Transcript Understanding Agricultural Prices

Lecture 6:
Understanding Agricultural Prices
Outline
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Extend the supply and demand model to incorporate
specific features of agriculture to better understand
agricultural prices
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Identify the determinant of agricultural price change
Show how to construct time-series diagrams in the presence
of seasonality, market shocks, and production lags
Review the causes and nature of price cycles
Understanding Agricultural Prices
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Most agricultural markets are close to perfect competition
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The supply and demand framework is applicable to describe
the general behavior of agricultural prices
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Changes in agricultural prices are caused by
 Changes in long-run supply and demand
 Seasonality
 Supply and demand shocks
 Market adjustments
 Price cycles
Changes in Long-run Supply and Demand
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Successful agribusiness develop their strategies with a long-run
view
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Livestock producers/processors build expensive production
facilities based not only on expected prices next year, but on the
expected prices for the next several years
During 2003-05 beef price rose to historical high, and cattle
business was more profitable than ever
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Should cattle producers expand their herds to produce more cattle?
Should others enter the business to take advantage of the high
prices?
It depends on the reasons for high prices during that period
 The price increase was due to import ban for BSE scare
Changes in Long-run Supply and Demand …
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Long-Run: The long run is the conceptual time period in
which there are no fixed factor of production as to changing the
output level and entering or leaving an industry.
Long-run supply curve tells us how much firms will produce
at each price level, given long enough time to adjust production
level
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Adjustments - Increase/decrease the plant size, adopt new technology
Long-run demand curve tells us how much consumers will
purchase at each price level, given long enough time to adjust
their consumption level
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Adjustments – Acquire education or training to increase income level
Changes in Long-run Supply and Demand …
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Over many years, prices are due to changes in long-run
supply and demand
Changes in long-run supply
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Due to changes in factors other than price of the commodity
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Technological Change, change in the supply of land for agriculture
Change in weather pattern (global warming), soil quality, or water supply
Long-run supply shifts to the right (increase) or left (decrease)
Changes in long-run demand
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Due to changes in factors other than price of the commodity
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Change in average income level, change in preferences, availability of
substitutes
Change in weather pattern (global warming), soil quality, or water supply
Long-run demand shifts to the right (increase) or left (decrease)
Changes in Long-run Supply and Demand …
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Change in long-run supply of corn
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Over the years, technological improvements have made
producing corn less expensive
The long-run supply curve for corn keeps shifting right, causing
a downward trend in price and an upward trend in production
Change in long-run demand for beef
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Over the years, consumer demand for beef has fallen, probably
due to health concern
The long-run demand curve for beef keeps shifting left, causing
a downward trend in beef price and production
Seasonality
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Agricultural production depends on sunlight, and the sun
shines brighter during some seasons than other
The impact of seasonality is most obviously seen in crop
production
Our primary crops – corn, wheat, and soybeans – produce
seeds only once in a year
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We harvest once in a year and store the grain for continual
consumption until the next harvest
Indifference principle – Price of the grain should rise continually in the
months between harvests
 Theoretically, the price difference between months must equal
storage costs between months
Seasonality …
Price
Harvest 2008
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Harvest 2009
Harvest 2010
The price of a crop should continually rise between harvests
Seasonality …
U.S. Corn prices between harvests
6
5
4
3
2
1
0
Nov
Dec
Jan
Feb
2010
Mar
Apr
May
2009
Jun
Jul
Aug
2008
Sep
Oct
Seasonality …
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Although, indifference principle suggests that prices of grain
should rise continually in the months between harvests, the
seasonal prices of most crops follow an upside-down U-shape
pattern.
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Prices rise in the months following harvest, but then begin falling the
months before the next harvest
Livestock prices also exhibit seasonality, especially cattle prices
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Feeder cattle prices are highest during Feb-Apr. – because it costs more
to raise calves born in late summer or early fall.
Feeder cattle prices are lowest during Fall months (Sep-Oct.) – because it
costs less to raise calves born in winter.
Market (Supply – Demand) Shocks
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Some aspects of agricultural prices are not predictable and
appear somewhat random
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U.S. corn experienced an extraordinary period of high prices
during 1974-76 – caused by a large wheat failure in the USSR.
One-sixth of the U.S. wheat crop was exported to the USSR –
increasing the domestic demand for corn
Supply Shock – Low wheat production in the USSR
during 1974-76, due to a drought
Demand Shock – Increase in export demand for U.S.
wheat during 1974-76
Market (Supply–Demand) Shocks …
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Because of temporary demand and supply shocks
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The market temporarily deviates from the long-run price trend
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Positive Supply Shock: Unexpected temporary increase in
supply – temporary price decrease
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Negative Supply Shock: Unexpected temporary decrease in
supply – temporary price increase
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Positive Demand Shock: Unexpected temporary increase in
demand – temporary price increase
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Negative Demand Shock: Unexpected temporary decrease in
demand – temporary price decrease
Market Adjustments
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After a temporary demand or supply shock, the market has to
rediscover the long-run equilibrium, and that search can be
long and wild.
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The reason is that agricultural production experience production lags
 Crop production – 1 year
Price
 Beef production – 2 years
 Pork production – 1 year
Shock
Long-run eq. price
 Chicken – 6 weeks
Time
Market Adjustments …
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The Cobweb Model:
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There is production Lag
Producers make production decisions for the futures based on current
prices
P
S
D
Q
Price Cycles
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Agricultural prices, especially livestock prices are known
for exhibiting price cycles beyond that explained by
seasonality.
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Prices go up, then go down – those ups and downs are partially
predictable
The cattle cycle lasts for about 10 years
The hog cycle lasts about 4 years
Market shocks occur all the time in agriculture
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When a shock occurs, price over- and undershoots the long-run
equilibrium value as it discovers long-run equilibrium
The magnitude of this over- and undershooting dampens with time
and , and the price settles back to its long-run value
Price Cycles …
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Assume that an external shock drives cattle prices below the longrun equilibrium.
As soon as the shock is over, cattle price starts rising.
Cattle producers respond to the rising price by planning to produce
more cattle – retaining more animals for breeding
This is called the expansion phase because producers are expanding
their breeding stocks to produce more cattle in future
As fewer cattle are available for slaughter (more are being retained
for breeding), cattle price goes further up
Eventually, the price surpasses the long-run equilibrium, production
of cattle exceeds the long-run equilibrium quantity, and beef floods
the grocery stores as more cattle are slaughtered.
Price Cycles …
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Price must fall to entice consumers to purchase the excess beef
supplied in the market
As the price falls, cattle producers respond by planning to produce
less cattle in future – reducing the breeding stock (by selling some
of the breeding animals)
This is called the contraction phase because producers are
liquidating their breeding stocks to produce less cattle in future
As the breeding stock hits the market, more cattle are available for
slaughter (excess supply) and cattle price goes further down
Eventually, the breeding stock falls to a new low, the quantity
supplied of beef falls short of quantity demanded, and consumers
bid up the price of beef again
The price begins its ascent and the cycle repeats itself.
Price Cycles …
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Price
Effect of price cycle on profits – producers make profits during the
years of prices higher than the long-run equilibrium, and makes
losses in the years of prices lower than the long-run equilibrium.
Expansion
Contraction
Time