Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Chapter 2 Basic Price Analysis: Supply and Demand

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Introduction Supply and demand are not the only determinants or price. Objects of this Chapter: 1. To present the basics of supply and demand 2. To discuss price formation and price changes in the model of perfect competition 3. To present a general theory of prices

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Economic Profit = Revenues – Opportunity Costs  The difference between economic profit and accounting profit is this: Accounting profit tells you whether you are making money Economic profit tells you whether you are making the most money you can

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Production: the transformation of inputs to outputs. Marginal Opportunity Costs (or Marginal Costs): the additional opportunity cost of producing one more unit.  Example: Marginal Opportunity Cost of jogging. Suppose you jog in one mile intervals. Marginal cost is analogous to the time it takes to run an additional mile. The first mile you are full of energy and complete it rather fast. The second mile you have less energy and it takes you longer—the marginal cost rises. The marginal cost or jogging a mile increases the more miles you jog.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Marginal Opportunity cost is increasing in the number or units produced.  Some inputs to production are always limited. Arable acres, fertilizer, potential employment  Some inputs can remain fixed, but at least one input must increase for production to increase. A farmer can produce more soybeans on the same amount of land but use more irrigation or fertilizer.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Two things happen when industry output rises the availability of some inputs is limited. 1. When firms try to increase their use of inputs that are limited, they bid up the price of those inputs, which raises production costs. If farmers collectively increase production by using more pesticides, they will bid up the price of the pesticides in the process increase the cost of production. Marginal cost rises when industry production rises.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Two things happen when industry output rises the availability of some inputs is limited. 2. The more one uses an input, the less productive that input becomes.  The first ten pounds of fertilizer applied to crops increase yield more than the second ten pounds.  The more days you feed hogs the larger they will grow; but just like you grew faster when you were younger, hogs grow slower as they grow older. This means it becomes more and more expensive to grow heavier hogs the longer you feed them. Feed becomes less productive the more it is used.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Marginal Product: the additional output realized from one unit increase in input use.  Feeding a hog one extra pound of corn daily may increase daily weight gain by 0.5 lbs. But increasing daily feed by another pound may only increase daily weight gain by 0.25 lbs. This is called diminishing marginal product. Diminishing Marginal Product: concept describing the fact that the more input one uses, the smaller the marginal product.  As input use rises, the contribution of each additional input to production falls.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.1. The marginal opportunity cost of production increases with the number of units produced As the industry increases its production level, the low-cost firms hit capacity and cannot produce anymore.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. The additional production must come from high-cost firms. Figure 2.1. The marginal opportunity cost of production increases with the number of units produced

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.2. If firms are price takers, they will produce where price equals the marginal opportunity cost of production “Price Takers”: producers who have no control over the price they receive for their product. If firms produce the first unit and sell it, they will receive a price higher than the marginal cost of production. Anytime a firm can sell for a greater price than their cost of production, they earn more money.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.2. If firms are price takers, they will produce where price equals the marginal opportunity cost of production The marginal cost of the second unit is also lower than the price, so firms can produce a second unit as well. Still making a profit.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.2. If firms are price takers, they will produce where price equals the marginal opportunity cost of production Once the industry has produced three units, the marginal cost of producing another unit is equal to the price. Another way to say it is: Break-even point.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.2. If firms are price takers, they will produce where price equals the marginal opportunity cost of production If the firms sell the fourth unit, they will lose money! The firm is loosing money buy selling the fourth unit.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Firms will produce where the price equals the marginal opportunity cost of production. Marginal Cost Curve = Supply Curve  Supply curve tells us exactly how much firms will produce at a given price.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve Producer Surplus = Price – Marginal Costs The shaded area on the graph shows the Producer Surplus. PS

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Opportunity Cost of Production: The Supply Curve There is a direct relationship between producer surplus and economic profits  To see the relationship you must understand more about costs.  There are two types of costs: Fixed and Variable Fixed Costs: those costs that are the same no matter how many units are produced. Variable Costs: those costs that change depending on how many units are produced. (Marginal Cost only includes variable costs.) Producer surplus = Total Revenues – Total Variable Opportunity Costs  This is profits without fixed costs.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Supply Curve Shifts Supply Curve tells how many more units will be produced as the price increases. Supply curve tells how many fewer units will be produced as the price decreases. These changes are referred to as changes along the supply curve. Change in the Supply Curve or a Shift in the Supply Curve: any factor that changes the marginal opportunity cost of production changes the position of the supply curve.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Supply Curve Shifts Decrease in Supply: any factor that tends to increase the marginal opportunity cost of product will shift the supply curve upward. Increase in Supply: any factor that tends to decrease the marginal opportunity cost of product will shift the supply curve downward.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Supply Curve Shifts There are many factors that can change the marginal opportunity cost of production and they can generally be categorized as follows:  Price of Related Outputs  Price of inputs  Technology

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Supply Curve Shifts Example: Soybean Farmer  If seed prices increase, the marginal cost increases, there will be a decrease in supply.  Scientists and Commercialized genetically modified seed was developed lowering production costs. This increased supply. If producing cotton is the next best alternative:  As the cotton prices rise, some farmers will cease growing soybeans and begin growing cotton, causing the quantity supplied of soybeans to fall.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Supply Curve Shifts An increase in supply is not always good for producers.  A new technology, such as genetically modified seeds, will likely cause an increase in the supply curve by shifting the supply curve downward.  This means producers are producing more soybeans, also meaning that there will be more soybeans to be consumed which will lower the price. (Price lowering is used to entice consumers to increase their purchases.)

