Unit 2 Demand for Agricultural Products PDF

AGE 4142 UNIT 2: DEMAND FOR AGRICULTURAL PRODUCTS Demand for Agricultural Products 1  PRICE DETERMINATION Theoretically, prices for a commodity/service are determined by the interaction of the consumer and producer sides of the market  Consumers demand for a pr...

AGE 4142 UNIT 2: DEMAND FOR AGRICULTURAL PRODUCTS Demand for Agricultural Products 1  PRICE DETERMINATION Theoretically, prices for a commodity/service are determined by the interaction of the consumer and producer sides of the market  Consumers demand for a product  Producers supply the product The price – market clearing. Demand for Agricultural Products 2 Individual demand Individual supply Market demand Market supply Market Equilibrium Demand for Agricultural Products 3  LOGICAL BASIS OF DEMAND THEORY Basic unit of demand theory is the individual consumer or household Each consumer is confronted by two problems:  Problem of choice  Limitation of income Challenge is to choose the specific goods and services that “best” satisfy the consumers wants within the limits imposed by income. Demand for Agricultural Products 4  Economists define best in terms of the consumer’s attempt to maximise utility (measure of wellbeing due to consumption). We can identify this best by combining preference and income information for the consumer  Utility function  Budget line Concept – utility maximizing rule – maximize utility subject to a budget line (constrained optimization) Demand for Agricultural Products 5  Mathematically – function of goods consume, function for the budget line given particular income Graphically – indifference curve, budget line depending on complexity Demand for Agricultural Products 6 Suppose we have only 2 goods, X and Y, budget level BL1 and utility level U1; from Utility maximization theory: Y, clothing A U1 BL1 XA X, food Demand for Agricultural Products 7  Utility is maximized at point A, giving XA and YA units of the goods  Each point A has a specific income, utility level and prices of goods. For good X, the utility maximizing quantity XA corresponds to these specific levels, the same applies to Y. We figure out the consumer’s demand for each good by altering the parameters in the utility maximization model – to draw a single demand curve we change price  Any changes in satisfaction (e.g change in tastes and preferences, age etc), prices and income will lead to a different equilibrium point  Key output is the consumer’s demand model for each good Demand for Agricultural Products 8  CONSUMER DEMAND Depicts various quantities of a particular commodity that an individual consumer is able to buy as price varies, ceteris paribus(all other factors affecting demand held constant).  Varying price leads to different utility maximizing points in our 2 goods market  Demand for good X will be the different XA s corresponding to each price  Holding income, utility and prices of other goods constant Demand for Agricultural Products 9  Consumer demand described in two ways:  Demand schedule  Demand curve Law of demand - Inverse relationship between price and quantity demanded  Evident in downward slope  Can be explained by substitution and income effects of a price change Demand for Agricultural Products 10 Effects of a Price change Substitution effect: Change in the amount of a good that would be consumed as the price of that good changes, holding constant all other prices and the level of utility.  Change in relative attractiveness Income effect: Change in the amount of a good that a consumer would buy as purchasing power changes, holding all prices constant Demand for Agricultural Products 11 Final basket after decrease in Px Y, clothing A C B U2 BL1 U1 BL2 XA X, food XC Demand for Agricultural Products 12  Substitution effect is always negative - an increase in price invariably results in a decrease in consumption if there is an offsetting change in money income Income effect can be  negative – normal good, increase in price, decrease in real income, decrease in q  or positive - inferior good, increase in price, decrease in real income, increase in q Size of total effect changes Demand for Agricultural Products 13 Individual demand curve Price PXA PXC XA XC Quantity of X Demand for Agricultural Products 14  MARKET DEMAND Demand functions vary across individuals based on their tastes and preferences and the utility maximization dynamics Market demand for a commodity will be the aggregate of these individual demand functions  Summation of quantities demanded at each price Market demand is alternative quantities of a commodity that all consumers in a particular market are able to buy as price varies. Demand for Agricultural Products 15 STATIC AND DYNAMIC ASPECTS OF DEMAND Static concept of demand refers to movements along a demand curve; change in quantity demand.  