Marketing Strategies for Farm Success PDF

Marketing DXP02706 —UN—23FEB11 INTRODUCTION DXP01709 —UN—10SEP10 Chris is starting to get really...

Marketing DXP02706 —UN—23FEB11 INTRODUCTION DXP01709 —UN—10SEP10 Chris is starting to get really interested in his dad's farming the farm gate. From such a perspective, the various operation. Chores that used to be a real drag are starting activities involved are seen as part of an overall system. to take on a new meaning. This thing called “farming” looks like it could be fun and a big challenge. But Chris is also The related functions that form something of an assembly concerned. In the farm magazines, he keeps running into line are these: articles that talk about how important marketing is to the 1. Producing success of a farm operation. One article even suggested 2. Processing that effective marketing was the sufficient condition to 3. Wholesaling successful farming operations. After wrestling with that 4. Retailing one, Chris decided that the experts are saying that just 5. Consuming being a good producer is not good enough anymore. You have to be good at marketing too. Chris decides to Viewed this way, it is clear that the farm level activities and look into this thing called marketing and he schedules a the processing, wholesaling, and retailing activities are meeting with the county extension agent, Mark Smart. not at all independent of each other. Mr. Smart suggests to Chris that it will help if he simplifies the situation and Mr. Smart says the first need is to define marketing. does in fact think about what is going on as an assembly He notes that historically, there has been a tendency line. As the product moves up through the system to for the books to use a “farm-gate approach” to defining the consumer, each station in the assembly line does marketing. Everything that was done to the product something to the product to get it ready for the consumer. after it leaves the farm is lumped together and labeled “marketing.” Chris likes that idea because it is a clear and Thus, it is more appropriate to define marketing as all the obvious separation of the farm-level production articles economic activities involved in preparing and positioning he is familiar with and this new notion of marketing. But the product for the final consumer. Such a definition Mr. Smart suggests that while the approach is simple, it stresses the interrelationships between production and also has major shortcomings. The biggest shortcoming is the other activities along the assembly line. that it implies that the production activity on the farm and marketing are separate and independent. Chris is starting to grasp the importance of this, but he still needs some type of common measure to help him think Actually, quite the contrary is true. It is important to stress, about how the farm activities and all these other activities not ignore, the interrelationships between activities on the fit together. Mr. Smart has an answer for that one too. He farm and what is done to the product after it passes through introduces Chris to something called utility. OUO1023,0002CF1 -19-24FEB11-1/1 6-1 090117 PN=86  Marketing THE CONCEPT OF UTILITY Utility means satisfaction. Products have “utility” to consumers if they meet a need and in the process provide satisfaction. Mr. Smart uses this notion to further drive home the point that farm level production is correctly viewed as part of a bigger system. DXP01708 —UN—10SEP10 FORM UTILITY Chris is told that there are three basic types of utility. The first is form utility (Fig. 1). The creation of a product form starts at the farm level. Satisfaction with the product grows as processing changes the product form and prepares it to match the needs of the final consumer. Chris can easily understand that the modern consumer does not want to Fig. 1 — Product form is changed as the final product is buy a live broiler and face all the processing requirements made ready for the consumer that come with that product form. Many modern consumers do not want to bother with cutting up a broiler, be just as important in the total concept of “production” so processors offer packaged parts of the chicken. In as what he has been doing on his dad's farm. It is utility some stores, deli sections offer cooked chicken or sliced that is being produced. He sees Mr. Smart's point when chicken breasts ready for a sandwich or a salad. All these he advises Chris to remember that it is often this added processing efforts are designed to change the product form processing that modern consumers want and are willing to increase the level of satisfaction to the consumer. Value to pay for as they choose how they spend their money. is being added, and Chris starts to see that processing can OUO1023,0002CF2 -19-24FEB11-1/2 PLACE UTILITY A second and important type of utility is place utility. Modern consumers not only demand a particular form of the product but they also want it to be convenient. This demand for “place utility” has led to the modern supermarket where almost any food product the consumer DXP01709 —UN—10SEP10 wants is found under one roof. Growth in recent years of home delivery attests to the importance of place utility and is concrete evidence of consumers' willingness to pay for added services. Chris is told it is no longer just products like pizza that are delivered to the home (Fig. 2). Companies are offering both prepared and unprepared foods to consumers who, Fig. 2 — Consumers will get the product where they want it for various reasons, do not want to drive to the local if they are willing to pay for the service restaurant or the local supermarket. If consumers want convenience and are willing to pay for it, it will be provided. this entire process of getting the product ready for the That is the way the marketplace works. final consumer. But as he thinks about all this, Chris starts to worry about where this leaves the farmer. He TIME UTILITY remembers a comment his dad made about an article in a Mr. Smart identifies a third type of utility: time utility. farm magazine that referred to the often small part of the Consumers want the products to be available in a timely consumer's food dollar that is getting back down to the fashion — they do not want to have to wait. Thus, farmer. Will it get still smaller? Will there be enough to assuming that needs, in terms of product form and keep the farm in business? Chris brings up these growing where products are being offered, are met, time-related concerns, and Mr. Smart is ready with an explanation. He requirements must be met. The consumer wants had anticipated that Chris would be concerned! convenience. The product that does not meet demands for time-related convenience will be doomed to failure. Chris is starting to put things together as Mr. Smart continues. Obviously, there are many participants in OUO1023,0002CF2 -19-24FEB11-2/2 6-2 090117 PN=87  Marketing DIVIDING THE CONSUMER’S DOLLAR Mr. Smart tells Chris that this area can be controversial. Producers and producer groups often feel they are being cheated because they are only getting a small percentage of the consumer's food dollar. He notes, however, that the concept of utility gives a base upon which rules can be established about how the consumer's food dollar should be divided. The consumer buys the final bundle of product and service. Form, place, and time utility have all been created, and an overall bundle of satisfaction is what the consumer DXP01710 —19—10NOV10 buys. There is a total utility, a total satisfaction, which the consumer demands and wants. It makes sense, Chris is told, that the various contributors to that final product get paid based on what portion of the total utility they provide. That rule, for example, means that dairy farmers will get a relatively large part of the consumer's dollar. Not much processing is needed in fluid milk. It has to be packaged, but the product form changes very little and there is no Fig. 3 — The producer gets 34% of the consumer's food