Theories of Demand and Supply PDF

Lilongwe University of Agricultural and Natural Resources Faculty of Development Studies Department of Agricultural and Applied Economics Course Name : Agricultural Economics I Course Code : AEC 211 Offered to Year : 2 Academic Calendar : 2013/2014...

Lilongwe University of Agricultural and Natural Resources Faculty of Development Studies Department of Agricultural and Applied Economics Course Name : Agricultural Economics I Course Code : AEC 211 Offered to Year : 2 Academic Calendar : 2013/2014 Course Lecturer : Maonga B.B. (PhD) 1  Topic 3 Theories of Demand and Supply 3.1 Demand – Demand is defined as a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time, (ceteris paribus). – In this definition, we say “willing and able” because willingness alone is not effective in the market. Without the backing of a necessary amount of money your willingness will not be effective, and therefore will not be reflected in the market. Thus, “willingness” backed by purchasing power creates effective demand. 2  3.1.1 Ways of Showing Demand There are three ways of describing or showing demand as follows: (i) Demand schedule (table form), (ii) Demand curve (Geometric or Graphic form) (iii) Demand function (Mathematical form) 3  Presentation of demand (1) (i) Demand schedule (table form). – Demand can easily be shown in table form. Table 3.1 is a hypothetical demand schedule for a single consumer purchasing beef. Table 3.1: An individual demand for beef Price per kg (Malawi Kwacha) Quantity Demanded per month (kg) 500 10 400 20 300 35 200 55 150 80 – Table 3.1 reveals the relationship between the various prices of beef and the quantity of beef that a particular consumer would be willing and able to purchase at each of the given prices. 4 Presentation of demand (2) (cont’d) (ii) Demand curve (Geometric or Graphic form) – The inverse relationship between price and quantity demanded for any product can be represented most conveniently on a simple two- dimensional graph (Fig. 3.1). – On this graph, quantity demanded is measured on the horizontal axis and price on the vertical axis. Connecting the price-quantity points produces a demand curve. Price per kg 500 400 300 200 100 D 0 20 40 60 80 100 Quantity demand per month (kg) Figure 3.1 An individual buyer’s demand curve for beef 5 Presentation of demand (2) Cont’d)  The downward slope of the demand curve reflects the law of demand. Law of demand – The law of demand states that price and quantity demanded have an inverse relationship. People buy more of a product, service, or resource when its price falls. 6 Presentation of demand (3) (iii) Demand function (Mathematical form) – The demand function represents a functional relationship between price (P) and quantity demanded (Q). We write the general mathematical form as follows: Qdx = (Px) Where Qdx is quantity demanded for commodity x; Px is Price of commodity x;  means function of or depends on. – If a demand function is a linear relationship, the function becomes: Qdx = a + bPx Where a + b are parameters in which a is an intercept (a constant); b is a coefficient. – From the demand schedule we can use simple regression method to construct the demand function in the form of Y = a + bPx or Y =  + Px in which Y is Qdx. 7 Why inverse relationship between price and quantity?  The law of demand is consistent with common sense. ▪ People ordinarily buy more of a product at a low price than at a high price. Price is the obstacle that deters consumers from buying. The higher that obstacle, the less a product they will buy; and vice versa.  Consumption is subject to diminishing marginal utility. ▪ In any specific time period, each buyer of a product will derive less satisfaction (or benefit or utility) from each successive unit of the product consumed. 8  Law of Demand further explained  The law of demand can also be explained in terms of income and substitution effects. ▪ Income effect indicates that a lower price increases the purchasing power of a buyer’s money income, enabling the buyer to purchase more of the product.  The substitution effect suggests that at a lower price, buyers have the incentive to substitute what is now less expensive product for similar products that are now relatively more expensive. ▪ For example, a decline in the price of chicken, relative to that of beef will make buyers increase the purchase of chicken. 9  3.1. 3 Individual Demand and Market Demand Individual demand focuses on one consumer’s demand for a commodity. However, in any market there exist several consumers that have a demand for a given product. By adding (horizontally) the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand. Table 3.2 shows the market demand for beef by three buyers and the summing procedure of individual demand to arrive at market demand. Table 3.2 Market Demand for Beef, Three Buyers Price per kg (K) Quantity Demand per month (kg) Total Qdbeef (kg) 1st Buyer 2nd Buyer 3rd Buyer 500 10 + 12 + 8 = 30 400 20 + 23 + 17 = 60 300 35 + 39 + 26 = 100 200 55 + 60 + 39 = 154 150 80 + 87 + 54 = 221 10 Horizontal summation of individual demand schedules to produce market demand If there are just three buyers in the market, as represented in Table 3.2, it is relatively easy to determine total quantity demanded at each price. Table 3.2 shows the graphical summing procedure: – At each price we add the individual quantities demanded to obtain the total quantity demanded at that price; – we then plot the price and the total quantity demanded as one point of the market demand curve. Competition entails many more than three buyers of a product. – To avoid thousands of additions, we suppose that all the buyers in a market are willing and able to buy the same amounts at each of the possible prices. – Then we just multiply those amounts by the number of buyers to obtain the market demand as shown in Table 3.3. 11 Determinants of Demand (Factors Affecting Demand) Demand is a multivariate relationship. It is determined by many factors simultaneously. – The basic determinants of demand are (1) the price of the commodity itself (Px), (2) consumers’ tastes and or preferences (T), (3) number of consumers in the market (N), (4) consumers’ incomes (Y), (5) prices of related goods Py), and (6) consumer expectations about future prices and incomes (E). – Using functional notation, we can write the demand function as follows: Qdx = [(Px... Pxn), T, N, Y, (Py... Pyn), E] 12 (1) Price as determinant of demand Price of commodity itself (Px) – We have already seen how demand changes when prices of a commodity change; the inverse relationship between Px and Qd. 13 (2) Consumer tastes as determinant of demand Consumer’s Tastes (Preferences) (T) – A favorable change in consumer tastes (preferences) for a product – a change that makes the product more desirable – means that more of it will be demanded at each price. Demand will increase; the demand curve will shift rightward. – New products may affect consumer tastes; for example, the introduction of compact discs (CDs) greatly decreased the demand for cassette tapes. – In advanced societies, consumers’ concern over health hazards of cholesterol and obesity have increased the demand for broccoli, low-calorie sweeteners, and fresh fruit while decreasing the demand for beef, eggs and whole milk. Also demand for bottled water. 14 (3) Number of consumers as determinant of demand Number of Consumers in the Market (N) – An increase in the number of buyers (consumers) in a market increases demand, and vice versa with the decrease in the number of buyers of a given product. – An increase in population in the cities is associated with a corresponding increase in demand for housing and in commodities sold in city markets. 15 (4) Consumers’ Income as a determinant of demand Consumers’ Income (Y) – How changes in income affect demand is a more complex matter. – However, for most products, a rise in income causes an increase in demand. – Consumers typically buy more steaks, furniture, and computers as their incomes increase. Conversely, the demand for such products declines as their incomes fall. 16 Consumer Income and demand: Normal Goods Normal Goods and Inferior Goods – Normal Goods Products whose demand varies directly with money income are called superior goods or Normal goods. Although most products are normal goods, there are some exceptions. – As incomes increase beyond some point, the demand for used clothing, retread tires and third-hand cars may decrease, because the higher incomes enable consumers to buy new versions of those products. Rising incomes may also decrease the demand for beans and most likely increase the demand for fish. Similarly, rising incomes may cause the demand for charcoal to decline as wealthier consumers switch to the use of electricity or gas for cooking, warming and lighting. 17 Consumer Income and demand: Inferior Goods Inferior Goods - Goods whose demand varies inversely with money income are called inferior goods. For example, consumption of cassava and sweet potatoes for breakfast may decline while consumption of bread may rise as consumers’ incomes increase. 