It is static in the sense that we are looking only at quantity response to price, ceteris paribus. Dynamic can be understood in two ways:  Changes in demand – a shift in the demand curve associated with factors influencing demand  Lags in adjustment –posits that quantity adjustments do not take place instantaneously because of imperfect knowledge, time required to make changes etc. Demand for Agricultural Products 16  CHANGES IN DEMAND Critical to distinguish between a change in quantity demanded and a change in demand. Determinants of demand include:  Population size and its distribution by age, geographic area, etc.  Consumer income and its distribution  Prices and availability of other commodities and services  Consumer tastes and preferences Demand for Agricultural Products 17 Increase in Demand Decrease in Demand 11/06/2024 Unit 2: Demand for Agricultural Pr 18 oducts Population Dynamics Increase in demand is closely linked to the rate of population growth Age distribution also influences total demand as well as the demand for different commodities. Changes in the regional distribution of the population Changes in the ethnic composition Demand for Agricultural Products 19 Income and its distribution For most agricultural commodities, income and demand are positively related.  But they are some products for which the reverse is true. Relationship between total income and the quantity purchased is sometimes referred to as an Engel curve/consumption function. Changes in demand can also occur as a result of distributing income from the rich to the poor Demand for Agricultural Products 20 Price Dynamics Demand of each commodity is a function of own price and prices of other commodities Direction of change in demand depends on:  Direction of change in the price of the related commodity  Whether the related commodity is a substitute or a complement Most agricultural products are substitutes Demand for Agricultural Products 21 Tastes and Preferences Changes in tastes and preferences contribute to shifts in demand for agricultural products. Tastes and preferences for individual consumers may change for a variety of reasons:  Age  Education  Experience  Advertising Long-run trends in per capita consumption are used as indicators of changes in preferences. Demand for Agricultural Products 22 CONCEPT OF A DISTRIBUTED LAG In the real world, the quantity demanded at a given price is likely to change gradually over time. Lapse of time between a cause and its effect is called a lag. Effect is likely to be spread through time leading to distributed lag.  Arises from a delayed response that is spread over time. Demand for Agricultural Products 23  SPECULATIVE DEMAND Speculative demand represents a type of demand related to anticipated use and prices, relative to current prices. Agricultural products are seasonal in nature, thus speculative demand is of interest in agriculture economics. A demand function can be interpreted as including both demand for current use and for speculative purposes. Additional factors may contribute to shifts in demand assuming speculative demand is incorporated in the demand function. Demand for Agricultural Products 24  What drives speculative demand?  Inventory holders such as grain traders wanting to maximise profits  Prospects of changes in production in future Speculation can be viewed as:  Bad when it increases the amplitude and frequency of price changes  Good when it correctly anticipates future events and leads to a moderating effect on prices Demand for Agricultural Products 25  DERIVED DEMAND Ultimate consumer is one who determines the shape and position of the demand curve Consumer demand relationships are often referred to as primary demand. Derived demand is a term used to denote demand schedules for inputs that are used to produce the final products.  Demand for wheat and maize is derived from the demand of end products like bread and mealie meal. Demand for Agricultural Products 26  Derived demand differs from primary demand by the amount of marketing and processing charges per unit of product. Derived demand curve can change either because the primary demand curve shifts or because marketing margins change Demand for Agricultural Products 27  UNIT 2 PART B: DEMAND ELASTICITIES AND RELATED COEFFICIENTS Demand for Agricultural Products 28 Price Elasticity of Demand Measures the sensitivity of the quantity demanded to price:  Point formula (an increase/decrease in price at particular point)  Average elasticity – arc elasticity formula, elasticity between 2 points (look it up) Value of εQ,P must always be negative, reflecting the fact that demand curves slope downward. Demand for Agricultural Products 29 Price Elasticity of Demand (2) Value of εQ,P Classification Interpretation 0 Perfectly inelastic Quantity demanded is demand completely insensitive to price Between 0 and -1 Inelastic demand Quantity demanded is relatively insensitive to price -1 Unitary elastic % increase in demand is demand equal to % decrease in price Between -1 and -∞ Elastic demand Quantity demanded is relatively sensitive to price -∞ Perfectly elastic Any increase in price results demand in quantity demanded decreasing to zero, and any decrease in price results in quantity demanded increasing to infinity Demand for Agricultural Products 30 Price Elasticity of Demand (3) Remember varies along the demand curve Linear demand curve, from -∞ to Zero  Can you demonstrate? When we say demand for a product is elastic/inelastic, refer to the normal range of prices for that good Demand for Agricultural Products 31 Price Elasticity of Demand (3) Price elasticity of demand is an important aspect in several ways:  Useful piece of information for businesses deciding to price their products or services  Important determinant of the structure and nature of competition within particular industries  Important in determining the effect of various kinds of governmental interventions such as tariffs, price ceilings and import quotas. Demand for Agricultural Products 32 Elasticity of Demand and Total Revenue Price change affects a business’ total revenue. A price increase does not necessarily translate into increased revenue.  