dollar for dairy products significant loss in weight or volume during processing. Mr. Smart has a pie chart which shows that the producer does in fact get a relatively high percentage of the consumer's be true for fresh fruits and vegetables, for eggs, and for dollar for dairy products (Fig. 3). The farmer gets, on other products that require little change in form as they average, 34 cents of every dollar spent on milk. The rest flow toward the final consumer. For these products, it is goes to all the processors and distributors that can be mostly time and place utilities that are added beyond the lumped together, and the value of all their contributions is farm level. The original producer creates a big part of the called the “marketing bill.” The same type of division will utility in the final product and gets paid accordingly. OUO1023,0002CF3 -19-24FEB11-1/9 Chris starts to think about farm products for which the situation is different, and in response to his question, Mr. Smart indicates it is different for a product such as beef. For every pound of live weight in the slaughter steer, only 0.40 to 0.45 pounds of beef are offered at retail (Fig. 4). There are many services added beyond the farm. The processors and other middlemen will have to be paid for those services if they are to continue providing them. DXP01711 —UN—10SEP10 The beef cattle producer ends up getting a smaller share of consumers' dollars spent on beef than does the milk producer. Chris can see that this is fair. The beef cattle producer contributes a smaller percentage of utility in the final product. Fig. 4 — There is a lot of change going from a steer to a steak Continued on next page OUO1023,0002CF3 -19-24FEB11-2/9 6-3 090117 PN=88  Marketing An extreme situation is identified when the two think about products like breakfast cereal. The wheat, corn, or oats that provide the base for a $2.79 box of cereal actually comprise a very small part of the total cost of the product. Typically, the package itself will be a bigger percentage of the final cost of the product than will the grain (Fig. 5). A great deal of processing is involved, and someone (the consumer) has to pay for the billions of dollars DXP01712 —19—10NOV10 spent on advertising breakfast cereals and other grain products. Chris is told that some critics have argued that consumers should not have to cover all those advertising costs. But Mr. Smart suggests that as long as consumers demonstrate a willingness to do so by buying the product off the grocery shelf, no major changes are likely. After all, the consumer is “king'' in the marketplace and it is the consumer's willingness to pay that determines what they Fig. 5 — For grain mill products, the farmer gets an average of only 9% will be offered. This is all starting to look complicated to Chris. The and services that work for them. In slightly more technical importance of making sure that what is being produced terms, they try to maximize their satisfaction or their utility will match the needs of consumers is clear. But there are subject to the constraints imposed by their incomes. a lot of participants along that “assembly line” between Obviously, different consumers will react differently to producer and consumer. How do all these separate the product offerings because incomes and preference activities get coordinated? Mr. Smart has the answer. patterns differ. But all rational consumers do basically the Price directs the system. The different contributors get same thing: they allocate their scarce dollars across the paid according to what they do, and there is logic to that competing uses so as to maximize their standard of living. economic rule. But Mr. Smart admits that the perception Recognizing that each consumer is an individual, and that of the system to this point appears to be like that of a their “votes” will differ, the retailer can aggregate across snapshot at one point in time. How is change fostered? all the consumers with whom they deal and pull out a What are the dynamics of the process? message: the product is either moving or it is not moving. PRICE DIRECTS THE SYSTEM A price signal that reflects the message is started down through the system. A price discount is attached to those In a market-oriented exchange system, such as that in products that are not being accepted by consumers. the U.S., price is the catalyst for change. It is price that Retailers reason that price will have to be reduced to provides consumers with the means of prompting change move the product, so they bid lower for the next shipment and making sure they will get what they want. Chris is from their supplier. The processor who supplies the encouraged to think about a system of price signals that retailer gets the message, and proceeds to bid lower for communicate up and down through the system. the raw product as it leaves the farm level. Producers note the lower price and will be forced to either reduce The process starts at the retail level where the product costs so that they can survive at the lower price or divert is made available to the consumer. Consumers make their money, time, and resources to some other now more a yes or no decision or cast a yes or no vote on each profitable use. product. Taking account of their incomes and their unique preference pattern, consumers have to buy the products Continued on next page OUO1023,0002CF3 -19-24FEB11-3/9 6-4 090117 PN=89  Marketing Fig. 6 pictures the dynamic adjustment process. The price discount “message” starts at the top of the system and is passed back down to the producer. The product flow, which runs in the other direction, reflects an adjustment. Less of the product that consumers are ignoring or avoiding will be produced, or the product form is changed so that the consumer will find it acceptable. DXP01713 —19—10NOV10 Chris asks for an example, and Mr. Smart is quick to oblige. Historically, the ground beef sold in the retail supermarket could meet regulatory requirements, so long as it contained no more than 30% fat. As consumers became more conscious of fat in their diets, they were less inclined to buy the regular ground beef product. Price on ground beef declined relative to other meats Fig. 6 — Price signals become messages that flow to the producer, and the producer answers in terms of product flows and other competing foods, and the adjustment process was underway. and producers are getting a smaller return to their land, The industry responded in several ways. First, less of capital, labor, and management than would be possible. the 30% product was produced. Processors changed the Thus, how well the system communicates via the price mix of raw materials they were using to produce ground mechanism is important to the individual consumer, beef with 20 or even 10% fat, and this change in product the individual producer, and to society in general. A form was a second adjustment. As the message started misallocation of resources carries with it a cost in the to filter down through the system, producers started form of a lower standard of living for everyone. As the the process of making a long-term and more nearly discussion continues, Chris starts to see why this is all so permanent adjustment. They changed their breeding important. Clearly, the effectiveness of the market system programs to produce breeds of beef cattle that had the is important to society in general. But how does all this potential to produce less fat. At the live animal level, the come down to the individual producer's level? How does cattle showing more fat get price discounts. The cattle it impact on his dad's farm or the farms of his neighbors? with higher percentages of lean in the total carcass weight get price premiums. The adjustment process prompted by Chris finds there are answers to this as well. Mr. Smart the price signals is being completed. Chris and Mr. Smart reviews the role of price and price signals and the type talk further about how price changes at the producer of system that is driven by the price