18 (5) Prices of related goods as a determinant of demand ❖ Prices of related goods (Py), – A change in the price of a related good may either increase or decrease the demand for a product, depending on whether the related good is a substitute or a complement: A substitute good is one that can be used in place of another good. Beef and chicken are examples of substitute goods or simply substitutes. – When the price of beef rises, consumers buy less beef, increasing the demand for chicken. – Conversely, as the price of beef falls, consumers buy more beef, decreasing the demand for chicken. – When two products are substitutes, the price of one and the demand for the other move in the same direction. – Substitution in consumption occurs when the price of one good rises relative to the price of a similar good. 19 Prices of related goods (Py) - continued, A complementary good is one that is used together with another good. – Complementary goods (or simply, complements) are goods that are used together and are usually demanded together (they have joint demand). – If the price of car fuel (petrol and diesel) falls and, as a result, you drive your car more often, the extra driving increases your demand for motor oil. Thus, fuel (petrol, diesel) and motor oil are jointly demanded; they are complements. – So, it is with ham and eggs, bread and butter (or margarine), etc. – When two products are complements, the price of one good and the demand for the other good move in opposite direction. 20 Prices of related goods (Py) - continued, Unrelated Goods - The vast majority of goods that are not related to one another are called independent goods. Examples are butter and golf balls, potatoes and cars, and bananas and wristwatches. A change in the price of one does not affect the demand for the other. 21 (6) Consumer expectations as a determinant of demand ▪ Consumers’ Expectations about future Prices and Income (E) A newly formed expectation of higher future prices may cause consumers to buy now in order to “beat” the anticipated price rises, thus increasing current demand. ✓For example, when drought destroys much of maize in a given region, consumers may reason that the price of maize will rise. They may stock up on maize by purchasing large quantities now. In contrast, a newly formed expectation of falling prices or falling income may decrease current demand for products. 22 Consumer expectations as a determinant of demand (cont’d) ▪ Expectations related to future availability of the product – Similarly, a change in expectations relating to future product availability may affect current demand. For instance, in late December 1999 there was a substantial increase in the demand for fuel because motorists became concerned that the Y2K computer problem might disrupt fuel pumps. – Finally, a change in expectations concerning future income may prompt consumers to change their current spending. For example, workers who become fearful of losing their jobs may reduce demand for vacation travel. 23 Summary of determinants of demand ▪ In summary, an increase in demand – the decision by consumers to buy large quantities of a product at each possible price – may be caused by: – A favorable change in consumer tastes. – An increase in the number of buyers. – Rising incomes if the product is a normal good. – Falling incomes if the product is an inferior good. – An increase in the price of a substitute good. – A decrease in the price of a complementary good. – A new consumer expectation that either prices or income will be higher in the future. 24 Change in Demand (versus Change in Quantity Demanded) A change in one or more of the determinants of demand will change the demand data (demand schedule) in Table 3.3, and therefore the location of the demand curve in Figure 3.3. – A change in the demand schedule or graphically, a shift in the demand curve is called a change in demand. – These changes are distinguished from a change in quantity demanded, which is caused by a change in the price of the product, as shown by a movement from point a to point b on fixed demand curve D1 Price (K) 500 400 b 300 a 200 c D2 100 D3 D1 0 q2 q1 q3 QD Figure 3.3 Illustration of change in demand and change in quantity demanded 25 Change in Demand (versus Change in Quantity Demanded) (cont’d) If consumers desire to buy more beef at each possible price, the increase in demand is shown as a shift of the demand curve to the right, (from D1 to D2). Conversely, a decrease in demand occurs when consumers buy less beef at each possible price. The leftward shift of the demand curve from D1 to D3 in Figure 3.3 shows that situation. Caution – A change in demand must not be confused with a change in quantity demanded. A change in quantity demanded is a movement from one point to another point – from one price-quantity combination to another – on a fixed demand schedule or demand curve. The cause of such a change is an increase or decrease in the price of the product under consideration. – For example, a decline in the price of beef from K400 to K300 will increase the quantity of beef demanded from q1 to q2. – A change in the quantity demanded does not change demand. Demand – the entire curve remains fixed in place. 26 Elasticity of Demand The price theory, like the law of demand, just tells us an inverse relationship between the quantity demanded (Qd) and its price (Px). – However, the inverse relationship itself says nothing about the responsiveness (sensitivity) of quantity demanded to price changes for a commodity and the variations of the responsiveness from commodity to commodity. For instance, when the prices of beef and maize or salt change by 10% do quantities demanded also change by the same margin? Elasticity of demand answers this question. Elasticity of demand is the measure of the extent or degree of responsiveness of demand to changes in the determinants of demand such as own price, price of related goods and consumers’ incomes. – In general, there are three kinds of elasticity of demand: (Own) Price elasticity (Ed) Income elasticity (Ei) Cross price elasticity (Exy) 27 Price elasticity of demand (Ed) Price elasticity of demand (Ed) is the measure of responsiveness of quantity demanded to a change in price (ceteris paribus). – Consider the case of demand for maize whose demand curve is D1 and beef whose demand curve is D2 as shown in Figure 3.4. Price per kg P1 (K300) P2 (K225) D2 (Beef) D1 (Maize) Q0 Q1 Q2 Figure 3.4 Price of demand elasticity for maize and beef – At market price P1 demand for both commodities is Q0. When the price falls to P2 quantity demanded for the two respective commodities increases but with different rates. 28 Mathematical definition of price elasticity of demand Price elasticity of demand is computed as the percentage change in quantity demanded (Q/Q) divided by percentage change in price (P/P). – A simple method to derive the price elasticity of demand over a small segment of the demand curve may be expressed by the following formula: Ed = [(Q1 –Q2)/(Q1 + Q2)]  [(P1 – P2)/(P1 + P2)] – This formula measures “average” price elasticity between two points on the demand curve, and is called arc elasticity. The formula could be written as Ed = [(Q1 – Q2)/(Q1 + Q2)]/2  [(P1 – P2)/(P1 + P2)]/2. – Rewriting the formula: Ed = Q/P  P/Q In this formulation, Q1 stands for the first quantity observation, Q2 and Q3 stand for the second and third quantity observation(s), P1 stands for the first observed price, P2 stands for the second (new) price; (Q1 – Q2)  (Q1 + Q2) represents the percentage change in quantity demanded while (P1 – P2)  (P1 + P2) represents the percentage change in price. 29 Calculating price elasticity of demand: An Example Assume that in the Figure 3.4, Q0 = 400 kg, Q1 = 500 kg and Q2 = 700 kg, P1 = K300 and P2 = K225 per kg. Substituting these values into the formula, we have For Maize, Ed = [(400 –500)/(400+500)] [(300-225)/(300+225)] = [(-100/900)(75/525)] = - 1/9  525/75 = - 525/675 = - 0.78 For Beef, Ed = [(400 –700)/(400+700)] {(300-225)/(300+225)} = (-300/1100)  (75/525) = -300/1100  525/75 = -157500/82500 = - 1.9 The figure of Ed is called the coefficient of elasticity and this figure has a negative sign (recall the law of demand). However, the negative sign is ignored and take the figure as with an absolute valueEp. 30 Interpreting of the elasticity coefficient From the analysis of price elasticity of demand for maize (Figure 3.4), the coefficient of –0.78 means that a 1 percent decrease in price results in 0.78 percent increase in the quantity of maize purchased (demanded). For beef, the coefficient of –1.9 means that a 1 percent decrease in price results in 1.9 percent increase in the quantity of beef purchased (demanded). Characteristics of Ed – Ed  1, when price elasticity is less than 1, demand is said to be inelastic. – Ed  1, when price elasticity is greater than 1, demand is said to be elastic – Ed = 1, when price elasticity equals 1, demand is said to be unitary elasticity 31 Characteristics of elasticity of demand (cont’d) Elasticities are usually measured for only small price movements along a demand curve, with different elasticities at each point along any straight-line demand curve. Demand is generally more elastic at higher prices and more inelastic at lower prices. Price elasticities for farm commodities vary widely. – For example, the price elasticity of demand at the farm level may be as follows: – For Cattle –0.68; – For calves –1.08; – For eggs –0.23; – For vegetables –0.10, and – for wheat –0.03. 