Lecture 6: Understanding Agricultural Prices

1. Lecture 6: Understanding Agricultural Prices

2. 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

3. 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

4. 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

5. Changes in Long-run Supply and Demand … • Long-Run: The long runis 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

6. 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)

7. 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

8. 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

9. Seasonality … Price • The price of a crop should continually rise between harvests Harvest 2008 Harvest 2009 Harvest 2010

10. Seasonality …

11. 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.

12. 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

13. 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

14. 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 • Beef production – 2 years • Pork production – 1 year • Chicken – 6 weeks Price Shock Long-run eq. price Time

15. Market Adjustments … • The Cobweb Model: • There is production Lag • Producers make production decisions for the futures based on current prices P S D Q

16. 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

17. 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.

18. 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.

19. Price Cycles … • 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. Price Expansion Contraction Time