messages. He then level would in fact get producers' attention. It is easy to notes that from that type of system comes an important see why each producer would want to adjust and sell economic rule: the demand for a product at the farm level the type of cattle or any other product that commands a is a derived demand. Price at the farm level is a derived price premium. price, and the individual producer is a price taker. As an individual, the producer has no power to set or control The opposite situation prevails when the consumer likes price. a particular product or a particular grade within a product line. The retailer has trouble meeting the demands DERIVED DEMAND of consumers. Higher price bids are extended to the processor or supplier in an attempt to get more of the To understand the concept of derived demand, Mr. Smart product. The processor, in turn, bids higher and the suggests it is necessary to introduce demand in its most farmer seeks to respond by increasing production levels. basic form. The following chart provides a simple demand If the price advantage lasts across years, resources schedule. A column of prices is shown. The quantity will be attracted from some other use. The increase in column shows the number of units a typical consumer will production in response to higher prices will be greater buy at each price. The price and quantity columns make over time. Chris suggests, and Mr. Smart agrees, that the up a demand schedule. increased production of fresh fruits and vegetables and A Simple Demand Schedule increased production of low-fat milk are both responses to Price Quantity changing consumers and their “price signals.” $5.00 1 How effective the system is in communicating needed $4.50 2 changes and prompting the proper response is $4.00 3 referred to as pricing efficiency. It is a very important $3.50 4 measure of the overall economic efficiency of the entire production-marketing system. If clear price signals do $3.00 5 not get transmitted to the producer, then the entire $2.50 6 system can persist in a state of imbalance. Consumers' $2.00 7 desires are not being met as well as they could be, $1.50 8 Continued on next page OUO1023,0002CF3 -19-24FEB11-4/9 6-5 090117 PN=90  Marketing LAW OF DEMAND Examination of the schedule reveals what is referred to as the law of demand. At any time, the rational consumer will take more only at lower prices. The demand schedules for different consumers will be different, but they all share this common characteristic — the consumer will take more only at lower prices. To reveal the clear logic of this, Chris is encouraged to go back and think about the concept of utility. For most consumers, the second 8-inch pizza will add less to their cumulative utility or satisfaction than did the first (Fig. 7). To buy two pizzas, then, the per-pizza price would need to be lower. And how much would most consumers pay DXP01714 —UN—10SEP10 for the third pizza, or the fourth? The added satisfaction diminishes with each added pizza, especially if they have to be eaten at the same meal. Consumers will pay less and less for each added pizza. If our price-quantity data are plotted as in Fig. 8, this “law of demand” means the demand schedule or demand curve will have a negative slope. Quantity taken will increase only if the price comes down. Chris understands that Fig. 7 — Most consumers would not pay much for the fourth pizza this will be true for any product the consumer buys. He is starting to get comfortable with this idea of a “system” made up of different players, like an assembly line, that is controlled and directed over time by the demands of the consumer. The middlemen in the system operate on a margin, notes Mr. Smart. The soybean crusher, for example, looks at what soybean oil and soybean meal can be sold for and DXP01715 —19—10NOV10 then calculates what he can pay for soybeans to realize a predetermined margin per bushel. Over time, that soybean crushing operation — and other middlemen — will try to ensure they get some desired margin per bushel. In the process, they reflect their margin in calculating their bids to the producer. The result is what is shown in Fig. 9. The demand at Fig. 8 — The demand curve for consumers has a negative slope retail (Dr) is reduced by the middlemen's margins, and the demand at the farm level (Df) is a derived demand. If the middlemen's margins stay constant, the demand at the farm level moves up and down with movements in demand at retail. If the margins increase over time, and they often do, then demand at the farm level can decline, which means a move down and to the left. Obviously, several combinations of change in retail demand, margins, and farm level demand are possible. DXP01716 —19—10NOV10 Chris is encouraged by Mr. Smart to think carefully about this concept of derived demand. What it means is that the producer at the farm level can be exposed to changes in demand and therefore changes in price that are totally beyond the producer's control. That is what the term “price taker” means, and being a price taker is starting to take on an ominous tone as Chris reflects on its implications. Fig. 9 — Middlemen's margins determine the demand at the farm level He remembers his dad fussing about selling corn at prices below his costs of production. Continued on next page OUO1023,0002CF3 -19-24FEB11-5/9 6-6 090117 PN=91  Marketing Mr. Smart agrees with Chris's concerns. He notes that all this is important because it is the root of all the price variability problems that plague farmers and make marketing strategies so important and so challenging. As they sketch the situation, Mr. Smart adds a supply function to the graph that shows the typical demand curve. This addition generates a simple but very powerful framework that the two can use to examine the issues of DXP01717 —19—10NOV10 price variability. A demand curve is shown in Fig. 10. A supply curve is added. The supply curve slopes up and to the right, reflecting the fact that producers will offer more only at higher prices. Chris can easily agree with this — he understands that it costs more to produce an added quantity of product. Price is determined where demand Fig. 10 — An equilibrium price is the only price whereby what and supply intersect and that price (labeled Pe) is an buyers want matters to what sellers offer equilibrium price, a market-clearing price. It is the only price at which the quantity demanded by buyers is exactly equal to the quantity offered by producers. Qe is the equilibrium quantity, the quantity at which demand and supply match. Chris can see how there will be automatic forces that move the price level toward that equilibrium price. If price is temporarily too high, sellers will see the product start DXP01718 —19—10NOV10 to pile up in inventory and start to reduce their offers. The price is pushed down toward the equilibrium price by competition among sellers. If price is temporarily too low, buyers will want more than is being offered. They will start to compete for the limited supplies. Price will be pushed up toward the equilibrium price by competition among buyers. It is clear that it is a dynamic process. There is no Fig. 11 — Information is always less than perfect and price is uncertain way to know precisely, at any time, exactly what the market-clearing price should be. This dynamic process of searching for the equilibrium, or market-clearing price, Whatever price is discovered, it is important to remember is called price discovery. Buyers and sellers bring their that the producer is a price taker. A corn farmer who information on supply and demand to a marketplace. As sees the weather-induced increases in price offers for a consensus starts to be formed, a price is discovered. harvest-period delivery has no power to influence that Since information is never perfect, the process is variable. price. He calls the local elevator and gets a price quote, Imagine, for example, the efforts of the marketplace to but there is no negotiation. Price is being discovered at “discover” the correct price for corn in late July when a more aggregate level. The price quote offered to the dry weather is threatening crop yields throughout the producer is a derived price that reflects final use value of Midwest. How much damage will be done? How low will the corn and the elevator's operating margin. the yields be? Will export buyers now buy less than earlier expected because prices will be higher? Will livestock The derived price is always what is left after the margins producers buy and feed less corn at the higher prices? have been deducted from the final user-level price. It is From his own experiences with weather and its impact on certainly true that the producer is a residual claimant and crop yields, Chris can see that there is a great deal of is very much a price taker. Mr. Smart sees Chris's interest uncertainty (Fig. 11). But a price must be discovered. Mr. and is quick to point out that the “price taker” status facing Smart reminds him again that the producer is exposed to producers creates interesting market-related challenges a lot of risk and uncertainty. for the agricultural producer. Continued on next page OUO1023,0002CF3 -19-24FEB11-6/9 6-7 PN=92 090117  Marketing The key point, the two agree, is that no individual producer can influence price. Each producer, acting alone, is too small to make a difference. The U.S. corn crop is typically about 8.0 billion bushels, clearly too big for any one producer to influence. But the combined actions of thousands of relatively small producers can make a big difference. DXP01719 —19—10NOV10 If every producer decides to expand production by bringing in more land, machinery, or other new capital, then the industry-level supply curve shifts to the right. If demand stays the same, then price will be discovered at a lower level as Fig.12 shows. The increase in supply from S1 to S2 pushes the market-clearing price down from P1 to P2. MICRO-MACRO PARADOX Fig. 12 — Lower prices come with increased supplies Mr. Smart senses the graphs are proving to be difficult if demand does not change for Chris, so he proceeds to focus on the key point. With this lower price, every producer may now be facing a reverse in the short run. If the price increase is likely to cost-price squeeze. Herein lies a micro-macro “paradox.” be temporary, the producer should expand only by using Individual producers (the micro level) cannot control price, more variable resources such as fertilizer or labor. Those but they are very vulnerable to the actions of producers in commitments can be changed in the next production the aggregate (the macro level). And there is not much period if prices come back down. they can do to stop the pain of the lower prices. If new equipment, buildings, and other fixed assets have been There is another important result to the micro-macro brought into production, it is very difficult to reverse the issue. The price pressure that results from the periodic process and reduce production. The new resources tend and excessive surges in production brings immense to get trapped in use and will be used until they are worn pressure to reduce costs in order to survive. Producers out or become obsolete. must seek every available bit of technology in an effort to keep costs down. Over time, the result is production at the Mr. Smart demonstrates using a bit of history from the lowest possible cost and that keeps prices to consumers 1970s. In 1972-73, the Soviet Union was facing a poor low. Chris struggles with the complexity of the situation, grain crop. Reversing past behavior, she came into the but he also gets the important point: There is a benefit to market and bought grain and oilseeds heavily. U.S. prices society in the form of low-cost food and fiber. were driven up to levels that are still records or near the all-time record highs. Corn prices moved above $4.00 per Mr. Smart notes that keeping the micro-macro issues, bushel, and wheat and soybean prices surged to $6.00 and the fact that the individual producer is a price taker, and $11.00, respectively. in mind is thus very, very important. Marketing strategies to be used in managing exposure to short-run price U.S. producers responded to the higher prices in dramatic variability have to be developed accordingly. But Mr. fashion. By the late 1970s, some 50 million added acres Smart is clear and firm in noting that no marketing strategy had been brought into production in corn, wheat, and will be sufficient to overcome the problems that come soybeans. When the Soviet Union crops improved and with making a long-term response to a short-run surge in reduced grain purchases in subsequent years, grain price. With rare exception, the response that brings in prices in the U.S. plunged. Producers were caught in a new equipment and land (the long-run response) will put vicious “micro-macro trap” with no way to turn. It was the producer on a higher level of costs. If selling price is primarily the surge in acreage that brought on excessive then pushed lower by a supply response spread across expansion and prompted the “farm crisis” of the early thousands of producers, individual producers with the 1980s when many grain farmers were forced out of new equipment and higher costs are caught. They are in business. Many of those added acres were grasslands, worse shape and in a tougher cost-price squeeze than the erodible fields, and drained wetlands that are still being producer who increased production without adding new targeted by governmental conservation programs in the equipment and incurring the higher costs. 2000s as acres that should be taken out of production. Chris is encouraged to pull an important rule from all this: Never make a long-term commitment to an increase in market prices that is likely to be temporary. Buying new equipment, bringing in new acreage, and putting up new buildings are all long-term responses that are difficult to ECONOMIES OF SIZE Continued on next page OUO1023,0002CF3 -19-24FEB11-7/9 6-8 090117 PN=93  Marketing Another adjustment to this recurring price pressure, one that is related to the notion of technological advancement, is the tendency for producers and processors to try to reduce costs by getting larger. Within limits, larger farms and larger processors can do the job more cheaply. This is the important notion of economies of size at work, and Chris is cautioned to spend some time on this point. DXP01720 —19—10NOV10 The cost per unit (Fig. 13) (per bushel, for example) is plotted on the vertical axis, and the size of the farm operation, in acres, is plotted on the horizontal axis. The plot suggests that corn, soybeans, or any other crop will be produced more cheaply on the 800-1,000 acre farm than on the 300-acre farm. Eventually, and the research is not clear on exactly where Fig. 13 — Larger farms can produce most products more cheaply this happens, the operation may get so large it is hard to manage, and per unit costs may start to increase again. The source of the “economies” Mr. Smart refers to is apparent upon examination. The machinery used on a 700-acre farm may not be much different from that on a 350-acre farm. Tractors and combines may be operated for more hours during the day on the 700-acre farm, especially during the busy planting and harvesting periods. But the 700-acre farm does not usually buy twice as many tractors and combines as the 350-acre farm. DXP01721 —19—10NOV10 If you spread the fixed costs, the machinery, buildings, insurance, taxes, etc., across more bushels, then the per bushel cost of producing corn goes down. And since there should not be that much difference in the per acre variable costs, such as fertilizer and herbicides, the combined variable and fixed costs get pulled down on a per bushel basis on a larger farm. Fig. 14 — Costs of slaughtering cattle come down for Fig. 14 indicates that processors also understand the the large volume plants concept. The estimated costs of slaughtering cattle are shown for a plant at a rate of up to 325 head per hour, and