32 Factors that influence price elasticity of demand Three primary factors influence the elasticity of demand: (1) Whether good substitutes for the product are available; (2) Whether or not there are many alternative uses for a product; (3) Whether the product is an important expenditure in a consumer’s total budget. 33 (2) Income elasticity of demand Income elasticity is defined as a measure of the responsiveness of quantity purchased (demanded) to changes in income (ceteris paribus). – It can be expressed as the percentage change in quantity bought (demanded) divided by the percentage change in income at any point along an Engel curve. – When the income change is small, a rough estimate of the income elasticity of demand can be made using the following arc income elasticity formula: EI = [(Q1 – Q2)/(Q1 + Q2)]  [(I1 – I2)/(I1 + I2)] = Q/I  I/Q The relationship between changes in consumer income and quantity of an item purchased is called the Engel curve. – As income increases, more or less of a commodity may be bought depending on whether the commodity is a normal good or an inferior good. 34 Income elasticity and the Engel Curve A different Engel curve exists for each commodity and for each individual. For food commodities, the quantity of food purchased increases as income rises, but at a proportionately decreasing rate. Thus, the proportion of income spent for food decreases as income increases (Figure 3.5). Monthly purchases Food Monthly purchases of clothing Q2 B Q2 B Q1 A Q1 A 0 I1 I2 0 I1 I2 Figure 3.5: An Engel curve for food and non food items 35 Positive and negative income elasticities NOTE that analyses such as income elasticity of demand are important in determining the impact of income changes on the purchases of farm food items. – The income elasticity for food in the aggregate, as well as for many individual food products, is thought to decrease as incomes increase. – Therefore, income elasticities will usually change over various income levels and can be positive or negative. Positive income elasticities indicate normal goods, Negative elasticities indicate inferior goods. An Example: Assume your monthly income changes from K10,000 to K22,000 and during this period your monthly purchase of beef increases from 5 kg to 15 kg. (a) Draw the Engel curve and label the segment between income – quantity combinations as AB. (b) Calculate arc income elasticity coefficient of demand for beef over segment AB and give its interpretation 36 (3) Cross Price Elasticity of Demand Cross price elasticity of demand is a measure of the responsiveness of the quantity demanded of good (commodity) X to a change in the price of good (commodity) Y (ceteris paribus). – Arc cross price elasticity of demand for commodity X with respect to a small change in the price of commodity Y can be illustrated with the following algebraic expression: Exy = (Qx1 – Qx2)/(Qx1 + Qx2)  (Py1 – Py2)/(Py1 + Py2) If the cross elasticity coefficient from the calculated equation is positive, the two commodities (X and Y) are called substitutes. – Examples: peanut and soybean oil. An increase in the price of soybean oil will decrease its quantity demand and increase the demand and price of peanut oil. Therefore the increase in price of soybean oil and the increase in consumption of peanut oil are both positive, making Exy positive. 37 Cross price elasticity of demand for complementary goods For complementary goods, cross elasticities of demand are negative. – Bread and butter for example, are complements and therefore have negative cross elasticity coefficient. If the price of bread increases, the quantity of bread demanded decreases and the demand for butter would also decrease. Hence, as the price of bread increases, the consumption of butter would decrease, giving a negative sign to the cross price elasticity between these two complementary commodities. Interpretation: – When the cross price elasticity of pork with respect to the price of beef is +0.15, for example, it means that the quantity of pork purchased will increase 0.15 percent for each 1 percent increase in the price of beef (ceteris paribus). – Commodities with highly positive cross elasticities coefficients are very close substitutes, – Highly negative cross elasticity coefficients represent strong complementary commodities, – Commodities with coefficients of cross elasticity close to zero are unrelated. 38 Supply Theory Supply is defined as a schedule or curve showing the amounts of a product that producers are willing and able to offer for sale at each of a series of possible prices during a specific period, (ceteris paribus). Ways of Describing (Showing) Supply Just like demand, supply is described in three ways: (1) Supply schedule (table form), (2) Supply curve (graphic or geometric form), and (3) Supply function (Algebraic form). 39 Ways of describing Supply (1) Supply schedule (table form) Table 3.3 is a hypothetical supply schedule for a single producer of maize. – It shows the quantities of maize that will be supplied (or offered for sale) at various prices, (ceteris paribus). – This table reflects the relationship between the price of products and the quantity that producers would be willing and able to sell at each of the prices. Table 3.3: An individual producer’s supply schedule of maize Price per kg (MK) Quantity supplied per week (kg) 50 6000 40 5000 30 3500 20 2000 10 500 – Note that as the price of maize (Px) rises, the quantity of supply (QSx) increases. 40 Ways of describing Supply (2) (2) Supply Curve As with demand, it is convenient to represent supply geographically. In – Figure 3.6 the supply curve (SS) represents all price – quantity possibilities, given in Table 3.4. S Price per kg (MK) 60 50 40 30 20 S 10 0 2000 4000 6000 Quantity supplied per week (kg) Figure 3.6: An individual producer’s supply curve for maize – The supply curve slopes upwards from left to right. It reflects the reasonable expectation that as the price rises the producer’s supply will increase. 41 Ways of describing Supply (3) (3) Supply Function (Algebraic form) Supply function represents the functional relationship between price (Px) and quantity supplied (QSx). – We write the general form as follows: QSx = (Px). where QSx → Quantity supplied of commodity x Px → Price of commodity x  → Function of or depend on – If a supply function is a linear relationship, it is written as: QSx = a +bPx or QSx =  + Px. – The coefficient b or  is normally positive indicating direct variation between price and quantity supplied. 42 Law of Supply Table 3.3 above, shows a positive or direct relationship that prevails between price and quantity supplied. – As price rises, the quantity supplied rises; as price falls, the quantity supplied falls. This relationship is called the law of supply. – The law of supply implies that producers are willing to produce and offer for sale more products at a high price than at a low price. This, again, is basically common sense. If we offered a high price, more sellers would want to sell and each would want to sell a greater quantity, and the total quantities offered for sale would increase. – With demand, price is the obstacle from the standpoint of the consumer, who is on the paying end. The higher the price, the less the consumer will buy. – But the supplier is on the receiving end of the product’s price. To a supplier, price represents revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater this incentive and the greater the quantity supplied. 43  Law of Supply explained Consider a farmer who can shift resources among alternative products. – As price moves up, the farmer finds it profitable to take land out of other crops’ production and put it into maize. And the higher maize prices enable the farmer to cover the increased costs associated with more intensive cultivation and the use of more seed, fertilizer and pesticides. The overall result is more maize. Now consider a manufacturer. – Beyond some quantity of production, manufacturers usually encounter increasing costs per added unit of output. Certain productive resources – in particular, the firm’s plant and machinery – cannot be expanded quickly, so the firm uses more of other resources, such as labour, to produce more output. – But as time passes, the existing plant becomes increasingly crowded and congested. As a result, each added worker produces less added output, and the cost of successive units of output rises accordingly. The firm will not produce the more costly units unless it receives a higher price for them. Hence, the direct relationship between price 44 and quantity supplied. Market Supply The market supply of a commodity is the sum of the quantities of that commodity which individual firms (producers) are willing and able to offer for sale at a given price over a period of time. – Table 3.4 presents the market supply schedule of maize for 200 firms (producers). Table 3.4: Market supply of maize, 200 producers (1) (2) (3) (4) Price per kg Quantity Supplied per Number of Total Quantity (MK) week, Single producer Sellers in the Supplied per (Supplier) Market week (kg) 50 6000 × 200 = 1,200,000 40 5000 × 200 = 1,000,000 30 3500 × 200 = 700,000 20 2000 × 200 = 400,000 10 500 × 200 = 100,000 – From the data in Table 3.4 above we obtain the market supply curve by horizontally adding the supply curves of the individual producers. 