Drought in Central America, and prices in Australia

In an article in The Conversation last month, Stephen Bartos (University of Canberra) wrote that:

What does a drought in Central America have to do with Australia’s cost of living? Quite a lot, if the drought affects the Panama Canal.

The 425 square kilometre Gatun Lake was built in the early 1900s to store water for the Panama Canal. Water is needed to float ships so they can navigate the canal. Now drought has severely affected the lake’s water levels.

Because of this the Panama Canal Authority has had to cut the number of ships using it. Hundreds of ships have queued up to wait their turn...

Delays mean higher costs. These in turn flow on to prices charged by wholesalers and retailers. We see it in the prices we now pay for the goods we buy.

Supply chain disruptions are only one of the many reasons why the cost of living is going up.

To see how the shipping delays caused by the low water levels in the Panama Canal affect prices of goods in Australia, consider the market for some good that is produced in Europe (or the East Coast of the US) and then transported to Australia, as shown in the diagram below. Initially, the market operates at equilibrium, where the demand curve D0 intersects the supply curve S0. The equilibrium price of the good is P0, and Q0 of the good is traded. The delays increase the costs of supplying the good to consumers in Australia. This is represented by a decrease in the supply of the good from S0 to S1. As a result, the equilibrium price of the good increases to P1, and less of the good (Q1) is traded.

So, while the Panama Canal is far from Australia, the low water levels there flow through into higher prices in Australia. This won't affect all goods directly, as many goods (and basically all services) don't require transport through the Panama Canal. However, as Bartos notes:

Yes Panama, at 1,000 kilometres north of the equator, is in the northern hemisphere. For trading, it is more important to America and northern Asia.

But Australia will still be affected by the disruption. Our supply chains are connected. Ripple spread through supply chains through prices. Even if products we buy or sell are not physically in the affected part of a supply chain, when their prices increase ours do too.

Bartos offers a solution to these higher prices:

Strategies for dealing with the unavoidable impacts on supply chains include diversifying.

This would mean having more suppliers, all using different chains, so that if one fails, we have other options.

Shortening chains by using more local suppliers where possible, would also help, as would embracing the joy of substitution – if one product becomes more expensive or unavailable, often there is another just as good.

Of course, none of those solutions really solve the problem of higher prices, because they must be higher-cost options than the existing transportation of goods through the Panama Canal. If they weren't higher cost, then someone would be using them already! As for substituting for other goods (such as those produced locally), that will increase the demand for those substitute goods. This is shown in the diagram below. Initially, this market operates at equilibrium, where the demand curve DA intersects the supply curve SA. The equilibrium price of the good is PA, and QA of the good is traded. The increase in the demand from DA to DB leads to an increase in the price of the substitute goods to PB, and an increase in the quantity of the substitute good traded, to QB.

So, the prices of goods transported via the Panama Canal increase, and the prices of substitute goods also increase. Overall, higher prices seem almost inevitable - all that Bartos is really suggesting is that Australians have a choice over how they end up with those higher prices.