Thursday, July 4, 2013

Breaking the Rules of Supply

Economics 101 has a simple explanation of how markets work. Consumers have a cumulative demand function that expresses how much of a product they will purchase as a given price level. Suppliers have a cumulative supply function that expresses how much of a product they will supply at a given price level. The intersection of these functions represent a market equilibrium that determines how much of a product will be produced and purchased. Easy, right?

Unfortunately, the real world is rarely ever so tidy.  Rent ceilings, taxes, subsidies, natural monopolies, and a hundred other distortions warp our simple representation of market interactions. Today, I'm going to discuss one distortion that is a result of nature more than man.

There is a sort of commodity known as rare earth elements (REE). The specifics of this commodity are relatively unimportant to this discussion except for these facts; REEs are mined from the earth and are generally found together with distinct rates of abundance. For example, one sort of rare earth ore may have twice as much cerium as neodymium.

The difficulty with REE markets is that the supply of all elements in an ore is dictated by the scarcity and demand of the most needed.  For example, in light rare earth element (LREE) ores neodymium is the most valuable and rarest REE. Thus LREE ores are mined at a rate which satisfies the market for neodymium. However, this also results in the production of cerium, praseodymium and samarium at rates that exceed equilibrium market demand; resulting in a non-optimal price.  In this unusual circumstance the prices of the less desired LREEs are very much influenced by the demand for neodymium, despite the fact that the elements are generally not substitutes for one another.

There are essentially three possible production points. We can produce REEs to the point that the demand for all REEs are met. We can produce REEs at the point which maximizes the suppliers profits. Or we can produce REEs to the point that no excess REEs are produced.

In the first case, production of REEs to the point that demand for all is met, we end up with a large excess of the more prevalent and/or less desirable rare earth elements. This leads to an increase in price for all REEs due to the cost of extraction being shared by all REEs in a given ore group as well as costs associated with stockpiling. Clearly this is non-optimal as consumers are paying more and suppliers are earning less profit.

In the second case, profit maximization, we end up with a shortage of some elements and an excess of others. Here supplier profit is maximized but consumers must deal with high prices for some REEs due to high price inelasticity and higher overall prices for the reasons discussed in the paragraph above. This supply point is a middle ground which features the negative aspects of the other two supply points, but to a lesser extent.

The final case, production resulting in no excess, is likely the worst of all.  It sets the price of the most abundant or least used element at a market equilibrium.  However, every other REE will have a far higher than necessary price due to price inelasticity and market shortages. This supply point benefits no one as suppliers do not profit maximize and consumers of all but the least useful element pay far higher prices than they must.

The easiest solution economically speaking is to produce at the point that demand for all REEs is met and then find uses for the excess REEs.  However, technologically that becomes a much more difficult problem. Unfortunately our grasp of alchemy has not yet risen to the point of transmutation of one less desirable resource into a more useful one. So how do we deal with the problem?

Interestingly, the answer here may very well be recycling.  After REEs are used in industry their production costs are no longer associated.  Thus recycling of rarer or more useful elements increases their supply within the market space. This then allows for lower rates of associated ore extraction and thus lesser excess production of less demanded REEs. This solution allows us to meet demand (good for consumers) while moving production towards the profit maximizing rate of supply (good for suppliers) by increasing supply of more demanded REEs without increasing supply of the excess REEs as well.

Balancing the REE market is a difficult task. However, it does seem manageable through either innovative use of excess REEs or advances in REE recycling. One way or another the market's needs will be met.

As an interesting aside, apparently rare earth elements with an even atomic number are more common than those with an odd atomic number. Once again nature meddling in man's efforts to set rational prices.  Until next week, stay safe and rational.

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