45  Change in Supply versus Change in the Quantity Supplied A change in one or more of the determinants of supply will change the supply data (supply schedule) in Table 3.4, and therefore the location of the supply curve (S1) in Figure 3.7. – A change in the supply schedule or graphically, a shift in the supply curve is called a change in supply. – These changes are distinguished from a change in quantity supplied, which is caused by a change in the product’s price and is shown by a movement from one point to another, as from A to point B, on fixed supply curve (S1). Supply is the full schedule of prices and quantities shown, and this schedule does not change when price changes. Price per kg S3 50 B S1 40 S2 30 A 20 10 0 500 1000 1500 Figure 3.7: Changes in the supply of maize 46  Determinants of Supply (Factors Affecting Supply) Just like demand, supply is also a multivariate relationship. – It is determined by many factors simultaneously. When we construct a supply curve, we assume price is the most significant influence (determinant) on the quantity supplied of any product. But other factors (the “other things equal”) can and do affect supply. The supply curve is drawn on the assumption that these other things (factors) are fixed and do not change. If one of them changes, a change in supply will occur, meaning that the entire supply curve will shift either rightward or leftward. The basic determinants of supply other than own price of the product are (1) Resource prices, (2) Technology (Change in technology), (3) Taxes and subsidies, (4) Prices of other goods, (5) Price expectations, and (6) The number of sellers in the market 47  Determinants of Supply (Explained) (1) Resource Prices (Prices of factors of production/input prices/costs) The prices of the resources used in the production process help to determine the production costs incurred by firms (producers). Higher resource prices raise production costs and, assuming a particular product price, squeeze profits. – That reduction in profits reduces the incentive for firms to supply output at each product price. For example, an increase in the prices of seed and fertilizer will increase the production cost of maize and reduce its supply. In contrast, lower resource prices reduce production costs and increase profits. – So, when resource prices fall, firms (producers) supply greater output at each product price. For example, a decrease in the prices of seed and fertilizer will increase the supply of maize. 48  Determinants of Supply (Explained) (2) Technology (Change in Technology) Improvements in technology (technical know-how) enable firms to produce more units of output with fewer resources. – Because resources are costly, using fewer of them lowers production costs and increases profits. High profits motivate producers to produce more and thus increase supply of a given product. – A technological advance allows more production from the same level of inputs as before. For instance, the development of hybrid and disease-resistant seeds, cultivars of cassava or potatoes will allow more output per unit of land over time. – Through technical know-how, selective breeding of hens leads to laying of more eggs over a given period of time with the same amount of feeds. Output Y2 (With Technology) Y2 Y1 Y1 (Without Technology) Fig. 3.8 Impact of T on Y 0 x Inputs 49  Determinants of Supply (Explained) (3) Taxes and Subsidies Businesses treat most taxes as costs. – An increase in sales or property taxes will increase production costs and reduce supply. In contrast, subsidies are “taxes in reverse.” – If the government subsidizes the production of a good (product), it in effect lowers the producers’ costs and increase supply. Consider the case of a surplus maize production in Malawi during the period 2005-2011 farming years as a result of the government’s Farm Input Subsidy Program (FISP) especially on fertilizer and hybrid maize seed. 50  Determinants of Supply (Explained) (4) Prices of Other Goods Firms (producers) that produce a particular product, say, pork can sometimes use their resources (plant and equipment) to produce alternative goods, say, beef and chicken. – The higher prices of these “other goods” (beef and chicken) may entice pork producers to switch production to those other goods in order to increase profits. A good example is the increase in tobacco farmland in relation to maize farmland in response to the higher profits from tobacco among smallholder farmers in Malawi. This substitution in production results in a decline in the supply of pork. – Alternatively, when the prices of beef and chicken decline relative to the price of pork producers of those goods may decide to produce more pork, thereby increasing its supply. 51  Determinants of Supply (Explained) (5) Price Expectations Changes in expectations about the future price of a product may affect the producer’s current willingness to supply that product. – It is difficult, however, to generalize about how a new expectation of higher prices affects the present supply of a product. – Farmers anticipating a higher maize price in the future might withhold some of their current maize harvest from the market, thereby causing a decrease in the current supply of maize. – In contrast, in many types of manufacturing industries, newly formed expectations of price increases may induce firms to add another shift of workers or to expand their production facilities, casing current supply to increase. 52  Determinants of Supply (Explained) (6) Number of Sellers Other things equal, the larger the number of suppliers, the greater the market supply. – As more firms (producers) enter an industry, more will be supplied. The supply curve shifts to the right. – Conversely, the smaller the number of firms (producers) in the industry, the less the market supply. The supply curve shifts to the left. 53 Supply and Demand: Market Equilibrium Let’s now bring together supply and demand to see how the buying decisions of households and the selling decisions of businesses interact to determine the price of a product and the quantity actually bought/sold. – In Table 3.5 below, the market demand for and market supply of maize are presented with the assumption that it is a competitive market situation – neither buyers nor sellers can set the price. Table 3.5: Market Supply of and Demand for Maize (1) (2) (3) (4) (5) Price per kg Total Quantity Total Quantity Surplus (+) or Effect on (MK) Supplied per Demanded per Shortage (Deficit Price week (kg) week (kg) (-) 50 12,000 2,000 +10,000 Decreased 40 10,000 4,000 +6,000 Decreased 30 7,000 7,000 0 Stabilized 20 4,000 11,000 -7,000 Increased 10 1,000 16,000 -15,000 Increased 54 Surplus and Shortage or Deficit Surpluses – The K50 price encourages farmers to produce lots of maize but discourages most consumers from buying it. The result is 10,000 kg surplus or excess supply of maize (excess of quantity supplied over quantity demanded – shown in column 4). – The unsold 10,000 kg of maize prompt competing sellers to lower their price to encourage buyers to take the surplus off their hands. – The lower price of K40 encourages consumers to buy more maize, and at the same time, induces farmers to offer less of it for sale. The surplus diminishes to 6,000 kg. Since there is still a surplus, competition among sellers will once again reduce the price. Shortages (Deficits) – Now let’s consider the possible price of K10 per kg. – You will observe that at K10 per kg, quantity demanded exceeds quantity supplied by 15,000 kg. – The K10 price discourages farmers from devoting resources to maize production and encourages consumers to attempt to buy more than is available. The result is a 15,000 kg shortage of or excess demand for maize. 55 Equilibrium Price and Quantity By trial and error we have eliminated every price but K30 per kg. – It is at K30 per kg only that the quantity of maize that farmers are willing to produce and supply is equal to the quantity that consumers are willing and able to buy. This price (where supply = demand) is called the market clearing or equilibrium price. The price of any product bought and sold in competitive markets will be established where the supply decisions of producers and the demand decisions of buyers are mutually consistent. A graphic analysis of supply and demand should yield the same conclusions (see Figure 3.11). Price (MK/kg) 50 S 40 30 E 20 10 D 0 4 7 10 11 Q (‘000) Figure 3.9: Equilibrium price and quantity 56 Rationing Function of Prices The ability of the competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent is called the rationing function of prices. – The rationing function of prices is also referred to as the ability of market forces to synchronize selling and buying decisions to eliminate potential surpluses and shortages. In our case, the equilibrium price of K30 clears the market, leaving no burdensome surplus for sellers and no inconvenient shortage for potential buyers. – It is the combination of freely made individual decisions that set the market-clearing price. In effect, the market outcome says that all buyers who are willing and able to pay K30 for a kg of maize will obtain it; all buyers who cannot or will not pay K30 will go without maize. Similarly, all producers who are willing and able to offer maize for sale at K30 a kg will sell it; all producers who cannot or will not sell for K30 per kg will not sell their product. 