Lecture 5: Supply and Demand

Lecture 5: Supply and Demand

Understanding Consumer: Demand

• “What is best in life?” The sun on your face, the wind in your hair??

• Wrong!!

• “Crush your enemies, see them driven before you, and here the lamentations of the women??”

• Okay..it worked for Conan the Barbarian, but what does that philosophy have to do with modern business.

• Actually, quite a bit…

Understanding Consumer: Demand

• Longe term profit and customer satisfaction are key.

• Achieved by setting an acceptable price

• Lower price = more purchases (consumption)

• Lower input $$ + higher $$ paid by consumer = more profit

The Profit Equation/Total Revenue (TR)

• Profit = total revenue - total cost (or price paid - production cost)

• Must max. diff. between TR and total costs.

• TR = price/unit x quantity sold (this drives profit potential)

• Simple goal: high TR = sell fewer units @ $$$$!

• How? Depends on product!!

Price - Where to Start?Price - Where to Start?

• The lowest price is equal to the cost per pound, including fixed and variable costs.

• The highest price is what you could talk desperate people into paying (prawn buyers: good example).

• The lowest price is equal to the cost per pound, including fixed and variable costs.

• The highest price is what you could talk desperate people into paying (prawn buyers: good example).

Total Revenue: Demand Schedules

• Fair market value (true market value in autos) is most often found between extremes!

• They are driven by cost factors and consumer perceptions

• As price and quantity fluxuate, total revenue rises and falls, or…

• “Demand Schedule” -- it shows marketers how much the consumer is willing to pay at each price shown.

Normal Demand Schedule

• Higher price = fewer sold

• Negative relationship

• Law of demand: consumers buy less as the price rises, more as it drops QUANTITY SOLD

PR

ICE

DEMAND

Demand, Total Revenue and Price Changes

• Managers should be concerned about revenue when a price changes.

• As prices increase, quantity sold/available decreases, but so does TR!

• Whats’ important: size of change• At low prices, consumers are not very

sensitive to price increases (i.e. US postal stamps)

• At high prices, consumers are very sensitive to price increases and don’t buy as much.

Total Revenue and Price Changes: Practical Steps

• You must understand how demand for a product is influenced by price

• If demand will not change much within a certain price range, raising the price would likely increase revenue, right??

• Must know consumer sensitivity to price change.

• This knowledge allows you to set pricing policy to achieve long-term profit increases.

Total Revenue and Price Changes: Products

• Conclusion: Don’t sell products which are sensitive to price changes.

• Reality: few products exhibit such tendencies

• Necessities are insensitive: gas, salt

• Higher prices = reduction in consumer purchases

• Long term result?

Total Revenue and Price Changes: Products

• Using lower-priced substitute (or generics).

• Demand slopes flatten as items become more price sensitive

Demand and Price Sensitivity

P2

P1

Q2 Q1

P2

P1

Q2 Q1

more sensitive to price increaseless sensitive to price increase

Total Revenue and Price Changes: food

• In general, the quantity of food purchased is not very sensitive to price

• For specific food items, quantity demanded is sensitive to price because of high potential for substitution!

• The more specific, the more sensitive

Total Revenue and Price Changes: food

• A good example is shrimp and its substitutes (prawn, crayfish)

• Also dependent upon consumer preferences

Consumer Demand: guidelines

• Free market economy: customer directs production through purchases:– 1) We buy what satisfies us!– 2) However, more and more = less

satisfaction.

• Example: First piece of pizza (great), 5th piece (not as great), i.e. you have less satisfaction.-satisfaction level maintained by ordering a salad, breadsticks, vs. one pizza.

Role of Price in Demand

• Even the richest people (companies) have budgets (guidelines)

• But, they are still after greatest satisfaction for least cash...

• Ergo, price helps consumers/producers maximize finite resources.

• Further, a producer’s demand for inputs is related to the consumer’s demand for products

• This applies to firms linked together in the agribusiness system (i.e., they are all linked together by demand)

Factors Influencing Consumer Demand

(changers)1) Own price (price to own): the price of the item studied

(shrimp)

2) Substitute price: item that could be substituted as price of original increases (prawn)

3) Complement price: item that is often sold or used in conjunction with original (batteries for flashlight)

4) Income: people tend to trade-up for better goods5) Change in population: increase = greater demand6) Tastes and preferences: varies constantly7) Seasonality: demand influenced by time of year (e.g.,

eggnog)

Demand Shifters

• Demand “shifters” factors which cause an increase/decrease in demand, but are not really price-related

• A “change” in demand occurs when the demand changes as a result of price

• If the own price increases and the amount of product sold decreases, the change in sales is a result of the law of demand

• If product sold simply increases without a change in price, it is a shift—can work both ways (up or down)

Examples of Demand Shifters:

• price of substituted goods• price of complementary goods• income• population• taste and preference• seasonality• Summary: managers must stay on

guard!

(2) Supply: strongly linked to production

• Aquaculture produces goods and services sold to others using materials, equipment, buildings, trucks, people, (inputs)

• Managers use production inputs to create an output have economic value (fish, shrimp, plants, etc.)

• Outputs can be commodities, a service or a food product

• Services can also be inputs (e.g., accounting)

Supply: Production Decisions

• Decisions: what, how to, how much, when—depends on demand (and cost) of inputs (efficiency)

• Technological efficiency is having a high efficiency of output per input at all levels of input use

• After this is achieved, economic efficiency to achieve the highest level of profit is undertaken

• Rem: If you can’t grow a fish efficiently, it may not matter what your selling price might be; you still could loose!!

