OverviewOverview DemandDemand SupplySupply Underlying principlesUnderlying principles Factors impacting supply and Factors impacting supply and

demanddemand Special S&D curvesSpecial S&D curves Chapter 4 in textChapter 4 in text

DemandDemand Various quantities of a commodity Various quantities of a commodity

that an individual is willing and that an individual is willing and able to buy as the price of the able to buy as the price of the commodity varies holding all commodity varies holding all other factors constant.other factors constant.

Law of DemandLaw of Demand All else equal consumers will by All else equal consumers will by

more of a item at lower prices and more of a item at lower prices and buy less at higher prices.buy less at higher prices.

Demand begins with individual Demand begins with individual consumerconsumer

Inverse relationship between Inverse relationship between quantity and pricequantity and price• Two dimensional, Price and QuantityTwo dimensional, Price and Quantity

Downward Sloping Downward Sloping Demand CurveDemand Curve

Px

Qx

D

A

BPB

PA

QA QB

Downward sloping Downward sloping demanddemand

Begin with individual’s utility Begin with individual’s utility function and a budget constraintfunction and a budget constraint

Substitution effectSubstitution effect• consumers buy what’s cheaperconsumers buy what’s cheaper

Income effectIncome effect• ““income” increases if prices fallincome” increases if prices fall

Representation of Representation of DemandDemand

P Q

$6.00 2.0

$5.00 4.0

$4.00 6.0

$3.00 8.0

$2.00 10.0

$1.00 12.0

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

0.0 5.0 10.0 15.0Q

P

Q = 14 – 2xP

Market or Aggregate Market or Aggregate DemandDemand

Add individual demand curvesAdd individual demand curves Horizontally across consumersHorizontally across consumers http://www.aaec.vt.edu/rilp/Demandhttp://www.aaec.vt.edu/rilp/Demand

%20Changes-2000.pdf%20Changes-2000.pdf (Pages 1-10) (Pages 1-10)

Aggregate DemandAggregate Demand

Add horizontally across Add horizontally across consumers at each priceconsumers at each price

1 2 3 Market

Change in Demand orChange in Demand orin Quantity Demandedin Quantity Demanded

Px

Qx

D1 D2

A

B

Moving from A to B due to a price decline is a change in quantity demanded by moving along the same demand curve.

A shift in demand is a move from B to C as the curve shifts from D1 to D2

C

Factors that Cause a Shift in DemandFactors that Cause a Shift in Demand

Price of substitutesPrice of substitutes Price of complementsPrice of complements Consumer incomeConsumer income Taste and preferencesTaste and preferences IS NOT FUNCTION OF THE IS NOT FUNCTION OF THE

GOOD’S OWN PRICEGOOD’S OWN PRICE

Factors that cause a shift in Factors that cause a shift in aggregate aggregate demanddemand

PopulationPopulation ExportsExports Consumer incomeConsumer income AdvertisingAdvertising New informationNew information Product differentiation Product differentiation New product developmentNew product development Government interventionGovernment intervention

Observing Demand in Observing Demand in DataData

Each P and Q are an equilibrium Each P and Q are an equilibrium point where supply equals demand point where supply equals demand at a point in time.at a point in time.

Demand typically more stableDemand typically more stable As supply changes the demand As supply changes the demand

curve is traced outcurve is traced out

US Corn Price, US Corn Price, 1995-96 to 2004-05 Crop 1995-96 to 2004-05 Crop

YearsYearsCrop Year Quantity Price

1995-96 8974 3.24

1996-97 9672 2.71

1997-98 10099 2.43

1998-99 11085 1.94

1999-00 11232 1.82

2000-01 11639 1.85

2001-02 11416 1.97

2002-03 10578 2.32

2003-04 11190 2.42

2004-05 12780 1.95

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

0 2000 4000 6000 8000 10000 12000 14000

Quantity (million bu)

Pri

ce

($

/bu

)

US Corn Price, US Corn Price, 1995-96 to 2004-05 Crop Years1995-96 to 2004-05 Crop Years

US Soybean Price, US Soybean Price, 1996-97 to 2004-05 Crop 1996-97 to 2004-05 Crop