57 Changes in Supply, Demand and Equilibrium Changes in demand (Supply constant) ▪ Case (a): Increase in Demand – When demand increases while supply is constant, both equilibrium quantity and price will increase. Price per kg MK) S P’ Pe D’ D 0 Qe Q’ ▪ Case (b): Decrease in Demand – Conversely, a decrease in demand under constant supply reduces both Pe and Qe. Price per kg (MK) Pe P’’ D D’’ Figure 3.10(a) : Changes in supply, D, & E 0 Q’’ Qe 58 Changes in Supply, Demand and Equilibrium Changes in Supply (Demand Constant) Case (c): Increase in Supply An increase in Supply, reduces equilibrium price from Pe to P1but increases equilibrium quantity from Qe to Q1. Price per kg S0 Pe P1 S1 D 0 Qe Q1 Case (d): Decrease in Supply In contrast, if supply decreases the equilibrium price rises from Pe to P1 while the equilibrium quantity declines from Qe to Q1. Price per kg S1 P1’ S0 Pe D Figure 3.10(b) 0 Q1 Qe 59 Changes in Supply and Demand (Complex Cases) When both supply and demand change, the effect is a combination of the individual effects. (i) Supply Increase; Demand Decrease – What effect will a supply increase and a demand decrease have on equilibrium price (Pe) and equilibrium quantity (Qe)? (ii) Supply Decrease; Demand Increase – What effect will a supply decrease and a demand increase have on equilibrium price (Pe) and equilibrium quantity (Qe)? (iii) Supply Increase; Demand Increase – What if supply and demand both increase? (iv) Supply Decrease; Demand Decrease – What about decreases in both supply and demand? 60 Summary of effects of changes in Supply and Demand Table 3.6: Effects of changes in both Supply and Demand Case Change in Change in Effect on Equilibrium Effect on Supply Demand Price (Pe) Equilibrium Quantity (Qe) 1 Increase Decrease Decrease Indeterminate 2 Decrease Increase Increase Indeterminate 3 Increase Increase Indeterminate Increase 4 Decrease Decrease Indeterminate Decrease 61  Government-Set Prices In a market economy (Capitalism), occasionally supply and demand may result in prices that are either unfairly high to buyers or unfairly low to sellers. In such instances the government may intervene by legally limiting how high or low a price may go. What are the economic implications of government-set prices? (1) Price Ceilings A price ceiling or ceiling price is the maximum legal price a seller may charge for a product or service. – A price at or below the ceiling is legal; a price above it is not. – The rationale for establishing price ceilings (or ceiling prices) on specific products is that they purportedly (or it is implied that they) enable consumers to obtain some “essential” goods or services that they could not afford at the equilibrium price. – Sometimes the government imposes price ceilings either on all products or on a very wide range of products – so called price controls – in order to restrain inflation. We can easily demonstrate the effects of price ceilings graphically as shown in the following Figure. 62 Effect of state intervention on product price (1) What will be the effect if the government imposes a price ceiling below the equilibrium price on maize in order to help the poor? Price S Pe E Pc A B Shortage D 0 QS Qe QD Qunatity Figure3.11: Effect of price ceiling on availability of commodity 63  Given demand function P = 10-0.2Qd --- (1) and Supply function P = 2+0.2Qs ---- (2) Assume Qs = Qd, Solve the equations to determine Pe and Qe. In Eqn (1) Make Qd subject of the formula Then Qd = (10 – P)/0.2 Finally in (2) P = 2+ 0.2(10-P)/0.2 64 Effect of Ceiling Price Explained Basically, at PC the rationing ability of the free market will be rendered ineffective. Of course, some of the poor consumers will have a chance to buy the commodity. However, supply will reduce from Qe to QS. Furthermore, since there is excess demand AB (or QD) at the ceiling price, suppliers may reserve some quantities of the commodity for their friends or relatives and acquaintances not necessarily for the poor. There will be shortage of the commodity on the market (QD - QS) (as first problem) – Suppliers may even be induced to accept bribes from those who can pay more money for the commodity, thereby creating an illegal market. So, holding down the price might not help the poor after all. 65 Effect of Ceiling Price Explained The important point is that the price ceiling PC prevents the usual market adjustment in which competition among buyers bids up price, including more production and rationing some buyers out of the market. That process would continue until the shortage disappeared at the equilibrium price (Pe) and quantity (Qe). By preventing these market adjustments from occurring, the price ceiling poses problems born of the market disequilibrium. 66 Ceiling Price and the Rationing Problem How will the government apportion the available supply QS among buyers who want the greater amount QD? – Should maize be distributed on a first-come, first-served basis on the queue? Or should ADMARC distribute it on the basis of favoritism? – Since an unregulated shortage does not lead to an equitable distribution of maize, the government must establish some formal system for rationing it to consumers. The rationing system would entail first the printing of coupons for QS kg of maize and then the equitable distribution of the coupons among consumers so that the wealthy family of 4 and the poor family of 4 both receive the same number of coupons. During critical maize shortages Malawi government often rations the available maize through quota distribution in which a specified quantity is imposed per buyer of maize. – Without quota distribution, the situation would likely get worse. 67 Ceiling Price and the Proliferation of Black Markets Ration coupons would not prevent a second problem from arising. – The demand curve has shown that many buyers are willing to pay more than the ceiling price PC. – And, of course, it will be more profitable for maize sellers (including ADMARC) to sell at prices above the ceiling. – Thus, despite a sizeable enforcement bureaucracy that would have to accompany the price controls, black markets in which maize is illegally bought and sold at prices above the legal limits will flourish. – Counterfeiting (forgery) of ration coupons will also be a problem. – And since the price of maize is now or mostly “set by the government” there would be political pressure on government to set the price even lower. 68 Effect of state intervention on product price (2) (2) Price Floors Price floors are minimum prices fixed by the government. A price at or above the floor price is legal; a price below it is illegal. Price floors above equilibrium prices are usually invoked when society feels that the free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers. Supported minimum prices for agricultural products and minimum wages are some of the examples of price (or wage) floors. S PF A Surplus B PE S D 0 QD Qe QS Quantity Figure 3.12: Effect of Floor Price on Availability of commodity 69 Effect of Price Floor Explained Suppose the equilibrium farm-gate price for maize is K25 per kg and, because of that low price, many farmers have extremely low incomes. The government decides to help out by establishing a legal price floor or price support of K30 per kg. What will be the effect? At any price above the equilibrium price, quantity supplied will exceed quantity demanded – that is, there will be a persistent excess supply or surplus of the product. Farmers will be more willing and offer for sale more than private buyers are willing to purchase at the price floor (of K30). Just as with ceiling price, an imposed legal price disrupts the rationing ability of the free market. – As illustrated in the Figure above if the government imposes a price floor of PF, farmers will produce Qs but private buyers will purchase only QD. The surplus is the excess of QS over QD. 70 Coping with the Surplus resulting from the Price Floors (1) Restricting supply – The government can restrict supply (for example, by instituting hectare allotments by which farmers agree to take a certain amount of land out of production) (2) Increase demand (for example, by researching new uses for the product involved) – Also through Value addition. These actions may reduce the difference between the Pe the PF and thereby reduce the size of the resulting surplus. (3) Purchasing surplus output – If these efforts are not wholly successful, then the government must purchase the surplus output at the floor price PF (thereby subsidizing farmers) and store or otherwise dispose of it (for example, by selling to other countries). – Buffer storage facilities may be used in cases of surplus production as a price stabilization mechanism - commodity may be released for sale to ensure no surplus or shortage on the market. 71 Is government intervention on commodity prices necessary? Our discussion of price controls shows that government interference with the market can have unintended and undesirable side effects. – Price controls, for example, create illegal black markets. Because of these side effects, economists generally oppose government-imposed prices. Nevertheless, considering the fact that markets may at times fail to distribute economic benefits to society equitably, government intervention as a social function may be necessary to some extent. – Government intervention on commodity prices may be desirable where and only where safeguarding the interests of the disadvantaged groups is the major objective. 