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AGEC 452AGRICULTURAL MARKETING (II) VERTICAL MARKETS Derived Demand and Derived Supply Retail Market Farm Market Consumer Demand (Retail Demand) (Retail Supply ???) (Farm Demand ???) Producer Supply (Farm Supply) Derived Demand and Derived Supply Earlier we discussed consumer demand in the retail market and farm supply in the farm market. Obviously, there are buyers of farm raw products in the farm market. This is called the derived demand. Likewise, there are sellers of consumer food items in the retail market. This is called the derived supply. Derived Demand and Derived Supply Retail Market Primary Demand (Retail Demand) Derived Supply (Retail Supply) Derived Demand (Farm Demand) Farm Market Primary Supply (Farm Supply) What are the properties of the derived demand and what are the properties of the derived supply and what are their relationship? Expressing Quantities on an Equivalent Basis It is possible to directly compare demand curves at the retail and farm levels of the marketing system only if we express the quantities at one level in terms of quantities at the other level. For example, if we want to compare the demand for Wagashi with the farm-level demand for milk, we need to know that it takes 9.9 pounds of raw milk to manufacture one pound of Wagashi. Then, we can express quantities at both levels in terms of either the farm-level equivalent or retail-level equivalent. Derived Demand P Given our ability to express demand in terms of equivalent quantity units, we can draw demand curves for the two market levels on the same diagram. The difference between these two demand curves reflects the marketing costs associated with each quantity of product demanded. Primary Demand (Demand at Retail Level, DR ) PR PF Derived Demand (Demand at Farm Level, DF ) Qs , Qd Marketing Costs Derived Supply P Likewise, the difference between the two supply curves reflects the marketing costs associated with each quantity of product supplied. Derived Supply (Supply at Retail Level, SR ) PR PF Primary Supply (Supply at Farm Level, SF ) Qs , Qd Marketing Costs Marketing Margins: Marketing Cost SR P SF PR Marketing Margin It accounts for the costs of a collection of services that is rendered between the farmers and the consumers. PF DR DF QR = Q F QR must equal to QF Qs , Qd The Price of Marketing Services Marketing margin accounts for a collection of services that is rendered. These services include the provision of: Labor capital land/facility/materials entrepreneurship As such, marketing margin accounts for: wages (as a return to labor) interest (as a return to capital) rent (as a return to land/facility/materials) "normal" profit (as a return to entrepreneurship) In other words, marketing margin is: The Price of Marketing Services Like prices of any other commodities, the price of marketing service is determined by its demand and supply schedules. price of marketing services supply of marketing services PMS demand of marketing services This equilibrium price of marketing services is, in turn, the marketing margin of the agricultural market that we are investigating. QMS quantity of marketing services Marketing Service Demand Shifter PMS For a given market volume of the underlying commodity (e.g., beef), there is a demand curve for marketing services. If there is an increase in market volume of the underlying commodity (e.g., beef), the demand curve for marketing services will shift to the right. Thus, the equilibrium price of marketing services will increase. SMS P"MS P'MS D"MS D'MS Q'MS Q"MS That is, there will be an increase in the marketing margin in the market of the underlying commodity (e.g., beef). QMS Marketing Service Supply Shifter PMS If there is an increase in the cost of providing marketing services (e.g., an increase in the transport costs), the supply curve of marketing services will shift to the left. S"MS S'MS P"MS P'MS Thus, the equilibrium price of marketing services will increase. That is, there will be an increase in the marketing margin in the market of the underlying commodity (e.g., beef). DMS Q"MS Q'MS QMS Effects of a change in Marketing Margin SR P Consider the case where transportation rates in the marketing service sector increase. Because transportation is an important component of food marketing, it means that the marketing margin is increased. Obviously, the positions of some supply and demand curves have to change to make allowance for the increased marketing margin. SF PR PF DR DF QR = QF Which curves have to be shifted? Qs, Qd Effects of a change in Marketing Margin SR P Since we are holding constant prices of other goods, income, population, and SPPD, no shift can occur in the primary demand curve. Similarly, since we are holding constant the prices of inputs, prices of alternative outputs, and CAP, no shift can occur in the primary supply curve. Hence, the only way to make room for the increased marketing margin is to have: SF PR PF DR DF QR = QF (1) the derived demand curve shifts down (left), (2) the derived supply curve shifted up (left). Qs, Qd Effects of a change in Marketing Margin SR P No shift can occur in the primary demand curve. No shift can occur in the primary supply curve. Hence, the only way to make room for the increased margin is to have: (1) the derived demand curve shifts down (left), (2) the derived supply curve shifted up (left). SF P’R PR PF DR P’F DF Q’ Q Qs, Qd Thus: the