During the discussions, price keeps being identified as the per head costs are still going down. This cost-reducing the key catalyst for change. Price is also the source of attraction is clearly one of the reasons that the 1990s economic incentives that can either stimulate production shows a relatively small number of very large packing or force resources out of business. The market will plants, with hourly capacity up toward 400 per hour, in the eventually clear itself, but it can be a cruel taskmaster if beef packing business. Chris agrees with Mr. Smart's the need is to reduce supplies so that price will be pushed suggestion that the average size of farm and processing back above costs. This is exactly what was happening in plants is likely to continue to increase. He can see the the late 1970s and early 1980s as the market generated need to keep costs down when faced with variable prices corn prices that dipped on occasion below $1.00 per over which he has no control. After all, the farmer has to bushel, well below costs for even the most efficient survive, and being a low-cost and efficient producer will producer. In the beef industry, decreases in consumer certainly help. level demand prompted long-term price pressures that Like most technological advances, the benefits of the pushed total cattle numbers down from over 132 million large firms are eventually passed on to the consumer. But head in 1975 to under 100 million head in the early 1990s. adopting technology is a way for the individual producer to get more efficient and to relieve some of the pressure of market prices that are periodically being pushed lower. Continued on next page OUO1023,0002CF3 -19-24FEB11-8/9 6-9 090117 PN=94  Marketing FARM SUPPORT PROGRAMS Chris has the general impression that society has not always been willing to let the marketplace rule. Government programs have been enacted that influence, some would say interfere with, the workings of the marketplace. He has read about the programs in the farm magazines and he asks Mr. Smart about them. DXP01722 —19—10NOV10 Mr. Smart suggests that the most common element of the federal government's farm programs has been a price support element. For many crops (wheat, corn, soybeans, sugar beets, tobacco) and for other food products (milk, honey, sugar), some type of federal program has existed for many years. In the 1950s and 1960s, prices for many agricultural Fig. 15 — Supporting price above the market clearing commodities were supported at specific levels, often tied price will bring surpluses to a base period and the concept of parity. A historical base period was selected, a period that saw the farm sector on a parity with or equal to the non-farm sector. Chris can see that producers would be willing to produce, For decades, the 1910-14 period was used. Government at $4.00, a higher quantity such as 3.2 billion bushels. legislation set the support price at some percent of parity. But at $4.00, buyers would take only 2.4 billion bushels. Society was thus demonstrating a willingness to keep the A surplus of 0.8 billion or 800 million bushels develops incomes of farmers on a par with the non-farm sector. and the government must be prepared to deal with the surplus. The automatic self-correcting adjustments in There are many shortcomings of such an approach. The price are blocked and the equilibrium or market-clearing most apparent is that it ignores the impact of technological price cannot be discovered. advancement. In the early 1990s, the 100% parity price for wheat would be over $10 per bushel. Modern producers, Surpluses were generated in response to the price using modern technology and benefiting from economies supports through the 1960s and into the early 1970s. of size, can produce wheat for $3.00 per bushel or less. The surpluses were held by the government, sold at If wheat prices are supported at prices well above the below market prices, and given away in domestic and market-clearing price, surpluses are sure to accumulate. international food aid programs. In the presence of these programs, farm commodity prices tended to be very Mr. Smart demonstrates, using the supply-demand stable with the often huge surpluses constituting “buffers” graphs that Chris is increasingly coming to appreciate against droughts or crop shortages. (Fig. 15). Mr. Smart assumes that $3.00 is the equilibrium price for wheat, with the equilibrium quantity at 2.8 billion In 1972-73, price ceilings on food and other products bushels. In the early 1990s, those were roughly the price were imposed for the first time in non-war years. Price and production levels of wheat in the U.S. But if price is ceilings also block the self-correcting mechanisms of supported at higher levels, such as $4.00 per bushel, then the marketplace, but the results are different from those a surplus will develop. created by price supports. Continued on next page OUO1023,0002CF4 -19-24FEB11-1/3 6-10 090117 PN=95  Marketing Fig. 16 demonstrates what happens when a price ceiling is imposed at a level below the equilibrium price. If the market-clearing price for beef at retail is $1.75, for example, imposing a price ceiling at $1.50 per pound will create a shortage. At that price, consumers might wish to consume 85 pounds per person per year. But producers would only be willing to offer some lesser amount, say 75 pounds a year. The market has no way to move to DXP01723 —19—10NOV10 80 pounds, the equilibrium quantity in this case, where there is a balance between what buyers and sellers are willing to do. When price ceilings on meats were introduced by the Nixon Administration in the early 1970s, producers were concerned it would mean lower prices at the farm level on cattle and hogs. Their expressions of concern were countered by the claim that “the price ceilings were on Fig. 16 — Price ceilings set below the market clearing price will cause a shortage food at retail, not on livestock.” The implication was that the ceilings would not impact in a significant way on the price at the live animal level. But Chris is now in a with some variation in methods and terms. There has position to know that the markets do not work that way. typically been a target price which was initially tied to The discussion on derived demand and derived prices estimates of the cost of production and was considered a would suggest that the impact of the ceiling on the retail “fair” price to farmers. Below that price is a loan rate, the price would be passed down to the farm level. That is “price” the government will pay for the product going into precisely what happened. a 9-month loan program. The third basic component is a deficiency payment or some type of support payment that As soon as the ceiling for retail beef prices was announced represents something close to the difference between the and enforced, the middlemen reduced their bids for live target price and the cash price. cattle in an attempt to protect their margins. Very quickly, the reductions moved down toward the slaughter cattle Government programs typically are written every five to level. A derived price for slaughter steers evolved, and the seven years and will reflect the view of the governing price was below the price which had prevailed prior to the political party. In the past they have been written trying announcement. Then, the very predictable result occurred to provide an adequate supply of food and a reasonable — there were widespread shortages. Producers were not price to consumers in this country. There has also been willing to offer their cattle for sale at the lower price, and a component included that was intended to support the consumers were wanting to buy more beef at the reduced maintenance of farm families on the farm. Elements of the retail price. By the summer of 1974, just before the price government programs have tried to reduce the influence ceiling on beef was removed, many supermarkets had no that the programs would have on world markets. beef in their display cases. Chris is