72 Price elasticity of supply Price elasticity of supply (Es) is the measure of responsiveness of quantity supplied to changes in price of a given commodity over specific period of time. – If producers are relatively responsive to price changes, supply is elastic. – If they are relatively insensitive to price changes, supply is inelastic. Es is measured as percentage change in quantity supplied of product X divided by percentage change in price of product X. Algebraically, Es = [(Qs1 – Qs2)/(Qs1 + Qs2)]  [(P1 – P2)/P1 + P2)] 73 Calculating Price Elasticity of Supply Example – Suppose an increase in the price of a product from K400 to K600 increases the quantity supplied from 100 units to 140 units. Calculate price elasticity of supply. Es = (100 – 140)/(100 + 140)  (400 – 600)/(400 + 600) = (-40)/(240)  (-200)/(1000) = -1/6  -1/5 = 1/6  5/1 = 5/6; Thus, Es = 0.83 In this case, supply is inelastic, since the price elasticity coefficient is less than 1. – If Es is greater than 1, supply is elastic. – If Es is equal to 1, supply is unit-elasticity. Note that Es is never negative because price and quantity supplied are directly related. – Thus, there are no minus signs to drop as was necessary with elasticity of demand. 74 Determinant(s) of Price Elasticity of Supply The main determinant of price elasticity of supply is the amount of time producers have for responding to a change in product price. – The elasticity of supply varies directly with the amount of time producers have to respond to the price change. – A firm’s response to an increase in the price of product X over a give period of time depends on its ability to shift resources from production of other products whose prices are assumed to remain constant to the production of X. – Shifting resources takes time: the longer the time, the greater the degree of resource shifting. So, we can expect a greater response, and therefore greater elasticity of supply, the longer a firm has to adjust to a price change. – In the analysis of the impact of time on elasticity, economists distinguish among the immediate market period, the short run, and the long run. 75 Price Elasticity of Supply: The Immediate Market Period The market period is the period that occurs when the time immediately after a change in market price is too short for producers to respond with a change in quantity supplied. Suppose a smallholder farmer brings a truckload of tomatoes that is the whole season’s output. The supply curve for the tomatoes is perfectly inelastic (vertical); the farmer will sell the truckload whether the price is high or low. The reason is: because the farmer can offer only one truckload of tomatoes even if the price of tomatoes is much higher than anticipated. This farmer might wish to offer more tomatoes, but tomatoes cannot be produced overnight. – Another full growing season is needed to respond to a higher- than-expected price by producing more than one truckload. – Similarly, because the product is perishable, the farmer cannot withhold it from the market. If the price is lower than anticipated, the farmer will still sell the entire truckload. 76 Price Elasticity of Supply: The Immediate Market Period The farmer’s costs of production, incidentally, will not enter into this decision to sell. Though the price of tomatoes may fall far short of production costs, the farmer will nevertheless sell out to avoid a total loss through spoilage. During the market period, our farmer’s supply of tomatoes is fixed: Only one truckload is offered no matter how high or low the price. – As shown in the Figure 3.13, Supply is perfectly inelastic because the farmer does not have time to respond to a change in demand, (from D1 to D2). The resulting price increase (from P0 to Pm) simply determines which buyers get the fixed quantity supplied; it elicits no increase in output. Sm Pm Price P0 D2 D1 Figure 3.13: The immediate market supply 0 Qm 77 ES in the Immediate Market Period: Exceptions to the Rule However, not all supply curves need be perfectly inelastic immediately after a price change. – If the product is not perishable and the price rises, producers may choose to increase quantity supplied by opening up their inventories of unsold, stored goods. This will cause the market supply curve to attain some positive slope. – For our tomato farmer, the market period may be a full growing season; – For producers of goods that can inexpensively be stored, there may be no market period at all. 78 ES in the Short Run In the short run, the plant capacity of individual producers and of the entire industry is fixed. – Even so, firms do have time to use their fixed plants (resources) more or less intensively (applying more labour and more fertilizer and pesticides to the crop). – The result is somewhat greater output in response to a presumed increase in demand; this greater output is reflected in a more elastic supply of tomatoes, as shown by SS in Figure 3.14 below. PS SS D2 P0 D1 Figure 3.14: Es in the Short-run 0 Q0 QS – Note now that the increase in demand from (D1 to D2) is met by an increase in quantity from (Q0 to QS), so there is a smaller price adjustment from (P0 to PS) than would be the case in the market period 79.  The Long Run Price Elasticity of Supply The long run is a time period long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry or market. – In the “tomato industry,” for example, our farmer has time to acquire additional land and buy more machinery and equipment. – Furthermore, other farmers may, over time, be attracted to tomato farming by the increased demand and higher price. Such adjustments create a larger supply response, as represented by the more elastic supply curve SL in Figure 3.15, below. SL PL P0 D2 Figure 3.15: Es in the Long-run D1 0 Q0 QL – The outcome is a smaller price rise (P0 to PL) and a larger output increase (Q0 to QL) in response to the increase in demand from D1 to80D2. Revenue test for price elasticity of supply? Note that there is no total-revenue test for the elasticity of supply. – Supply shows a positive or direct relationship between price and amount supplied; the supply curve slopes upwards. – Therefore, regardless of the degree of elasticity or inelasticity, price and total revenue always move together. 81 Price Determination in Agricultural Markets: Behaviour of Farm Prices ❑ Market Prices ▪ Market prices are signals that direct production and consumption decisions. ▪ Price analysis and forecasting is fundamentally very useful in agricultural economics and any other disciplines that involve marketing of products and services. ▪ In any type of economy prices are the economic messenger for the entire system. For the free-market economy, the role of prices is crucial – for economic strength, direction as well as size. Societies depend upon market prices for a number of very important economic functions. It is commonly believed that in a free-market economy, prices are determined by the interaction of the forces of demand (buyers) and supply (producers). ▪ Actually, farm prices are determined jointly by (i) consumer demand, (ii) farm supply and (iii) the food marketing system. All these three are important in price determination; a change in any one of these usually results in adjustments of the other two. 82 Economic Functions of prices: (1) Prices fix standards of value ❑ To maximize satisfaction, consumers cast their purchasing votes in the form of prices that they are willing to pay in the market place. Thus, prices determine the relative values (or fix the standards of value) among commodities. In purchasing products in the market place, consumers send a message regarding the relative levels of satisfaction that are realized from various sorts of consumption. ❑ Producers who are committed to maximizing profits or returns to the resources that they control, strictly follow consumers’ purchases. Based on consumer’s desires, producers allocate their resources in such a manner that production maximizes returns to the resources. ❑ In other words, the standards of value, as fixed by the price system, provide the information necessary for the organizational types of managerial decisions made by producers. 83 Economic Functions of prices (continued) (2) Prices organize production ❑ How do prices organize production? This function of price is best studied through the production management models. Briefly, prices organize production in the following ways: ▪ (i) The Simple production function (Factor – Product Model). The Factor-Product model shows how producers use prices of inputs and outputs to determine levels of variable resources to use and the level of outputs to produce and offer for sale. ▪ In profit maximization criterion production manager would select that level of variable resource usage that equates the marginal cost of the variable input (MVC) with the value of the marginal product (MP). – i.e. MVC = MP. ▪ If the price of the product or the variable resource changes, the use of that resource and the output of the product would have to be adjusted to reflect that change. 