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Consumer Value: The Demand Curve Marginal Consumer Value of a good: the value to consumers of one more unit of the good.  The marginal consumer value declines as a greater number of units are consumed. This is referred to as diminishing marginal value of consumption. Example: Doughnuts  You want Krispy Kreme doughnuts. The 1 st one is heaven. The 2 nd one is pretty good. The 3 rd one is still good. The 4 th one you get halfway through and can’t eat anymore. Now, someone would have to pay you to eat more, this makes the marginal consumer value of a doughnut (the value of one more doughnut) becomes negative.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.4. Marginal Consumer Value

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Consumer Value: The Demand Curve The demand curve reflects the value to all consumers for all units purchased. Price Takers: Consumers who pay the listed price with out negotiations.  Wal-Mart customers are price takers.  Marginal Value Curve tells us exactly how many units consumers will purchase as price takers. Consumers keep purchasing another unit as long as the marginal value is greater than or equal to the price. This is why we call the Marginal Value Curve the Demand Curve

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.5. Consumers purchase a number of units where price equals the marginal value curve

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts A Movement Along the Demand Curve is when prices increase or decrease. Five Main Factors for shifting the demand curve:  Price changes of Relative Goods  Changes in Income  Changes in Population  Changes in Tastes  Changes in Expectations

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts Increase in Demand or Rightward Shift in Demand: something that tends to increase consumers’ willingness-to-pay. Decrease in Demand or Leftward Shift in Demand: something that tends to decrease consumers’ willingness-to-pay.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts Consider the price of related goods:  Most people would increase their willingness-to- pay for Dr. Pepper if the price of Coca-Cola increased in the vending machine. Dr. Pepper and Coca-Cola are substitute goods. Two goods are substitutes if people increase the amount they are willing to pay (or buy) for one good when the price of the other good increases.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts Consider the price of related goods:  If you tend to buy Dr. Pepper and Snickers bar at the same time for a midday snack, increasing the price of Snickers might actually reduce your willingness-to-pay for Dr. Pepper. The Dr. Pepper and Snickers bar are complement goods. Two goods are complements if people decrease the amount they are willing to pay (to buy) for one good when the price of the other good increases.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts Consider the price of related goods:  Perfect Complements: where one good is necessary to use the other. Example: Your willingness-to-pay for a n aluminum can is probably $0 unless it contains Dr. Pepper liquid, and your willingness-to-pay for Dr. Pepper liquid is probably $0 unless you have something to put it in. In this example Dr. Pepper liquid and the aluminum cans are perfect complements.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Demand Curve Shifts Consider how income affects demand for a good:  Normal Goods: where demand rises as income rises and demand falls as income falls Luxury goods: one where when income increases by a certain amount, demand for the good rises by a more than proportional amount. (Example: Buying more Starbucks as your income increases) Inferior Goods: demand for the good falls as income rises, and vise versa (Example: Buying Dr. Pepper instead of Dr. Thunder as income rises.) (College education is often viewed as an inferior good.)

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. A Perfectly Competitive Market Perfectly Competitive Markets:  Exists when: There are many buyers and sellers, each with roughly the same market share. All sellers produce identical goods. Information on how to produce and use the good is freely available Easy entry and exit into the market.  In perfect competition, prices are the same for buyers and sellers.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Equilibrium Price Equilibrium Price: Price where supply and demand cross

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Price and Equilibrium In many cases the price can be set lower than the equilibrium price.  This will give you excess demand. In many cases the price can be set higher than the equilibrium price.  This will give you excess supply. An equilibrium quantity occurs when the buyers and sellers are in complete agreement over how much should be produced.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.8. A price lower than the equilibrium price leads to an excess demand. Excess demand leads to higher prices.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure 2.9. A price higher than the equilibrium price leads to an excess supply. Excess supply leads to lower prices.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Consumer, Producer, and Total Surplus Consumer Surplus: The happiness consumers get from their purchases; the area above price and below demand for all quantities purchased. Producer Surplus: The welfare of producers; the area above supply and below price for all quantities purchased. Total Surplus: Total societal welfare from the market. Consumer Surplus + Producer Surplus = Total Surplus

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure Consumer, Producer, and Total Surplus Under Perfect Competition

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Economic Model An Economic Model is a thought experiment where many complexities of human behaviors are ignored in order that one may concentrate on a few important relationships.  Can be expressed in words, as mathematical equations, or in graphs.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Example of a Mathematical Economic Model Given: Demand, MV: P = 120 – 8(Q) Supply, MC: P = (Q) P = Price; Q = Quantity Step 1: Both Supply and Demand Curves should correspond to the same price at the equilibrium quantity. 120 – 8(Q) = (Q) 120 – 20 = 2(Q) + 8(Q) 100 = 10(Q) Q – 100/10 = 10 Equilibrium Quantity = 10

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Example of a Mathematical Economic Model Step 2: Plug the equilibrium quantity into the supply or demand equation to calculate the equilibrium price. Demand: P = 120 – 8(Q) = 120 – 8(10) = 40 Supply: P = (Q) = (10) = 40 Equilibrium Price = 40

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure Equilibrium Price and Quantity Changes Any time the supply or demand curve shifts, there will be a corresponding change in the equilibrium price and quantity.

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. Figure Simultaneous Shifts in Supply and Demand

Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ All Rights Reserved. General Theory of Price Price is determined by:  Opportunity Costs of Production  Consumer Value  Negotiating Power  Psychological and Social Considerations