Price Analysis & the Exchange Function

Anyone can be an economist. All you must learn are two words, Supply & Demand

Objectives
Use supply & demand diagrams to locate equilibrium prices & quantities . Explain some producer marketing problems using supply and demand curves. Demonstrate how the law of one price connects all prices in a market.

Distinguish between price determination and price discovery.

Role of prices

Overview of the role of prices

In a competitive economy the price system is expected to transmit signals to agents as how they should behave prices firm profits Qs prices signal to consumers to slow down Qd prices adjust to clear the market prices firm profits Qs prices signal to consumers to consume more Qd prices adjust to clear the market

Prices have the following jobs to perform:

guide food producers output and selling decisions guide consumption decisions transfers ownership so that once you pay the price you own the product guide marketing decisions over time, form, and space

Law of One Price

Under competitive market conditions, all prices within the market are uniform. Two parts: 1. Uniform price of a commodity 2. Costs of adding place, time, & form utility Helps us: 1. Determine the size of a market 2. Predict price changes within a market 3. Evaluate pricing efficiency of a market

Price determination (price formation)

forces of supply and demand establish a general equilibrium price for a commodity Theory of how markets work (different market structures) Market efficiency

Price Discovery
Process by which buyers and sellers arrive at a specific price (trial and error)
Two stage process: evaluating supply and demand to estimate a market clearing price Apply estimated price to a specific trade with adjustments for several factors

Types of Price Discovery

Individual, decentralized negotiations Organized, central markets Formula pricing systems Bargained prices Administered pricing systems

Supply & Demand

Supply & Demand Analysis

Demand buyers viewpoint A schedule of different amounts of a commodity that buyers will purchase at different prices Supply sellers viewpoint A schedule of different amounts of a commodity that sellers will offer at different prices

Law of Demand
The lower the price, the __________ will be purchased. The higher the price, the _________ will be purchased.
Why does it work? Consumers attempt to maximize satisfaction Limited incomes Many product alternatives

Derived Demand
The relationship of a demand schedule at one market level to a schedule at another market level. Farm demand for lamb Consumer demand for lamb chops

Derived Demand Curve for Lamb Chops

Law of Supply
The higher the price, the ________ will be offered for sale The lower the price, the ________ will be offered for sale
Quantity supplied vs. supply available

The Equilibrium Price

Where supply & demand are equal Established by forces of competition
A compromise between: Desires of sellers for a higher price Desires of buyers for a lower price

The Equilibrium Price

Buyers market Supply is above the equilibrium price More is supplied than is demanded Sellers must cut their prices Sellers market Supply is below the equilibrium price Less is supplied than is demanded Buyers bid up the price

Prices and the Market Mechanism

Movements Along Supply & Demand Curves

Price increase Producers ____ production Quantity supplied ____ Consumers ____ consumption
Price decrease Producers ____ production Quantity supplied ____ Consumers ____ consumption Changes in the quantity supplied & quantity demanded

Change in Demand versus a Change in Quantity Demanded

Change in Supply versus a Change in Quantity Supplied

Demand Shifters 1. Population 2. Income 3. Tastes & preferences 4. Prices of substitutes 5. Expectations of price

Supply Shifters Technology Price of inputs Government policies/constraints Random events Expectations of future prices Costs of production

Price Elasticity

Own Price Elasticity

Price elasticity of demand how much buyers quantity demanded will change when prices change Price elasticity of supply how much sellers quantity supplied will change when prices change Depends on the number of substitutes

Own Price Elasticity of Demand

Own Price Elasticity of Demand

Unit elastic demand curve changes in quantity taken are proportional to the changes in price. Elastic demand curve changes in quantity taken are proportionately greater than the changes in price. Inelastic demand curve changes in quantity taken are proportionately less than the changes in price.

Elasticities of Demand

Own Price Demand Elasticity (Ed)

Inelastic Demand % Qd < % Price
Most Farm Commodities

Elastic Demand % Qd > % Price

Many Retail Food Products

Unitary Elastic Demand % Qd = % Price

Other Elasticities Income Elasticity (Einc):

Einc = % Qd / % Income Einc>1, Luxury goods (restaurant dinner) 0>Einc>1, Normal goods (most food commodities) Einc<0, Inferior goods (potatoes, pulses)

Cross Elasticity (Exy):

Exy = % Qd of X / % Price of Y If Exy>0, X and Y are substitutes (coffee & tea) If Exy<0, X and Y are complements (coffee & milk)