Supply & theProduction Function relates

• REM: the production function is a graph showing the output possible at various levels of input

• The amount of production is shown as a line called Total Physical Product (TPP)

• Low input and output quickly rises, eventually, adding more inputs decreases efficiency

• Curves can be drawn for each input type

Supply: the measurement of costs

• Costs can be separated as either those occurring as the result of passage of time or the undertaking of production

• fixed costs come with the passage of time and do not change with production level

• variable costs change with level of production

• fixed costs (time): insurance, tax, rent, labor (permanent)

• variable costs (production level): materials, shipping, packing, labor (seasonal)

Determination of Economic Efficiency: Law

of Supply• As we recall the production function, max.

profit occurs before highest input efficiency or highest output

• Rem: Max. profit is measured by input cost compared to profit revenue

• Max. profit means monitoring cost of production and price received for output

• The greatest worry is usually selling price

Law of Supply

• If the selling price drops too low the business will not make a profit.

• Law of Supply: as price increases, more product is produced or sold!

• Huh??

• At low price, only the lowest-cost producers can survive (foreign tilapia producers, vietnamese basa)

• Product is then kept on the market only for visibility

Typical Supply Schedule

QUANTITY PRODUCEDQUANTITY PRODUCED

PR

ICE

REM: producers want to sell more REM: producers want to sell more when the price is higher!when the price is higher!

More on Law of Supply

• Increased selling price = more product produced, more sellers

• Not only price, but other factors affect supply

• Changes in prices of other goods• Expectations of future selling price (grains)• Number of sellers in the market• Changes in production costs• Consumer must expect the opposite to occur

3) Matching Supply and Demand

• Price plays an important part in the use of finite resources/raw materials

• Changes in price cause quantity demanded or supplied to change!

• Constant change in price and factors affecting demand/supply, result in changing curves.

• If this is the case, we realize that price is determined by the interaction of demand and supply

Price Determination

• Where supply and demand curves intersect is a point known as price determination

• Here demand and supply are in balance

• No surplus, no shortage

• i.e., Perfect competition! Amt. Amt. DEMANDED DEMANDED OR OR PRODUCEDPRODUCED

PR

ICE

Price Discovery

• Price determination seems logical; however, supply and demand curves are very seldom based on data, usually estimates

• This doesn’t reflect the real world market.

• Price discovery: price is typically negotiated: haggling wherein neither party is fully informed regarding supply and demand

• Your ability to arrive at the general price level is determined by information available and your bargaining ability (car sales)

Maintaining Balance

• Economists like to consider commodities or products as having a basic, fundamental price

• Price differences are only the result of adjustments made for handling (storage, transport and processing)

• Called the Law of One Price• If prices differ after taking adjustments into

consideration, the price is said to be “out of line”“out of line”• When this happens, there is an incentive to shift

from an area of low prices to one of higher prices

Maintaining Balance

• The Law of One Price states that cost of storage (time), place (transport costs) and form (raw vs. processed costs) is the difference in estimated future price of seasonal markets

• If true, the present and future markets are said to be in balance

Understanding Aqua Markets

• As usual, aquaculture is different…ugh, fish!!

• What special characteristics do these products possess?

1) Physical characteristics: bulky (water), low in value per unit freight, produced in areas remote from consumers, seasonal supply. Thus, transportation costs for these products are typically high

2) Perishability: a constant problem

Aqua Business Supply Characteristics

3) Price changes wreck havoc on aquaculture markets (production)

4) Because these products are biological in nature (e.g., living things), they are different from other commoditiesa) this means there is little control by the farmer over what

is produced once production is under wayb) production levels are then often determined by weather

and disease5) This means that the supply of these commodities is fairly

fixed between harvests, regardless of price (i.e., not changed by price)– however, small changes in supply cause big changes

in price

Aquatic Products SupplyP

RIC

EP

RIC

E

QUANTITY PRODUCED QUANTITY PRODUCED

S,0

S,1

D,0

P,0P,0

P,1P,1

Q,0Q,0 Q,1Q,1

What happens if the What happens if the supplysupply, Q, changes only slightly?, Q, changes only slightly?

Aqua Business Demand Characteristics

• Demand for ag/aqua products is usually stable year to year: can have seasonal changes

• Consumer demand for foods is a matter of habit: “hungry” vs. “full” has little impact

• Demands for specific foods is price sensitive due to availability of substitutes

• Demand is less sensitive the closer you get to the farm

• At the farm level, there are no substitutes

Intersection of Supply/Demand

• REM: price is determined in each market by intersection of supply and demand

• Yet, in ag/aqua markets, supplies are unstable and not very sensitive to price changes (except for seafood)

• Demand curves not typically sensitive to price changes (except for seafood, get the point?)

• Large supplies = lower price (manufacturers and consumers win)

Aquaculture Price Patterns

• Ag/aqua commodity prices can show variation in time

• Variation is due to the biological nature of food and consumption patterns

• Two variations: “seasonal price patterns” and “price cycles”

• Price cycles are long-term, give managers a basis for making long-term profit predictions (El Niño and anchovies)

Aquaculture Price Patterns

• For single-crop commodities, price is lowest during harvest, then steadily increases

• Lower crop yields during winter are when production costs are highest

• Seasonal demand also occurs (e.g., turkeys, prawn)

• When do you expand production? At bottom of peak

• Implications of indoor production: not as subject to seaonality.