84 Economic Functions of prices (continued) ❑ Prices organize production ▪ (ii) The Factor- Factor model shows the manner in which managers utilize resource prices to determine the least-cost combination of resources to use in the production of given levels of output. ▪ For any level of output, managers will utilize that combination of variable resources where the marginal rate at which one factor of production may be substituted for another is equal to the inverse ratio of factor prices - i.e. when ∆x2/∆ x1 = Px1/Px2. ▪ If the price of one factor of production should change, the manager will substitute the now relatively cheaper factor for the expensive factor. ▪ Substitution will continue so long as a unit of money spent on one resource will replace more than a unit of money’s worth of another. ▪ When the marginal rate of factor substitution is exactly equal to the inverse ratio of factor prices, the new cost minimizing combination of factors has been achieved. 85 Economic Functions of prices (continued) ❑ Prices organize production ▪ (iii) The Product-Product model is concerned with revenue maximizing combination of products to produce with a given resource outlay. ▪ In this model, managers will shift resources from one product to another so long as a unit of money lost from a reduction in the output of one product is replaced with more than one unit of money gained in the output of the other. ▪ Thus, managers will substitute one product for another up to the point where the marginal rate of product transformation is exactly equal to the inverse ratio of product prices – i.e. when ∆B/∆A = PA/PB. 86 Economic Functions of prices (continued) (3) Prices distribute products (both geographically and among consumers) ❑ The produced commodities must be distributed among its various consumers. ▪ The rationing function of price will determine who gets what based on consumer’s ability and willingness to pay the necessary price. ▪ Significantly, consumer income will determine how much will be bought. At very high prices, only a few people with high levels of income and who derive large degree of satisfaction from consuming the product will be willing and able to purchase the commodities. ▪ However, with increased production, the price falls and consumption of the goods spreads over a larger group. As the prices decline more and more people participate in the consumption, and the level of consumption also increases. ▪ Thus, product-distribution function of price is shown. As price declines, the number of people (consumers) participating in the market grows larger. 87 Economic Functions of prices (continued) (3) Prices distribute products (continued) ❑ Geographically, market prices are lowest at the point of production (farm- gate prices). ▪ Far away from the point of production, prices (retail prices) are higher in order to pay for cost of transportation from the farm to the point of consumption. ▪ Market prices at the point of consumption are also higher because of the costs of processing and other marketing services that are performed on a given food commodity. 88 Economic Functions of prices (continued) (4) Prices ration products (over time) ❑ The short-run rationing of the product as performed by the price system means that the use of the product is spread over a longer period of time. ▪ This price function is particularly important in the case of agricultural commodities, because of the seasonality in the production of many of agricultural goods. ▪ For example, maize is harvested between April and June and yet its consumption must spread over several months until the next crop is harvested. ▪ During this (between harvest) period, prices fluctuate as producers try to spread their income by holding some of the agricultural commodities and releasing them for sale during specified time periods. 89 Economic Functions of prices (continued) (5) Prices provide for maintenance and growth in the economy ❑ Product prices must be high enough for the replacement cost of capital equipment to be covered, otherwise the products produced by that capital equipment would gradually disappear. ❑ On the other hand, if costs are just barely being covered, then there will be no funds to reinvest in the business for expansion of the enterprise. ❑Thus, the money votes that consumers cast (the consumer purchases made) in the form of prices determine what products are to be available and in what quantities. ❑In a capitalism the dynamics of the economy provide the source of price movements that create entrepreneurial opportunities. ❑Anticipating these price movements can yield some enormous benefits to the astute (wise) and can extract some enormous penalties from those who are unaware. 90 Forces that influence farm prices ❑ There are four categories of forces that influence farm prices: ▪ (1) Supply conditions affecting farm and food prices including farm production decisions, weather, diseases, harvested hectares of land, and food imports. ▪ (2) The demand conditions including income, prices, tastes and preferences, population, and exports. ▪ (3) The food marketing sector influences farm prices through its value- adding activities, price and cost behaviour, and procurement strategies. ▪ (4) Government influence through price supports (e.g. subsidies), supply controls (e.g. quota), trade policies, or policies influencing domestic demand for food. 91 Farm and nonfood price trends ❑ Although food and non-food wholesale prices tend to move together broadly over the long run, there are significant short run differences in these prices. ▪ Food prices fluctuate much more than nonfood prices. ▪ Food prices also tend to be flexible in upward and downward swings while nonfood prices tend to rise steadily over time (on a year-to-year basis). ▪ A major reason for this difference in year-to-year price movements is the greater control over output that is possible with nonfood products. ▪ Annual variability in food prices reflects the difficulty of tailoring supply to demand when the product is susceptible to weather, disease, and other unpredictable elements. ▪ Factory production of nonfood products, on the other hand, is much more stable and prices also tend to be more stable than those of food products because factory production itself is easily controlled. 92 Price movements between retail food and non-food commodities ❑ In the long run, retail food and nonfood prices tend to move in the same direction, but at different rates. ▪ Price changes in retail food prices are sometimes greater and sometimes less than nonfood price changes. ▪ The reasons for the retail food and nonfood prices to move together in the long run are as follows: (i) A large percentage of retail food prices is determined by food marketing costs, such as energy (electricity), labour, packaging, and freight (transportation), which affect equally both food and nonfood prices; (ii) Farmers’ purchases of supplies from the industrial sector tend to build the above costs into food prices; and (iii) Over the long run, the same economic forces affect both food and nonfood prices. 93 How closely do farm, wholesale and retail food prices move together? ❑ Farm and retail price may not move together for the following reasons: (i) Time lag necessary to transfer the product from the farm to the grocery shelf. Fresh foods move through the marketing channel more rapidly than highly processed foods, but all products spend some time in transit and in inventory (storage). Therefore, a snapshot of today’s farm and retail prices would not record exactly the same commodity at each market level. (ii) Changes in marketing costs and profits also will reduce the relationship between farm and retail food prices. (iii) Many consumer products are often made from an individual farm commodity. For example, a steer is used for meat, hide and other by- products; soybean produces oil and meal. Because each of these products is subject to different economic conditions, the farm price of the commodity may not correlate precisely with any of the retail prices. (iv) Pricing strategies, such as weekend special discounts may also alter the day-to-day relationship between farm and retail food prices. 94 How closely do farm, wholesale and retail food prices move together? (continued) ❑ Farm prices are more closely related to wholesale prices than to retail prices. ▪ This suggests that the market price relationships decline as foods move closer to the retail level and as more marketing services are added. ▪ The correlation of farm and retail prices is greater for fresh foods than for highly processed foods. 95 Fluctuations in prices of agricultural commodities ❑ Many markets for agricultural products are notoriously unstable – that is, prices vary widely and erratically. ▪ Wide and frequent commodity price fluctuations are the rule; stable prices of individual commodities are the exception. ▪ Generally, quarterly crop prices tend to be more stable than livestock prices, and both often move counter to each other, suggesting relative stability in “all farm prices.” ▪ There are numerous conditions that contribute to agricultural price instability, but two factors predominate – one is a demand characteristic, the other is a characteristic of supply. 96 Factors behind fluctuating prices of agricultural commodities ❑ On the demand side- Demand factors also contribute to price variations in agriculture. ▪ At international level, changes in world market demand for a particular commodity tend to affect production of that commodity in a given country. ▪ For instance, some large trade partners may make substantial purchases of Malawian farm products one year but not the next. ▪ Increased demand for the product on the international market will correspondingly increase prices of the product in the domestic market. ▪ In response, farmers will be enticed to produce more of the given product in order to beat the world market demand, only to end up with surpluses when the demand dwindles. ▪ Domestic changes in consumer incomes, employment, and business conditions influence the demand for food and its price. ▪ In the short-run the food demand curve shifts up and down a relatively inelastic supply curve, making most of the adjustment in prices. 