YearsYears

Crop Year Quantity Price

1996-97 2573 7.35

1997-98 2826 6.47

1998-99 2945 4.93

1999-00 3006 4.63

2000-01 3052 4.54

2001-02 3140 4.38

2002-03 2969 5.53

2003-04 2638 7.34

2004-05 3258 5.54

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

0 500 1000 1500 2000 2500 3000 3500

Quantity (million bu)

Pri

ce

($

/bu

)US Soybean Price, US Soybean Price,

1996-97 to 2004-05 Crop Years1996-97 to 2004-05 Crop Years

Retail Poultry Deflated Price and Consumption

$0.90

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

$1.80

35 45 55 65 75

75

77

76

72

70

71

73

74

85

84

8382

81

80

79

78

89

88

87

86

97

96

94

95

9392

91

90

98

Per Capita Consumption in Pounds

Pork Deflated Price and Consumption, Retail

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

$1.80

$1.90

$2.00

48 50 52 54 56 58

96

97

86

87

82

90

91 84

83

89

85

88

00 98

93

95

92

94

99

81 80

Per Capita Consumption in Pounds

Inverse Demand Inverse Demand

Price is a function of quantityPrice is a function of quantity• P = P = ff(Q)(Q)

Important in agricultureImportant in agriculture• Short run supplies are relatively fixedShort run supplies are relatively fixed

• Prices change to clear the marketPrices change to clear the market

SupplySupply

The amount of a given commodity The amount of a given commodity that will be offered for sale per unit that will be offered for sale per unit time as the price varies, other time as the price varies, other factors held constant.factors held constant.

Law of SupplyLaw of Supply

An economic principle that states: An economic principle that states: All else equal, producers are All else equal, producers are willing to sell more products at a willing to sell more products at a higher price than at a lower one.higher price than at a lower one.

Positive relationship between price Positive relationship between price and quantityand quantity

Curve slopes up and to the rightCurve slopes up and to the right

SupplySupply Derived from cost functionDerived from cost function

• Production functionProduction function

• Input - output relationshipInput - output relationship

Assume that firms seek toAssume that firms seek to• Maximize profitsMaximize profits

• Minimize costsMinimize costs

Supply starts will individual firmSupply starts will individual firm

Production FunctionProduction Function

Total Product

Input

Output

Increasing returns to the input

Decreasing returns to the input

Cost CurvesCost Curves Average variable cost = AVCAverage variable cost = AVC

• Total variable cost / QTotal variable cost / Q• Total variable costs change with QTotal variable costs change with Q

Average fixed cost = AFCAverage fixed cost = AFC• Total fixed cost / QTotal fixed cost / Q• Total fixed costs do not change with QTotal fixed costs do not change with Q

Average total cost = ATC Average total cost = ATC = AVC+AFC= AVC+AFC

Cost CurvesCost Curves

Marginal cost = MCMarginal cost = MC• Change in total cost by producing 1 moreChange in total cost by producing 1 more

• TC / QTC / Q

Cost curvesCost curves

Cost

Q

MC

ATC

AFC

AVC

Profit for the firmProfit for the firm

Profit = total revenue - total costProfit = total revenue - total cost• TR= P x QTR= P x Q• TC = ATC x QTC = ATC x Q

Profit per unit = Profit/QProfit per unit = Profit/Q• = TR/Q - TC/Q= TR/Q - TC/Q• = P - ATC= P - ATC

Profit maximizing QProfit maximizing Q• MC=MR=PMC=MR=P• Profit/Q = P-ATC at optimal QProfit/Q = P-ATC at optimal Q

Optimal Q at P=MCOptimal Q at P=MC

MC

ATC

AVC

P1

P2

Cost

QQ1 Q2

Cost curves and supplyCost curves and supply Operate if ATC > P > AVCOperate if ATC > P > AVC Shut down if P < AVCShut down if P < AVC

• Lose on every unit producedLose on every unit produced• P>AVC make some payment to fixed costP>AVC make some payment to fixed cost

In the long run everything is variableIn the long run everything is variable• Short run defined by having fixed costShort run defined by having fixed cost

Long run supply curve for individualLong run supply curve for individual• Low point on ATC curveLow point on ATC curve

Supply curveSupply curve

MC curve above AVC curveMC curve above AVC curve Upward sloping curveUpward sloping curve

• Optimal output @ MC = MROptimal output @ MC = MR

• MR = Price => Optimal at MC=PriceMR = Price => Optimal at MC=Price

• The last unit of input just pays for itselfThe last unit of input just pays for itself– The change in the cost of the last unit is equal to

the change in revenue of the last unit.

