The markets for primary products – and especially those for mineral commodities – are known for their instability, exposing violent price fluctuations over time. As a result, profits (and thus taxes on profits) are notably volatile. This volatility can cause substantial fluctuations in government revenues and foreign exchange earnings in mineral dependent economies, creating boom/bust cycles and hampering the effective planning needed for economic development.
Why are mineral markets volatile?
The demand for minerals and metals fluctuates over the business cycle, reflecting the fact that they are used primarily in capital goods, such as buildings or machinery, as well as consumer durables. Meanwhile, the supply side is very inelastic; for example, it takes a long time to build a new mine in order to respond to market imbalances. Combining these characteristics results in distinctive price waves, or cycles (see graph). While some cycles are bigger than others, the mechanics behind them are fundamentally the same.
The volatility experienced by commodity markets may not be entirely detrimental, however. On one hand, a market slump provides mining companies with strong incentives to improve their productivity. On the government front, while sharp cycles make planning more difficult, downturns in commodity markets can force much needed changes in public sector management that would not occur under less stressful conditions. Policymakers can also smooth these fluctuations by placing mineral revenues into stabilization funds. In certain markets, new technologies are increasing the industry’s elasticity, speeding up the response to changes in global demand—such is the case of shale gas, for example, which can now bring in new supply within months, helping to reduce the amplitude of price swings. (Check our interview with Paul Stevens, End of the oil era?, to understand more).