starting to get lost in all this, so he asks Mr. Smart The price ceilings of the early 1970s have not been to focus on the key points. The net result, he is told, is repeated. Even when the increases in cost of living that the program subsidizes producers when cash prices measures such as the Consumer Price Index reached are low but not in such a way that the U.S. price is pushed annual rate of increase in excess of 10% in 1979 and above the world-level price. Therefore, price can fall 1980, the temptation to impose retail price ceilings was (down to the loan rate) if world supply-demand conditions resisted. Mr. Smart suggests that the lessons of the so dictate and U.S. grain exporters can still participate in 1970s were apparently well learned — that price ceilings world trade. But there is a cost, of course. Annual costs of do not really solve the problem of rapidly rising price the price support programs for grains, dairy, sugar, etc., in levels. But the idea of price supports for farm commodities the farm sector have exceeded $25 billion. In some years, is still present. Recent Farm Bill legislation is oriented when grain prices are low, 70% to 80% percent of the net toward providing support to producers without pegging a farm income in key Midwestern grain states come from specific price above the equilibrium price. the government. But the subsidy to farmers, which is paid by taxpayer funds, keeps resources in farming. This helps Chris agrees with Mr. Smart's suggestion that he needs to keep the supplies of food and fiber products high and their understand the existing government programs. The Farm costs to taxpayers low. It is a case of income transfer from Bill of 1985 and the 1990 legislation typified the recent the taxpayer to the farmer. Chris can see that consumers approach. These were followed by Farm Bills in 1996 and benefit in the long run because food and fiber prices are again in 2002 that essentially followed similar objectives relatively low due to subsidized production. Continued on next page OUO1023,0002CF4 -19-24FEB11-2/3 6-11 090117 PN=96  Marketing Mr. Smart stops at this point and summarizes for Chris. at or above costs, and government programs have been The farmer, he notes, is the first link in the chain or established to subsidize producers and keep producers in the assembly line that prepares the final product for the business. But the individual producer is still exposed to consumer. Because the individual producer is so small in highly variable prices. Chris is therefore more than ready a relative sense, producers are price takers. The total when Mr. Smart suggests it is time to think about what all system generates a price to which the individual producer this means to the individual producer and what marketing must respond. There is no guarantee those prices will be strategies they will need to be successful. OUO1023,0002CF4 -19-24FEB11-3/3 MARKETING STRATEGIES First, it is important to recognize that the farmer is vulnerable to price variability brought on by weather and crop uncertainty and the impact of government price support and occasional price ceiling programs. Individual farmers face huge levels of price risk. It is important that farmers understand the nature and source of the price variability. DXP01724 —19—10NOV10 Price movement, over time, occurs because demand shifts, supply shifts, or they both shift. Demand is usually relatively stable in the short run, such as within the year. It is, therefore, supply that prompts much of the short-run price variability. Fig. 17 demonstrates this for Chris. Year-to-year percentage changes in hog slaughter, and hog prices are plotted across a recent 15-year period. The Fig. 17 — Price and hog slaughter move in opposite directions inverse or opposite relationship is clear. When slaughter and production increase, prices are pushed lower. When slaughter is reduced, prices soar to higher levels. Continued on next page FB87413,000008D -19-03APR14-1/7 6-12 090117 PN=97  Marketing As suggested, much of the price variability shown in Fig. 17 is attributable to movement in supply with a largely constant demand. Fig. 18 shows what is happening, and Chris appreciates Mr. Smart’s willingness to keep working with the supply and demand curves. They are starting to make more sense and help keep things in perspective. In year A, supply is relatively small and price is high, at PA. In year B, supply has increased and price is pushed down DXP01725 —19—10NOV10 to PB. Over time, this keeps happening and producers face price movement over which they have no control. Chris can see the implications of this to producers like his dad. Is there any way to predict what will happen to price? What can I do that will give me an edge? Mr. Smart likes the questioning attitude Chris is showing, and he reminds Chris to pay close attention and moves into a discussion of how this supply-demand framework can Fig. 18 — Changes in supply bring most of the changes be used to predict prices. in price in the short run Chris is told that a demand curve for farm products such as slaughter hogs has a property called elasticity. It is increases 10%, for example, prices will tend to be pushed defined as: down by 20% — and the hog producer may be in trouble! Percent Change in Quantity Mr. Smart indicates that he identifies and works with two Percent Change in Price primary types of supply-side price variability. The first type, one that can last for a number of years, is the price cycle. Mr. Smart has access to state university research that The second type, price movement across months within shows that the value of the ratio is around –0.5 at the farm the year, is seasonal price variability. Mr. Smart says he level. This means a 1% change in quantity brings a 2% finds it convenient to use the hog sector to illustrate both change in price in the opposite direction. If hog slaughter since that sector offers such excellent examples. Continued on next page FB87413,000008D -19-03APR14-2/7 6-13 090117 PN=98  Marketing Mr. Smart plots the hog prices he used earlier in calculating the percentage changes (Fig. 19). Prices move up for one to two years and then are pushed lower as supply increases for one to two years. It is not unusual to see daily cash hog prices at $60 per hundredweight, an historically high level, followed by hogs at $30, a disaster to farmers, within 18 months after the $60 prices appeared. Even the yearly average prices range from $40 to $55. DXP01726 —19—10NOV10 Chris is quick to recognize that the hog cycle is a form of the micro-macro paradox they had discussed earlier. As hog prices improve, producers are tempted to expand and offer larger supplies. To do that, gilts (unbred female hogs) have to be removed from the slaughter channels and moved into the breeding herd. This short-run reduction in slaughter hog supplies pushes prices still higher. More Fig. 19 — The hog cycle brings big moves in price producers are motivated to expand. Soon, the breeding herd is significantly larger. Hogs reach slaughter weight at about six months of age, and the supply of slaughter well, until the land is forced out and into some other use hogs inevitably starts to increase. Prices are pushed via low prices. He wants to talk about strategies, but Mr. lower, often reaching levels so low that some producers Smart asks him to wait — the strategies are coming! are forced to sell breeding stock. This added slaughter accentuates the problems and prices are forced still lower. First, there is a need to deal with the fact that if there were no production cycle with its ups and down in supply, there Eventually, the breeding herd is reduced enough for the would still be a significant seasonal pattern in hog prices. supply of slaughter hogs to decline and prices start to Producers tend to avoid breeding during times that would increase. The “cycle” is ready to start over again. result in pigs being born in the middle of the winter or in Chris is wondering what a hog producer can do. He the middle of the