Lecture 6: Understanding Agricultural Prices

Outline

 Extend the supply and demand model to incorporate specific features of agriculture to better understand agricultural prices    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

 Most agricultural markets are close to perfect competition  The supply and demand framework is applicable to describe the general behavior of agricultural prices  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

 Successful agribusiness develop their strategies with a long-run view   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  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 …

  

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  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  Adjustments – Acquire education or training to increase income level

Changes in Long-run Supply and Demand …

   Over many years, prices are due to changes in long-run supply and demand Changes in long-run supply   Due to changes in factors other than price of the commodity   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   Due to changes in factors other than price of the commodity   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 …

 Change in long-run supply of corn   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   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

   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   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

Price

Seasonality …

Harvest 2008 Harvest 2009 Harvest 2010  The price of a crop should continually rise between harvests

Seasonality …

U.S. Corn prices between harvests

1 0 3 2 6 5 4 Nov Dec Jan Feb 2010 Mar Apr May 2009 Jun Jul Aug 2008 Sep Oct

Seasonality …

 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.

 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   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

   Some aspects of agricultural prices are not predictable and appear somewhat random  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 …

 Because of temporary demand and supply shocks  The market temporarily deviates from the long-run price trend  Positive Supply Shock: Unexpected temporary increase in supply – temporary price decrease  Negative Supply Shock: Unexpected temporary decrease in supply – temporary price increase  Positive Demand Shock: Unexpected temporary increase in demand – temporary price increase  Negative Demand Shock: Unexpected temporary decrease in demand – temporary price decrease

Market Adjustments

 After a temporary demand or supply shock, the market has to rediscover the long-run equilibrium, and that search can be long and wild.  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 …



The Cobweb Model

:   There is production Lag Producers make production decisions for the futures based on current prices

P S D Q

Price Cycles

  Agricultural prices, especially livestock prices are known for exhibiting price cycles beyond that explained by seasonality.    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   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 …

      Assume that an external shock drives cattle prices below the long run 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 …

      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 …

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