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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 -
product 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?
• 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 (real) value 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
DEMAND
• Negative relationship
• Law of demand:
consumers buy less as
the price rises, more as
it drops
QUANTITY SOLD
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: You shouldn’t sell products which are
sensitive to price changes.
• Reality: few products exhibit such tendencies
• Necessities are insensitive: gas, salt
• Higher prices = reduction in comsumer 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
P2
P1
P1
Q2 Q1
less sensitive to price increase
Q2
Q1
more 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 equals 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 have budgets (guidelines)
• 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: 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 goods
5) Change in population: increase = greater demand
6) Tastes and preferences: varies constantly
7) 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
REM: producers want to sell more
when the price is higher!
QUANTITY PRODUCED
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
• Perfect competition
Amt. DEMANDED OR PRODUCED
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”
• 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)
2)
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
Perishability: a constant problem
Aqua Business Supply
Characteristics
3)
4)
5)
Price changes wreck havoc on aquaculture markets (production)
Because these products are biological in nature (e.g., living things),
they are different from other commodities
a) this means there is little control by the farmer over what is
produced once production is under way
b) production levels are then often determined by weather and disease
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 Supply
What happens if the supply, Q, changes only slightly?
PRICE
S,
0
S,
1
P,0
P,1
D,0
Q,0
Q,1
QUANTITY PRODUCED
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.