summer. Weather extremes in either understands the “price taker” status of the individual direction create problems. The result is a tendency toward producer and what that means. Is there no solution? He pigs being born (farrowings) in the spring months and can see the same problem faces the grain producer when again in the fall months. Some six months later, there will many producers make decisions to expand production be an inevitable seasonal increase in hog slaughter. and drive prices down. There is a “price cycle” there, as FB87413,000008D -19-03APR14-3/7 Fig. 20 shows average monthly hog slaughter across a recent five-year period. There tend to be increases associated with the production patterns discussed above, especially in the fall months. DXP01727 —19—10NOV10 Fig. 20 — Slaughter levels have to change to reflect the monthly farrowing patterns Continued on next page FB87413,000008D -19-03APR14-4/7 6-14 090117 PN=99  Marketing Within the year, therefore, there are seasonal changes in slaughter that move the monthly supply along a largely stationary demand curve. The result is a clearly definable seasonal pattern in hog prices. In Fig. 21, Mr. Smart shows average monthly prices for slaughter hogs across the same five-year period he had used earlier to show the changes in slaughter. The tendency toward lower prices in March and April when the big number of pigs DXP01728 —19—10NOV10 born the previous fall come to market is apparent. Equally apparent is the tendency toward low prices in October and November when the numbers from the typically large spring pig crop hit the market. Changes in hog prices within the year can thus exceed 10%, even when the cycle is not in the middle of an expansion or liquidation phase. Producers have to be ready to manage their exposure to all this risk, and Chris is starting to recognize Fig. 21 — Price patterns within the year are related to what the magazines mean when they talk about the the slaughter patterns need for effective marketing strategies. And, finally, Mr. Smart is ready to talk strategies! Whatever the crop or transferred to speculators in the futures market. The livestock enterprise, Mr. Smart notes, there is increasingly speculators are willing to accept that risk in exchange for a mechanism that does allow producers to do something the chance to make a profit. about exposure to price risk. Nothing is going to change the “price taker” status of the corn, cattle, cotton, wheat, or The difference between the cash market and the futures hog producer. Each producer is too small to control price. market is called the basis. Since futures are traded in the But the existence of futures markets in most primary larger cities such as Chicago, New York, and Kansas agricultural commodities does allow the producer to do City, the cash price in Central Illinois will usually be below something about price risk. prices in Chicago. Therefore the basis, defined as cash minus futures, is usually negative. Mr. Smart suggests The marketplace is obviously full of risk. Producers will they look at how this works in illustrating a cash contract be influenced by weather around the world and by a being offered by an Illinois grain elevator and other multitude of forces that will influence their selling prices, alternatives facing the Illinois producer. forces that are totally beyond their control. The price taker status of the U.S. producer is perhaps the most important It is late June and weather concerns have pushed the fact that the student of agricultural markets must accept, prices for corn higher. The futures contract calling for understand, and deal with over time. delivery of corn in December has moved up to $5.10, one of the highest levels in recent years. Our Illinois Individual producers cannot set prices and are not in producer feels he should set price on 50 percent of his a position to negotiate prices sufficiently high to cover expected corn production by forward pricing, and he starts all costs to ensure economic viability. But Mr. Smart to analyze his alternatives. emphasizes that there is one dimension they can control. They can control when they price. Controlling when price The local grain elevator is offering a cash contract calling is set has the capacity to allow producers to do something for $4.80 for late October delivery. Corn futures are about level of price. But it requires understanding of traded for March, May, July, September, and December, forward pricing for later delivery, and producers have to and the producer understands the $4.80 offer is based be willing to learn new marketing techniques just as they on the December futures. It is simply the futures minus have learned new production techniques. a cash-futures basis allowance, which includes a margin for the elevator. In this example, Mr. Smart indicates it is There are a number of ways to forward price. Cash futures adjusted for basis, or $5.10 minus $0.30 equals contracts have long been used and are perhaps the $4.80. simplest approach for the producer to take. An alternative is to use the futures markets or to go to a relatively new If our producer accepts the bid and signs the contract, he tool, options on futures. Chris is told that it is important for is guaranteed $4.80 for corn delivered in late October. him to recognize that all these alternatives are based on Upon signing, the elevator will sell enough 5,000-bushel trade in futures. December corn futures contracts at the Chicago Board of Trade to cover the purchases. This protects the elevator A futures contract for corn, cattle, cotton, gasoline, etc., against decreases in price after it has committed to pay is a contract calling for delivery of a carefully described $4.80. commodity at some later time period. It is not a market designed for actual delivery of the physical commodity. By opening an account with a commodity brokerage firm, Rather, it is a market designed to discover prices for a our Illinois producer can forward price directly by either later time period. The price risk facing the producer of selling futures or by buying a put option on the futures. an agricultural commodity in the cash market can be Using the same illustration, the producer faces: Continued on next page FB87413,000008D -19-03APR14-5/7 6-15 090117 PN=100  Marketing Forward Price = Futures + Basis Net Price = Strike Price + Basis - Premium = $5.10 - 0.020 = $5.10 + 0.20 - 0.12 = $4.90 = $5.18 Chris is reminded that the elevator reduced the futures by When the futures are up to $5.50, the right to sell at $5.10 both the cash-futures basis and its operating margin. The will be worthless. The option value goes to zero and the price being offered directly by the futures market is $4.90, producer just lets the option expire. He has bought price a better price than the $4.80 offered by the elevator. insurance he did not need but he also gets to benefit from the higher prices. Note the $5.18 is well above either the The producer could do the following: $4.80 price from the cash contract or the $4.90 price from Date In Cash In Futures the futures hedge. Thus, part of what the premium of June 25 Sell December futures $0.12 bought (and premiums vary with the level of market at $5.10 volatility and length of time) was the flexibility to benefit Oct. 25 Sell cash corn at $4.50 Buy back December from an unexpected price surge. futures at $4.70 What if price moves lower? How is the producer Net Price $4.50 + 0.40 = $4.90 protected? If December futures go down to $4.70 and cash price is down to $4.50, the results are: Now, the producer is accepting the risk that the basis in late October will not be at or near the expected –$0.20. Net Price = Cash + Option Value - Premium If the cash corn is sold at $4.50 and the futures can = $4.50 + 0.40 - 0.12 only be bought back at $4.75, the net price is $4.85, = $4.78 not $4.90. There is some risk associated with the basis behavior. Still, the producer may prefer to take that risk When futures drop to $4.70, the right to sell at $5.10 will versus paying the