Example Cost Curves for Example Cost Curves for CornCorn

Units Fixed Variable Total AFC AVC ATC MC

130 160 186 346 1.23 1.43 2.66 0.60

140 160 193 353 1.14 1.38 2.52 0.75

150 160 202 362 1.07 1.35 2.41 0.90

160 160 214 374 1.00 1.34 2.34 1.15

170 160 228 388 0.94 1.34 2.28 1.40

180 160 246 406 0.89 1.37 2.25 1.80

190 160 269 429 0.84 1.41 2.26 2.30

200 160 298 458 0.80 1.49 2.29 2.90

210 160 334 494 0.76 1.59 2.35 3.60

220 160 378 538 0.73 1.72 2.44 4.40

230 160 433 593 0.70 1.88 2.58 5.50

240 160 498 658 0.67 2.07 2.74 6.50

250 160 574 734 0.64 2.29 2.93 7.60

Example Cost Curves for an Acre of Corn

$0.00

$1.00

$2.00

$3.00

$4.00

$5.0090

100

110

120

130

140

150

160

170

180

190

200

210

220

230

240

250

Yield in Bushels/AcreAFC AVC ATC MC

Market or Aggregate Market or Aggregate Supply Supply

Combination of individual supply Combination of individual supply schedulesschedules• Add horizontally across firmsAdd horizontally across firms

A B C Market

Market supply curves

Qx

Px S1 S2A

BC

Move from A to B is a change in quantity supplied due to a price decline.

Move from B to C is a shift in supply.

Supply Shifts from Supply Shifts from ChangeChange

in input pricesin input prices in returns for competing enterprisesin returns for competing enterprises in price of joint products in price of joint products in technology on yields or costsin technology on yields or costs in yield and/or price riskin yield and/or price risk institutional constraintsinstitutional constraints SUPPLY DOES NOT CHANGE DUE TO SUPPLY DOES NOT CHANGE DUE TO

A CHANGE IN PRICE OF THE A CHANGE IN PRICE OF THE OUTPUTOUTPUT

Following Supply ShiftFollowing Supply Shift

Firm level decision to supply Firm level decision to supply shiftershifter

Market impact of firms’ decisionMarket impact of firms’ decision Firm response to price reactionFirm response to price reaction

Supply Shift from Supply Shift from CostCost

D

Q Q

P1

Cost

MC1

MC2

Q2Q1

P2

Q1 Q2

S1S2

Firm Market

Steps to shift curvesSteps to shift curves

1.1. The impact changes the MC curve of the firm.The impact changes the MC curve of the firm.

2.2. The firm chooses output so that MC = MR.The firm chooses output so that MC = MR.

3.3. Market supply shifts.Market supply shifts.

4.4. Price moves along demand curve to new level.Price moves along demand curve to new level.

5.5. Repeat steps 2 - 4.Repeat steps 2 - 4.

Market supply curves Market supply curves flatten out over timeflatten out over time

Qx

PxSShort run

SLong run

Price and Costs in AgPrice and Costs in Ag Short runShort run

• Not necessarily a relationship between Not necessarily a relationship between cost and pricecost and price

• May be profit or lossMay be profit or loss Long runLong run

• Firms expand output to profits and Firms expand output to profits and reduce output to lossesreduce output to losses

• Average price = Minimum Long Run Average price = Minimum Long Run ATC ATC

Economies of scaleEconomies of scale Average total costs changes as the Average total costs changes as the

output of a firm changesoutput of a firm changes Increasing, decreasing or constant Increasing, decreasing or constant

economies of scale.economies of scale.• Short run cost curve (SRATC)Short run cost curve (SRATC)• Long run cost curve (LRATC)Long run cost curve (LRATC)