Inelastic – direct, increase price increase revenue  Elastic – inverse, increase price, decrease revenue Critical to know the elasticity of demand of the product sold Demand for Agricultural Products 33 Determinants of the Price Elasticity of Demand Demand tends to be more price elastic when there are good substitutes for a product. Demand tends to be more price elastic when a consumer’s expenditure on the product is large. Demand tends to be less price elastic when the product is seen by consumers as being a necessity. Demand for Agricultural Products 34 Income Elasticity of Demand Ratio of the % change of quantity demanded to the % change of income, holding price and other determinants of demand constant. Income elasticity can be positive or negative  A positive income elasticity indicates that demand for a good rises as consumer income goes up  A negative income elasticity indicates that demand for a good falls as consumer income goes up. Demand for Agricultural Products 35 Cross Price Elasticity of Demand Ratio of the % change of the quantity of one good demanded with respect to the % change in the price of another good Cross price elasticities can be positive or negative.  If a higher price for good j increases the demand for good i (demand substitutes).  If , a higher price for good j decreases the demand for good i (demand complements) Demand for Agricultural Products 36  Relationships among Elasticities in the Context of Consumer Demand There are key relationships among elasticities that are useful in the estimation of elasticities for food products. Three important relationships exist:  Homogeneity condition  Symmetry/slutsky condition  Engel Aggregation condition Demand for Agricultural Products 37 Homogeneity Condition States that the sum of the own- and cross-price elasticities and the income elasticity for a particular commodity is, taking account of signs, zero: Demand for Agricultural Products 38 Homogeneity Condition (2) Implications: Large income elasticity, large income elasticity - > large own price elasticity Large # of close substitutes, large eii Demand for Agricultural Products 39 Homogeneity Condition (2) Two assumptions are made with the homogeneity condition:  Income elasticity is positive  Most of the cross relationships are substitute relations and hence the cross elasticities are mostly positive numbers. With these assumptions, the homogeneity condition suggests that the absolute value of the own-price elasticity is likely to be greater than the values of the cross-price elasticities Demand for Agricultural Products 40 Symmetry Condition This specifies the relationship between the cross elasticities εiJ and εJi, namely: Demand for Agricultural Products 41 Symmetry Condition (2) An approximation of this condition has been developed with the following assumptions:  Consumer’s expenditure on commodity j is a small fraction of total income  Income elasticities for the two commodities are approximately equal Using the two formulas, if εJi is known, then εiJ can be estimated and vice versa Demand for Agricultural Products 42 Engel Aggregation Condition States that the weighted sum of the income elasticities for all items in a consumer’s budget is one. The weights are the expenditures on the respective commodities as a proportion of the total expenditures (the Ri’s) The equation for n items is: Demand for Agricultural Products 43 Total Elasticity If the price for one commodity changes, the price of its substitutes tend to change as well, but by varying amounts. Thus, a change in the price of one commodity sets in motion forces which ultimately result in a new structure of prices. Total elasticity is defined as the net % change in quantity resulting from one % change in own price, taking account of the interactions of related variables. Demand for Agricultural Products 44 Total Elasticity Assuming just one substitute (j) for the commodity i, the total elasticity for i is: Demand for Agricultural Products 45 PRICE FLEXIBILITY COEFFICIENT Inverse of price elasticity % change in price associated with a 1% change in quantity, other factors constant. One could infer from this that price is dependent on quantity. Concept is important in agriculture because in most cases, quantity is exogenous and determines price. Price flexibility coefficient is depicted as: Demand for Agricultural Products 46 END OF UNIT 2 Demand for Agricultural Products 47