This report focuses on the major factors affecting price formation for the five largest U.S.program crops -- wheat, rice, corn, soybeans, and cotton. (1) According to the U.S. Agricultural Census, these five cropsaccounted for 67% of harvested crop land in the United States in 2002. (2) Certain commoncharacteristics make a general description of market price formation relevant across this diverse setof commodities: each of these crops is produced annually; under modest conditions they are allstorable for long periods of time (potentially spanning several years); they all move from farm tomarket in bulk form; and they are all actively traded on at least one of the major commodity futuresexchanges which facilitates hedging and forward contracting. In addition, frequently several or (insome cases) all of them compete for the same crop land in production, thus, indirectly linking theirprices across markets. This report begins by briefly introducing some economic fundamentals common to mostagricultural commodity markets. This is followed in the second section by a discussion of the roleof futures markets in price determination of storable agricultural commodities with seasonalproduction patterns. The third section reviews the important role provided by the U.S. Departmentof Agriculture (USDA) in monitoring and disseminating agricultural market information. Therelease of timely information facilitates price discovery and helps to level the playing field betweensmall market participants and the large multinational agri-businesses. The fourth and final sectionhighlights some of the differences unique to each of these commodities that make pricedetermination in each market somewhat different. Price (P*) represents the equilibrium point where buyers (i.e., demand) and sellers (i.e.,supply) meet in the marketplace ( Figure 1 ). New market information (e.g., crop failure in a foreignmarket, widespread animal disease outbreak, a major revision to a previous crop production estimate,etc.) can alter the expectations of market participants and lead to a new equilibrium price as sellersrevise their offer prices and buyers revise their purchase bids based on the new information. An outward shift in demand from the market equilibrium (due, for example, to news of aforeign crop failure raising expectations for increased U.S. exports) would raise the price P* asDemand moves to the right along the Supply curve. Similarly, an outward shift in supply from themarket equilibrium (due, for example, to an upward revision in the planted acreage estimate byUSDA raising expectations for higher production) would lead to lower price P* as Supply movesto the right along the Demand curve. Both of these hypothetical price changes would only beshort-term. In the long-run, producers would alter their planting decisions in light of the new priceexpectations. Figure 1. Price Represents the Equilibrium of Supply andDemand The speed and efficiency with which the various price adjustments occur depend, in largepart, on the market structure within which a commodity is being traded. Common attributes ofmarket structure include the following. The number of buyers and sellers -- more market participants are generallyassociated with increased price competitiveness. The commodity's homogeneity in terms of type, variety, quality, and end-usecharacteristics -- greater product differentiation is generally associated with greater price differencesamong products and markets. The number of close substitutes -- more close substitutes means buyers havegreater choice and are more price sensitive. The commodity's storability -- greater storability gives the seller more optionsin terms of when and under what conditions to sell his products. The transparency of price formation, e.g., open auction versus private contracts-- greater transparency prevents price manipulation. The ease of commodity transfer between buyers and sellers and among markets-- greater mobility limits spatial price differences. Artificial restrictions on the market processes, e.g., government policies ormarket collusion from a major participant -- more artificial restrictions tend to prevent the price fromreaching its natural equilibrium level. Some restrictions (e.g., import barriers) limit supply and keepprices high, while other types of restrictions (e.g., market collusion by a few large buyers) maysuppress market prices. The general price level of an agricultural commodity, whether at a major terminal, port, orcommodity futures exchange, is influenced by a variety of market forces that can alter the currentor expected balance between supply and demand. Many of these forces emanate from domesticfood, feed, and industrial-use markets and include consumer preferences and the changing needs ofend users; factors affecting the production processes (e.g., weather, input costs, pests, diseases, etc. );relative prices of crops that can substitute in either production or consumption; government policies;and factors affecting storage and transportation. International market conditions are also importantdepending on the "openness" of a country's domestic market to international competition, and