deregulation of a marketallows the influx of new compeHtors v/ho see anopportunity to reap profits and introduce a cxjnditionwhere the forces of supply and demand determineprices. As supplies increase, prices are drivendown and as consumer demand increases, pricesIncrease, Such an increase in competitton willforce utilities to t>ecome more efficient producersand reduce the prices customers pay. Freeing themarket in California would have initially resulted InIncreased consumer prices but it would have alsobrought consumer demand closer to actualsupplies, encouraging conservation measures andnew construction of power plants. As newparticipants enter the market, prices would havegone down and consumers would have gained newchoices for their power supply. The partialderegulation plan that was purmed In Californiaresulted in deteriorating service and rollingblackouts, and has caused severe economichardship to both businesses and private Individuals.Lessons for the FutyreAs we look at the problem of deregulationand its effect on markets, there are sortie lessonsto be learned. The results of the partialderegulation in California should be no surprise.We have seen the same results in the formerSoviet Union, yaintalning price controls In thedomestic market while paying free market prices forgoods and resources needed for production andconsumption drove the USSR Into bankruptcy. Weare seeing the same situation being replayed inCalifornia. Paying high prices for inputs and havingoutput prices capped is a recipe for failure. Thesecond thing to be learned here Is that givingconsumers what they want may be politicallyexpedient in the short run, but may be very costly inthe long run. Consumers In California havedemanded cheap electricity. However, at somepoint the bills for providing cheap power will comedue. The laws of economics cannot be suspended.We are seeing the results now. Consumers arefacing disruptions In power supplies as well as afuture of higher power prices as the state bails outthe floundering utility companies. The final lessonfrom this process is to take the lime to thoroughlyexamine a problem before proposing a solution andexamine both the intended and unintended resultsof the policy. The externalities created must alsobe accounted for. The intended result of the law,iow power prices for consumers, was achieved.However, the unintended resuits, utilities on theverge of banknjptcy and lack of generationfacilities, were not anticipated. This doesn't meanthat deregulation will not work; ItJust needs to becarefully evaluated on a case by case basis.Due to different resource allocations,managerial abilities, and consumer needs, whatfails in one situation may be a great successsomewhere else. Adequate study and analysisprior to implementation is much easier than tryingto solve a preventable problem later. The problemsfacing California should not deter other states.Including South Dakota, from pursuingderegulation. There are also examples ofsuccessful utility deregulation. Pennsylvania is agood example. By truly deregulating the electricitymarket In that state, consumers have been therecipients of lower prices and better service.Markets that are allowed to work freely do a betterJob of allocating resources and discovering pricesthan regulated ones. The key is to allov^ themsufficient freedom and time to achieve a stableequilibrium and to allow consumers to makeinformed decisions regarding their purchases.SooroesFischer, Stanley and Dombusch, Rudlgsr. Economics.McGraw-Hill, 1983. p, 279Taylor. Jerry. "California's 8urn-ouf, National ReviewOrrline, February 7, 2001.(SD's Hog Market ... contimied frwi p.1}forward prices. The difference between cash pricescan also be compared, giving a location basis. Theweekly average price for market hogs in SiouxFalls, reported by USDA-AMS, was compared tothe CME Lean Hog index on expiration dates from1997 to 2000 For months without a contract, theindex value was from the business day of themonth, the day futures contracts typically expire.As shown In Table 1, the basis in Sioux Fails wasusualiy negative, but ranged from ~$7.27 to $4.22.A basis level of -$2.00 Implies that for any observedfutures price, the implied Sioux Fails' cash price isobtained by subtracting $2.00, then converting to acash price by multiplying the result by 0.74. (TheIndex is on a dressed basis and the dressingpercer^tage for butcher hogs Is about 74 percent ofits live weight).Sales revenue from hogs In South Dakotaclimbed back to around $280 million in 2000. Whatthat means In terms of future profitability is difficultto assess, given the equity-draining prices of late1998, Tfie prospects seem to raise as manyquestions as answers.^ However, given the movetoward year-round, continuous operations, there Ispossibly a niche to exploit given the continuedseasonal demand fluctuation (and higher prices) forpork.' USDA-NASS annually rspoUs numbers such as inshlpmefXs,farm slaughta~, and deaths in the Msat Animals Productbn,Dispo$itk>rs. and Inaome report,^For a morederailed discus$ior> see Oiersen, M.A. SouthDakota 's Hog Market: Qavatogn^nta and Prospects.Ecx»nomiGs Staff Paper 2001-2, Economics Department SouthDakota State University, Brookings, South Dakota, March2001.O Fig Crop ^ foshipisiessfe3,5083,0002^00"HI 2,000o 1300♦1,00050001095Source: USDA-NASS1990 1997 1998Figure L Soelh Dakota marketable bogs fey year1999 2000Table L Basis at Esplratloa for Sloax Falls' C^^asli and CME LH indexfun($/c\vt. lean)-7.27 3.17-4.62 -3.63-4.20 -3.93-3.12 -4.46Ang Sep Oct Nov DecYear Jan1997199819992000-2.11-0.83o •^'*5-3./5-2.43-5.81-2.87-3.71-0.40-1.68-4.20-1.95-0.60-0.51-4.23-2.37-0.43-1.92-3.99-3.28-2 364.22-3.42-5.13-3.892.300.09-3.12-1.01-5.40-2.52-0.83-1.55-4.21-0.14-2.57Note: Cash is lean equivalent of D.S, 1-2,230-250# slaughter barrows and gilts price.Ecommcs commENTATORrXY.)NOMiC:S DEF/WrMfiNTSouth Dakc'ta Stete UnivsrsityBox 504Brortkingfi, SO 5700?4>S95Phooe. (605)688-045Pb>;; (605 ?6S8-&.t86F-nmi!; Siover_rvnny.@s(55iat£,e<iuSOUTH DAKOTA STATE UNIVERSITYEconomics DepartmentBox .504Brookings, SD 57007-0895Change Service Requested-3.74-7.21-1.88-1.26N'on Profit Off.IJ, S- PostagePAIDBrookings, S. O.Permit 24

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Power Deregulation: Blessing or Curse; South Dakota\u27s Hog Market

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