97 Factors behind fluctuating prices of agricultural commodities (continued) ❑ On the supply side- Basic Features of Agricultural Supply (i) Agricultural production is generally is subject to natural factors. ▪ Variations in the producer output decisions, weather, disease, and other unpredictable events affect amount of cultivated land, yields, output and prices. ▪ Some supply factors can be controlled by farmers and some cannot, but even a farmer’s efforts to tailor supply to demand can be frustrated by uncontrollable events or elements of production. For instance, the farmer may respond to predictions or expectations by changing hactarage, but the yield may be lower than average. In most cases, farmer responses to changing prices will reduce price fluctuation, just as when high prices encourage increased supply, which in turn reduces prices. ▪ There is a biological lag in this process, which prevents immediate supply responses to high or low farm prices. ▪ Because of the natural factors, which affect agricultural production, planned production and actual quantities supplied to the market may be totally different. Thus, in an agricultural market, prices must vary to equate quantity demanded with the actual quantity supplied. 98 Factors behind fluctuating prices of agricultural commodities (continued) ❑ On the supply side- Basic Features of Agricultural Supply (ii) Most agricultural products have low price elasticities of demand. ▪ As such, market forces tend to magnify the fluctuations in output into proportionately greater price fluctuations. ▪ If actual supply always equals planned supply, market equilibrium would be established and maintained with a given level quantity at a given price level. ▪ Unplanned variations in output lead to proportionately larger variations in price. (iii) Revenue from the sale of the product will be inversely related to quantity supplied. ▪ This leads to the somewhat paradoxical development that what is a “good” year for crop yields can turn out to be a “poor” year for farm incomes. ▪ No wonder, farmers can develop a cynical attitude to the operation of agricultural markets. 99 Factors behind fluctuating prices of agricultural commodities (continued) ❑ On the supply side- Basic Features of Agricultural Supply (iv)There is production time lag. ▪ This characteristic is best described through a simple model of an agricultural market, called the cobweb. ▪ The cobweb model or theorem predicts the development of a market cycle. ▪ It relates a market for which the conditions of perfect competition apply with the incorporation of an additional assumption, that there is a time lag of sufficient length to encompass the biological life cycle, between the decision to produce a certain level of output and the produce becoming available for supply to the market. ▪ The cobweb theorem also explains the cyclic nature of agricultural production or supply of agricultural commodities. 100 Cobweb Theorem The economic theory that has been developed to explain cycles in agricultural prices and production is the Cobweb theorem. It was originally advanced by Mordecai Ezekiel in 1938. Although the Cobweb theorem faces some criticisms, it is useful in understanding just how cycles come into being. There are several assumptions associated with the cobweb model, some of which will be at odds with the facts for almost any agricultural product for almost any time period that an analysis is made. Some of the fundamental assumptions may be inconsistent with the reality however; this does not negate the usefulness of the model in understanding the reasons for the existence of cycles. 101 Cobweb Theorem (continued) ❑ Essential Assumptions of the Cobweb Model/Theorem (i) Price is determined in a purely competitive market environment in which no seller has a market share large enough to influence the price. (ii) Current prices are determined largely by currently available supplies, which are subject to little or no modification in the immediate period. (iii) Producers plan production for the next period primarily on the basis of recently observed prices. (iv) There is a lag of at least one production period between the time of a decision to produce and the actual availability of that production. That is, current production is a function of previously observed prices, and, under the constraint of the second assumption, current prices are largely a function of current supplies. (v) Planned production is ultimately realized as actual production – a heroic (superhuman) assumption in and of itself, given nature’s propensity to sabotage even the best of biological plans. (vi) Demand and supply relationships remain constant. That is, the ceteris paribus conditions do in fact remain constant long enough for the full adjustment process to occur – another heroic assumption. 102 Types of cobweb (i) The Stable (Continuous) Cobweb S Price per unit Pa Pe Pb D2 D1 Figure 3.16: Stable (Continuous) Cobweb 0 QSb Qe QSa ▪ Suppose an increase in the price of a substitute good has caused the market demand to shift from D1 to D2 (Figure 3.16). The equilibrium market price rises from Pb to Pe. Producers who produced QSb in anticipation of price Pb now find that consumers are willing to pay a higher price of Pa. Pa encourages producers to expand output to QSa, which in turn causes prices to fall to Pb. Producers reduce output in response to this lower price (Pb) and a continuous oscillation of both price and output is established. In this case, the new equilibrium position is never reached. ▪ The “stable cobweb” occurs when market supply and market demand are equally elastic in the neighborhood of the market equilibrium. 103 Types of cobweb (continued) (ii) The Diverging Cobweb Price per unit S Pb D4 Pe D3 Pa D2 D1 0 QSa Qe QSb Figure 3.17: Diverging Cobweb: Market demand is less elastic than supply ▪ Suppose that market demand is relatively less elastic than market supply. ▪ In this case, the price and output oscillate around the market equilibrium position, but are continually diverging farther and farther from that equilibrium (Figure 3.17). ▪ The resulting divergent pattern gives an enormously unstable pattern to both prices and output. 104 Types of cobweb (continued) (iii) The Converging Cobweb Price per unit S P1 D3 Pe P2 D1 D2 0 Qe Qs Figure 3.18: Converging Cobweb: Market demand is more elastic than supply ▪ In the case in which market demand is relatively more elastic at equilibrium than market supply (Figure 3.18), the adjustment process allows price and output to oscillate around the market equilibrium, but always converging on that equilibrium. ▪ The rate of convergence upon the equilibrium is primarily related to the degree of difference in the relative price elasticities of supply and demand at the equilibrium position. 105  Inconsistence among the three cobweb models ❑ There are several apparent inconsistencies among the three cobweb models, economic theory and reality. ▪ The Convergent Cobweb model is the only one that is consistent with the equilibrium theory that is advanced in most principles of economics courses in which market supply is less price elastic than is market demand. ▪ However, except for very short-term, empirical research elsewhere has shown the market supply of almost any agricultural product to be relatively more price elastic than is the market demand. ▪ Furthermore, the typical cycle in agricultural production is of the continuous type rather than the divergent sort that would be suggested by the relatively greater price elasticity of the supply relationship. ▪ Thus, it is clear that these models need some modification. 106  Inconsistence among the three cobweb models ❑ The straight-line relationships postulated for supply and demand in the cobweb models are inappropriate at least for most agricultural goods. ▪ It is far more likely that agricultural supply functions are of an inverted “S” type than a straight line (Figure 4.9). Price per unit S D Figure 3.19: Demand and supply relationships for agricultural products ▪ This type of supply function – quite inelastic on both ends and much less inelastic in the middle – suggests that at very low prices, only those resources, which are exceedingly well adapted, perhaps even exclusively adapted to the production of the good in question, will be employed. ▪ As prices rise, those resources, which are somewhat less well adapted to this product, will be drawn into production. ▪ As prices continue to rise, more and more of the less well-suited resources are attracted, up to the point at which all resources that can be used for this commodity are employed. 107 References Cramer, G.L., Clarence W. Jensen and Douglas D. Southgate, Jr., (1997). Agricultural Economics and Agribusiness, 7th Edition, New York, John Wiley and Sons, Inc. pp49 - 73. McConnell, R.C. and Stanley L. Brue (2002). Economics: principles, problems, and policies, 15th Edition, New York, USA, McGraw-Hill Companies Inc. pp40 - 58; pp374 - 393. 108