Cross Elasticity of Demand

The effect of a price change of one commodity on the quantity demanded of another product. Substitutes alternatives Price increase in one, ____ quantity demanded of other Price decrease in one, ____ quantity demanded of other Complements eaten together Price increase in one, ____ consumption of other Price decrease in one, ____ consumption of other

Own Price Demand Elasticity & Total Revenue

eg a 10% cut in prices
Unit elastic demand Quantity purchased ___ Total revenue ____ Elastic demand Quantity purchased ___ Total revenue ____ Inelastic demand Quantity purchased ___ --Total revenue ____

Own Price Demand Elasticity Total Revenue Different market level

Own Price elasticity and Total Revenue

inelastic demand: increased production decreases price > change in volume revenues decline elastic demand, increased production decreases price < change in volume revenues increase

unitary elasticity there will be no change in total revenue

Price Elasticity and Total Revenue

Elastic Price Increase TR

Inelastic TR

Unitary TR=K

Price Decrease

TR

TR

TR=K

Most farm products

Price Elasticity & Total Revenue

TR = P x Q
Elastic demand P and TR inversely related Inelastic demand P and TR directly related

Demand Elasticity & Total Revenue

1. Will a large crop return more money to growers than a small one, even though prices are lower? 2. What will be the effect of restricting output on the total returns from sales?
3. Should a food store lower its prices to sell more product?

Demand Elasticity at Different Market Levels

P More elastic

Hamburger
All Beef Q

All Food

All Meat

Retail & Farm Price Elasticity

Price Elasticity of Supply

Elastic supply curve commodities are very responsive to price changes. Inelastic supply curve commodities respond very little to price changes.

Time is an important factor. Short run Intermediate term Long run

Elasticity of Supply

Long and short run (time) market supply curves

Characteristics of Ag Supply and Demand

In

agriculture demand and supply are both inelastic This lack of responsiveness has a number of implications:

1. Instability of farm prices 2. Rightward supply shifts cause revenues to decline

Large crop penalty / small crop reward Technological improvements cause real prices to decline Inelastic demand provides farmers with a powerful incentive to restrict output generally this requires some form of government Intervention eg: govt supply management

Applications of Supply and Demand

Why Are Farm Prices So Unstable? Why Large Crop Penalty, Small Crop Reward? Who Benefits From New Farm Technologies? Why Is Supply Control So Important In Agriculture? Who Benefits From Price Floors and Ceilings?

Instability of Farm Prices

Which is more variable, farm prices or nonfood prices? Why? Inelastic supply & demand curves Weather, disease, and pests influence supplies

Prices drop => TR drops Prices rise => TR rises Complicates investment planning

Inelastic Demand and Supply: Instability

The

shocks can either be from supply or demand sides Supply shocks can involve a grouping of droughts across several regions

Large Crop Penalty, Small Crop Reward

Why are farmers punished in the marketplace when they produce good yields & high output? Drought is good for farmers. Lower yields shifts supply _______ Farm income ____ High yields shift supply _______ Farm income ____

Cost Reducing Farm Technology

Who benefits? New technology shifts supply _______ Farm income ____ Benefits are passed on to consumers Early innovators

Shifts in Supply and Demand

Technological change is shifting the supply curve to the right Income and population growth shift demand curve to right

Supply Control
Inelastic demand curves give incentive to restrict output. Shift supply left Raise total revenue

Difficult because: Farmers increase production when prices rise Free riders Requires government authority

Effects of Supply Restrictions on Gross Farm Income

Price Ceilings & Floors

Price ceiling legally set price below the equilibrium level Supply shortage Black markets, rationing, out-of-stock

Price floor legally set price above the equilibrium level Supply surplus Store, dump, sell in non competing markets

Effect of Food Price Ceilings and Floors

Food Price Dilemma

Dilemma help one, hurt the other Price supports/floors Help farmers at expense of consumers

Price ceilings Help consumers at farmers expense

Free/low cost imports to suffering countries Increase food supply => Decrease incentive to produce Teach a man to fish or give a man a fish

Relationship of Prices to Costs

Low prices & profits in farming cure themselves Long run: Lower prices Reduced output => Higher prices Higher profits => Increased output

Short and Long Run Effects of a Shock

Summary
Prices direct & coordinate decisions of producers, consumers, & marketing firms. Prices are the result of supply & demand forces. Supply & demand analysis can help understand pricing forces and predict the effects of market changes on prices. Farm prices tend to return to the equilibrium point when disturbed. In the short-run, farm & food products have an inelastic demand & supply, so farm prices & incomes tend to be highly variable. There are several ways to discover prices.