thedegree to which a country engages in international trade. Local Supply and Demand Conditions. Differences in grain and oilseed prices throughout the world reflect differences in local supply anddemand conditions (as well as differences in local market structures). In general, grain and oilseedprices are lower in the inland producing regions where they are in surplus, and higher in grain andoilseed deficit, densely populated and port regions where demand exceeds local production. Similarly for cotton, prices are lowest in the production zones, and highest around processing centersand textile mills. Product Characteristics. Today's marketparticipants tend to be very sophisticated buyers who carefully compare the price of differentagricultural commodities in terms of their cost per unit of desired end-use characteristic. As a result,supply and demand conditions in agricultural markets -- whether it be markets for export, feedrations, fresh products, food processing, or textile manufacturing -- may depend on a commodity'sparticular variety, quality, or end-use characteristic more than the overall supply of the genericcommodity. For example, a flour processor may base wheat purchase decisions primarily on thespecific variety of wheat and its particular milling and baking characteristics. A yarn or textilemanufacturer may select cotton based on its fiber color, strength, or length depending on the intendedprocessing outcome. A livestock or poultry operation strives for the least-cost, balanced ration(depending on the type of animal) that includes sufficient protein, carbohydrates, fats, vitamins, androughage. An ethanol plant may select corn based on its starch content, while a food processor mayprefer corn with an above-average oil content. Transfer Costs. Key components of the U.S.grain and oilseed handling network include on-farm storage, trucks, railroads, barges, and grainelevators (including county, sub-terminal, and export elevators). A complex web of local supply anddemand conditions determines how and when commodities move through this network. Pricechanges at any point along the chain can result in shifts to alternate transport modes or routes asgrain marketers search for the lowest-cost method of moving grain between buyer and seller. For grains and oilseeds, prices at the local country elevator are derived from a central marketprice less transportation and handling costs. Country elevator managers watch the prices in severalmarkets (whether a processing plant, feedlot, export terminal, or futures exchange) to determinewhere the demand is the greatest, then deduct transfer costs to the higher-priced market indetermining the bids they can offer local producers. In competitive markets, transfer costs -- loadingor handling and transportation charges -- are usually the most important factors in determiningspatial (i.e., location-based) price differentials. In the international marketplace, transfer costsinclude barriers to trade such as tariffs and quotas. The more it costs to transport a commodity toa buyer, the less the producer will receive and vice versa. Price differentials between regions cannotexceed transfer costs for very long as marketers will quickly move commodities from the low-pricedmarkets (raising prices there) and ship them to the higher-priced markets (lowering pricesthere). (3) From the farm to the processing plant or export terminal, trucks, trains, and barges competeand complement one another in moving grain to successively larger elevators. Shipping distanceoften determines each mode's particular role. Trucks traditionally have an advantage in moving grainfor shorter distances (less than 250 to 500 miles) and therefore function primarily as the short haulgatherers of grain product. Railroads have a cost advantage in moving grain long distances, butbarges have an even greater cost advantage where a waterway is available. (4) Most economists and marketanalysts agree that inexpensive barge transportation helps hold down rates charged by the rail andtruck transportation industries. Any disruption to the agricultural transportation network generally results in highertransportation costs throughout the system as the demand for transportation services shifts toalternate modes and routes in search of the next best means of moving production to market. Forexample, a weather event that dramatically slows or severely limits barge traffic on the MississippiRiver will have the effect of raising barge freight rates as the demand for barge services exceeds theirsupply. Higher barge freight rates for grains will in turn shift these commodities to alternate uses(feed, food, industrial, or storage), to alternate transport modes (rail or truck), or to alternate traderoutes (e.g., to the Atlantic via the St. Lawrence Seaway, or overland to Canada, Mexico, or alternateports along the Gulf coast or as far away as the Pacific Northwest). Because truck and rail aresignificantly more costly than barge transport, shifting bulk commodities to truck- or rail-basedroutes can substantially raise the cost of moving grain and result in a widening basis and fallingprices in interior positions. Government Policies.