retail price rises, the farm price falls, and the market volume decreases. Sharing the Burden: Equally? With an increase in marketing margin: the retail price rises, the farm price falls, and the market volume decreases. The marketing cost increase is shared by both: consumers (in the way of paying a higher retail price) and farmers (in the way of receiving a lower farm price). But, would the burden of marketing cost increases be shared equally by the two groups? Not necessarily. The answer depends on the relative magnitude of retail demand and farm supply elasticities. Sharing the Burden: Elasticity Matters The more inelastic demand is in relation to supply, the greater the impact on retail prices relative to farm prices. This is because since the retail quantity is less responsive to a price change, the retail price must bear most of the burden of the cost increase. On the other hand, the more inelastic supply is in relation to demand, the greater the impact on farm prices relative to retail prices. In this case, the farm quantity is less responsive to a price change and, hence, the farm price takes most of the heat. In-Class Exercise 3a Consider the vertical market discussed in class. Suppose there is a reduction in the transportation rate in the marketing service sector. What would be the effect on the price of marketing services? What would be the subsequent effects on the farm sector: i.e., on the retail price, farm price, and market volume? Which of the two prices would be affected more by the incidence? Work Space for Exercise 3a SR P SF No shift can occur in the primary demand curve. No shift can occur in the primary supply curve. Hence, the only way to adjust for the decreased margin is to have: PR P’R P’F PF DR Q’ DF Q (1) the derived demand curve shifts up (right), (2) the derived supply curve shifted down (right). Qs, Qd Thus: the retail price falls, the farm price rises, and the market volume increases. Effect of an Income Increase SR P SF Let's examine how a rightward shift in the primary demand curve is reflected through the market channel and how this shift affects the marketing margin. PR PF DR DF The rightward shift in the primary demand curve by itself will pull the derived demand curve to the right by the same amount if the original marketing margin were to remain the same. Q Qs, Qd It turns out that the equal-magnitude shift in the derived demand curve, DF, is an overkill. That is, the magnitude of the DF shift has to be smaller than the magnitude of the DR shift. SR The magnitude of the DF shift has to be smaller than the magnitude of the DR shift. Why? First, the rightward shifts in the demand curves result in a larger market volume. P SF PR PF DR DF PMS Q Second, with increased market volume, the price of marketing services must rise. SMS P"MS P'MS D"MS D'MS Q'MS Q"MS Qs, Qd QMS Finally, to allow for the increased marketing margin, the derived demand curve must shift back to the left somewhat. (Remember the previous example of the effects of an increased marketing margin.) Effect of an Income Increase SR P The demand curves shift to the right. Market volume increases. The demand for marketing services shifts to the right. SF P'R PR P'F PF DR Marketing margin increases. DF To allow for the increased marketing margin, the derived demand curve must shift back to the left somewhat. That is, it must not shift to the right as much as did the primary demand curve. Q Qs, Qd Remember from the previous problem that the increased marketing margin will also shift the derived supply curve to the left. Effect of an Income Increase SR P With an increase in consumer income: retail price rises, farm price rises, market volume rises, and marketing margin rises. SF P'R PR P'F PF DR DF As before, the relative magnitude of retail and farm price increases depends on the relative magnitude of retail demand and farm supply elasticities. Q Qs, Qd The more inelastic the curve, the larger is the price impact. In-Class Exercise 3b Consider the vertical market discussed in class. Suppose there is an improvement in the farm production technology. What are the effects on the retail price, farm price, market volume, and marketing margin? Hints: With the new technology, the primary supply curve will shift to the right. The derived supply curve will follow suit, but by a smaller magnitude (because it has to shift back to the left somewhat due to increased marketing costs). With increased marketing costs, the derived demand curve has to shift to the left as well. Work Space for Exercise 3b: Technology SR P The supply curves shift to the right. SF Market volume increases. PR P'R The demand for marketing services shifts to the right. PF Marketing margin increases. To allow for the increased marketing margin, the derived supply curve must shift back to the left somewhat. That is, it must not shift to the right as much as did the primary supply curve. DR P'F DF Q Qs, Qd Remember from the previous problem that the increased marketing margin will also shift the derived demand curve to the left. Work Space for Exercise 3b: Technology SR P SF With an improved technology: retail price falls, farm price falls, market volume rises, and marketing margin rises. As before, the relative magnitude of retail and farm price decreases depends on the relative magnitude of retail demand and farm supply elasticities. PR P'R PF DR P'F DF Q Qs, Qd The more inelastic the curve, the larger is the price impact.