Change across rangeChange across range L-Shaped cost curveL-Shaped cost curve

Externalities and cost Externalities and cost curvescurves

Q

Cost

Cost or benefit not perceived by the Cost or benefit not perceived by the firmfirm

Internal cost curveInternal cost curve Cost curve if external cost includedCost curve if external cost included

Processing cost curvesProcessing cost curves

Specialized plants/equipmentSpecialized plants/equipment High fixed costHigh fixed cost Low flexibilityLow flexibility SRATC

Q

Cost

Weekly Prices and Slaughter, 1998-99

1.2

1.4

1.6

1.8

2.0

2.2

1 14 27 40 53 66 79 92 105

$10

$15

$20

$25

$30

$35

$40

$45Price

Slaughter

Million

Law of One PriceLaw of One Price

Definition: Under competitive Definition: Under competitive market conditions all prices within market conditions all prices within a market are uniform after taking a market are uniform after taking into account the cost of adding into account the cost of adding place, time, and form utility.place, time, and form utility.

Marketing Adds ValueMarketing Adds Value Time utility: StorageTime utility: Storage Form utility: ProcessingForm utility: Processing Place utility: TransportationPlace utility: Transportation Does the added value offset the added Does the added value offset the added

cost?cost? Is the cost the same for everyone?Is the cost the same for everyone?

Law of One PriceLaw of One Price

Reason the Law of One Price Reason the Law of One Price Works: ArbitrageWorks: Arbitrage• Profit seeking individuals acting in their Profit seeking individuals acting in their

own self interestown self interest– Sellers, Buyers, Middlemen

• Buy low and sell high for profit by Buy low and sell high for profit by changing time, space, and formchanging time, space, and form

Law of One PriceLaw of One Price

Arbitrage opportunitiesArbitrage opportunities• TransportationTransportation

• StorageStorage

• ProcessingProcessing

How much price difference is How much price difference is sustainable between the two markets?sustainable between the two markets?

Seasonal Grain PricesSeasonal Grain Prices

Storable commodityStorable commodity One harvest periodOne harvest period Used throughout the yearUsed throughout the year

Monthly Average Iowa Corn Prices, 1979-

80 Through 1999-00 Marketing Years

1.50

1.70

1.90

2.10

2.30

2.50

2.70

SEPOCTNOVDECJANFEBMARAPRMAYJUNJULAUG

TransportationTransportation

Products flow from surplus region Products flow from surplus region to deficient region.to deficient region.

Competing demand for surplus in Competing demand for surplus in some regions.some regions.

Transportation infrastructure Transportation infrastructure importantimportant

Aug 17, 2007 Corn Basis http://www.card.iastate.edu/ag_risk_tools/

Aug 17, 2007 Corn Basis http://www.card.iastate.edu/ag_risk_tools/

Grain Price MapGrain Price Map

CARD: Daily Corn and Soybean Basis Maps for Iowa

http://www.card.iastate.edu/ag_risk_tools/basis_maps/

Percent Change in Rail Rates for Selected Cities from Omaha or Chicago, June 2003 is Base

-20%

0%

20%

40%

60%

80%

100%

120%Ju

n-0

3

Oct

-03

Feb

-04

Jun

-04

Oct

-04

Feb

-05

Jun

-05

Oct

-05

Feb

-06

Jun

-06

Oct

-06

Feb

-07

Jun

-07

Oct

-07

Amarillo, TX

Sterling, CO

Dodge City, KS

Los Angeles, CA

Raleigh, NC

Athens, GA

Buffalo, NY

Corn Basis to Chicago Cash for Cattle Feeding Regions

-$0.30

-$0.20

-$0.10

$0.00

$0.10

$0.20

$0.30

$0.40

IowaElevators

OMAHA SWNE Dodge City NECO TX N ofCanadian

TX Triangle

91-95 96-00 '01-05 '06-07

Monthly average of daily prices'06-'07 is Jan '06 - Sep '07

So what???So what??? Short run price implicationsShort run price implications Supply chain managementSupply chain management Open market or contractOpen market or contract

• Packing plantsPacking plants• Ethanol plantsEthanol plants• Soybean processingSoybean processing• BiodieselBiodiesel