elevator $0.10 per bushel to handle the approach $0.40. Here, the “price insurance” is needed transactions and extend a cash contract. and is used. The option is sold for $0.40. The premium Chris is quick to see that there will be disadvantages in costs must still be deducted, of course. Subject to basis both the cash contract or the direct hedge approach in the risk, the price floor is guaranteed, and the producer has eyes of some producers. What if the price goes sharply protection against lower prices. higher? The price has been pegged at $4.80 in the cash Mr. Smart senses Chris's uncertainty. He reminds Chris contract or at $4.90 subject to basis performance in the that this area will take more study, but that it is well worth hedge. In addition, if the market goes above $5.10, selling it. Producers can use cash contracts to peg a price or they the futures at $5.10 will mean sending more margin can place hedges directly in the futures. If there is too money to the brokerage firm to cover the possible losses much anxiety associated with having pegged a specific on the futures side if the contracts have to be bought back price when prices might move unexpectedly higher, then above $5.10. The concerns surrounding the pegging of a the options make sense. By buying price insurance via specific price may lead our producer to the use of options. the options, producers can have protection against lower Options are a relatively new tool for the agricultural prices and still be in a position to benefit from higher prices. commodities that came back into use in the mid-1980s, and Mr. Smart indicates the producers he works with like There are numerous ways producers can use the futures this new and flexible tool. and options on futures, Mr. Smart continues. The dairymen or cattle feeder who will need to buy corn for A put option is the right to sell underlying futures at a feed can peg costs by contracting for future delivery in the specific price. Offered in $0.10 intervals for corn, called cash market or by buying futures. If cash prices go up, strike prices, the producer could buy a put option for $4.80, the futures will go up as well, and the futures can be sold $4.90, $5.00, $5.10, $5.20, etc. Assume he decides to buy at higher prices. The net from the futures trade can then a $5.10 put (the $5.10 is a “strike price”) at a premium cost be applied to reduce the net cost of the now higher priced of $0.12 per bushel. Instead of pegging a specific price, cash corn. A call option, the right to buy corn futures at the producer has established a price floor as follows: a specific price, can be bought. This effectively puts a Price Floor = Strike Price + Basis - Premium cost ceiling on raw material costs, such as feed costs, = $5.10 - 0.20 - 0.12 and leaves the user in a position to benefit if corn prices fall unexpectedly. = $4.78 There are small costs (commission, interest on margin There can be two distinctive results. What if the price funds) associated with strategies that use the futures goes up, with the December futures going to $5.50 and markets or options on futures, but Mr. Smart indicates the cash price to $5.30? What does the producer net? these costs are not very important. Continued on next page FB87413,000008D -19-03APR14-6/7 6-16 090117 PN=101  Marketing The important point, he stresses to Chris, is that there when hog production surges either cyclically or seasonally are ways producers can improve on the price taker status within the year. the markets impose on them. Hog producers who study Chris is reluctant to see this part of the discussion and can anticipate the cyclical surges in production drawing to a close. He senses how important it is. All the can forward price hogs a year or more into the future previously developed understanding of how the marketing before the prices break under the weight of the cyclical system works argues for strategies which help protect expansion. The December corn futures for a particular against wildly fluctuating prices. He now knows there are year start to trade in the previous summer — up to 18 strategies that can be employed, and he is determined months in advance. There is a long time period during to learn more. He will be an avid reader of materials on which producers can monitor the price offers and decide pricing in the farm magazines and he will contact Mr. whether and when to forward price. To date, only a small Smart again when he has questions. It is clear that Mr. percentage of producers use these marketing alternatives. Smart is in agreement with the need to take aggressive The result has often meant financial disaster when corn action and the importance of becoming a better marketer. prices plunge under the weight of a huge crop, when an embargo on grain exports occurs for political reasons, or FB87413,000008D -19-03APR14-7/7 PULLING IT TOGETHER commitment to what will probably be a short-run increase in price. More than anything else, they reason, this is the The two students of marketing sit down to summarize source of protection against the micro-macro paradox. their session and collect their thoughts. Marketing is also a form of production, they recognize. It is the continuation In the grains, the government programs attempt to of what starts with producers' efforts to grow and offer “smooth” the price variability but they are only moderately the basic raw material. Viewed together, the activities of successful. Over time, the programs have turned the producer and the various middlemen constitute an into subsidy programs that attempt to minimize the assembly line that continually makes the product ready for interference with the marketplace and extend a direct the final consumer. Various types of utility or satisfaction subsidy to producers. The result has been continued use are produced in the process. of resources in production that might otherwise have been squeezed out and relatively low prices of food and fiber to Recognizing that the total span of activities constitutes a consumers. total system helps to clarify the position of the producer. At the farm level, the demand is a derived demand and the In this volatile and unpredictable economic and political farm-level price is a derived price. Individual producers, environment, it is easy to see that the producer gets and only producers, are so small in the total system that tossed around by market forces. Prices gyrate and the they have no significant influence on price. This relegates economic viability of the operation can be threatened. them to the status of price takers. It is important, then, that producers understand the nature of their marketplace and attempt to anticipate the Understanding all this is important because it frames aggregate developments that will influence them. Once the marketing challenge facing the producer. Any that understanding is accomplished, it is then important development higher in the system that will influence the to learn to manage exposure to that unavoidable price aggregate demand and supply will filter back down to risk. Getting comfortable with forward pricing in the cash the producer in the form of a price change. This is the contract, futures, and options markets will be important. source of the micro-macro paradox facing the individual It is perhaps the case that the producers have far more producer. What he or she does will not influence price, potential to help themselves by becoming better marketers but what many such relatively small producers do can than by just trying to become still better producers. On and will influence price. This is the source of the periodic that positive and encouraging note, Chris and Mr. Smart surges and shortages in crop production and in livestock close their discussion until the next opportunity they will production that prompt often dramatic and prolonged have to get together. moves in price. Chris and Mr. Smart review the rule they discussed in such situations. Never make a long-term OUO1023,0002CF6 -19-24FEB11-1/1 6-17 090117 PN=102